UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington, D.C.
20549





FORM
10-Q








(Mark
One)




[X]
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
      EXCHANGE ACT OF 1934





For the
quarterly period ended August 31, 2008




OR




[_]
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
      EXCHANGE ACT OF 1934





For the
transition period from ___________ to _______________




Commission
File Number 0-22182




PATRIOT
SCIENTIFIC CORPORATION


(Exact
name of registrant as specified in its charter)





Delaware
              (State
      or other jurisdiction of
              incorporation
      or organization)
            84-1070278
              (I.R.S.
      Employer Identification No.)





6183
      Paseo Del Norte, Suite 180, Carlsbad, California
              (Address
      of principal executive offices)
            92011
              (Zip
      Code)





(Issuer’s
telephone number): (760) 547-2700





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 Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES [X ] NO [  ]




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See definitions of “large accelerated filer,” “accelerated
filer” and “smaller reporting company” in Rule 12b-2 of the Exchange
Act.  (Check one):




Large
accelerated filer
[  ]                   
Accelerated filer
[X]                   
Non-accelerated filer
[  ]                   
Smaller reporting company [  ]




Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).




Yes
[  ]  No [X]




On
October 3, 2008, 409,721,630 shares of common stock, par value $.00001 per share
(the issuer’s only class of voting stock) were outstanding.







INDEX








PagePART
      I. FINANCIAL INFORMATIONITEM
      1. Financial StatementsCondensed
      consolidated Balance Sheets as of August 31, 2008 (unaudited) and May 31,
      2008
            3Condensed
      consolidated Statements of Operations for the three months ended August
      31, 2008 and August 31, 2007 (unaudited)
            4Condensed
      consolidated Statements of Cash Flows for the three months ended August
      31, 2008 and August 31, 2007 (unaudited)
            5Notes
      to condensed consolidated Financial Statements (unaudited)
            6-27ITEM
      2. Management’s Discussion and Analysis of Financial Condition and Results
      of Operations
            28-38ITEM
      3. Quantitative and Qualitative Disclosures About Market
    Risk
            39ITEM
      4. Controls and Procedures
            40PART
      II. OTHER INFORMATIONITEM
      1. Legal Proceedings
            41ITEM
      1A. Risk Factors
            42ITEM
      2. Unregistered Sales of Equity Securities and Use of
    Proceeds
            42ITEM
      3. Defaults Upon Senior Securities
            42ITEM
      4. Submission of Matters to a Vote of Security Holders
            42ITEM
      5. Other Information
            42ITEM
      6. Exhibits
            42-44SIGNATURES


2


PART I- FINANCIAL INFORMATION





Item 1. Financial
Statements





Patriot
Scientific Corporation


Condensed
Consolidated Balance Sheets





August
      31, 2008
            
            
            May
      31, 2008ASSETS
            
            (Unaudited)Current
      assets:Cash
      and cash equivalents
            
            $
            8,757,634
            
            
            $
            6,424,015Restricted
      cash and cash equivalents
            
            
            51,445
            
            
            
            51,122Marketable
      securities and short term investments
            
            
            89,761
            
            
            
            298,243Accounts
      receivable
            
            
            283,623
            
            
            
            538,500Accounts
      receivable - affiliated company
            
            
            6,780
            
            
            
            7,501Notes
      receivable
            
            
            824,843
            
            
            
            450,115Inventory
            
            
            741,884
            
            
            
            388,141Prepaid
      income taxes
            
            
            -
            
            
            
            222,311Deferred
      tax assets
            
            
            640,582
            
            
            
            1,390,832Prepaid
      expenses and other current assets
            
            
            291,971
            
            
            
            79,840Total
      current assets
            
            
            11,688,523
            
            
            
            9,850,620Marketable
      securities
            
            
            12,377,976
            
            
            
            12,527,675Property
      and equipment, net
            
            
            62,112
            
            
            
            68,504Deferred
      tax assets
            
            
            1,331,609
            
            
            
            -Other
      assets
            
            
            8,190
            
            
            
            8,190Investments
      in affiliated companies
            
            
            5,416,826
            
            
            
            2,913,614Patents and trademarks,
      net of accumulated amortization of $622,762 and $622,003
            
            
            41,013
            
            
            
            63,299Total
      assets
            
            $
            30,926,249
            
            
            $
            25,431,902LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilities:Accounts
      payable
            
            $
            639,367
            
            
            $
            555,690Accrued
      expenses and other
            
            
            327,477
            
            
            
            373,848Note
      payable
            
            
            140,592
            
            
            
            -Income
      taxes payable
            
            
            3,749,353
            
            
            
            -Total
      current liabilities
            
            
            4,856,789
            
            
            
            929,538Deferred
      tax liabilities
            
            
            -
            
            
            
            1,085,181Total
      liabilities
            
            
            4,856,789
            
            
            
            2,014,719Commitments and
      contingenciesMinority
      interest
            
            
            36,770
            
            
            
            115,406Stockholders’
      equity:Preferred
      stock, $0.00001 par value; 5,000,000 shares authorized: none
      outstanding
            
            
            -
            
            
            
            -Common
      stock, $0.00001 par value: 500,000,000 shares authorized: 410,979,163
      shares issued and 387,047,755 shares outstanding at August 31, 2008 and
      410,979,163 shares issued and 389,414,915 shares outstanding at May 31,
      2008
            
            
            4,109
            
            
            
            4,109Additional
      paid-in capital
            
            
            70,119,689
            
            
            
            70,004,814Accumulated
      deficit
            
            
            (30,553,844
            )
            
            
            (33,763,357
            )Common
      stock held in treasury, at cost – 23,931,408 shares and 21,564,248 shares
      at August 31, 2008 and May 31,
    2008,  respectively
            
            
            (13,227,943
            )
            
            
            (12,723,172
            )Accumulated
      other comprehensive loss
            
            
            (309,321
            )
            
            
            (220,617
            )Total
      stockholders’ equity
            
            
            26,032,690
            
            
            
            23,301,777Total
      liabilities and stockholders’ equity
            
            $
            30,926,249
            
            
            $
            25,431,902





See
      accompanying notes to unaudited condensed consolidated financial
      statements.





3




Patriot
Scientific Corporation


(Unaudited)





Three
      months endedAugust
      31, 2008
            
            
            August
      31, 2007RevenuesProduct
      sales and other
            
            $
            1,358,646
            
            
            $
            521,369Cost
      of sales
            
            
            584,253
            
            
            
            151,535Gross
      profit
            
            
            774,393
            
            
            
            369,834Operating
      expenses:Selling,
      general and administrative
            
            
            1,930,805
            
            
            
            1,958,190Settlement
      and license expense
            
            
            -
            
            
            
            30,000Total
      operating expenses
            
            
            1,930,805
            
            
            
            1,988,190Operating
      loss
            
            
            (1,156,412
            )
            
            
            (1,618,356
            )Other
      income (expense):Interest
      and other income
            
            
            112,846
            
            
            
            474,525Loss
      on sale of assets
            
            
            -
            
            
            
            (345
            )Interest
      expense
            
            
            (4,622
            )
            
            
            (237
            )Gain
      on sale of subsidiary interest
            
            
            -
            
            
            
            150,000Equity
      in earnings (loss) of affiliated companies
            
            
            6,558,770
            
            
            
            (1,200,542
            )Total
      other income (expense), net
            
            
            6,666,994
            
            
            
            (576,599
            )Income
      (loss) before income taxes and minority interest
            
            
            5,510,582
            
            
            
            (2,194,955
            )Provision
      (benefit) for income taxes
            
            
            2,379,705
            
            
            
            (232,569
            )Minority
      interest
            
            
            (78,636
            )
            
            
            -Net
      income (loss)
            
            $
            3,209,513
            
            
            $
            (1,962,386
            )Basic
      income (loss) per common share
            
            $
            0.01
            
            
            $
            (0.01
            )Diluted
      income (loss) per common share
            
            $
            0.01
            
            
            $
            (0.01
            )Weighted
      average number of common shares outstanding - basic
            
            
            388,132,502
            
            
            
            390,455,132Weighted
      average number of common shares outstanding - diluted
            
            
            388,650,596
            
            
            
            390,455,132




See
accompanying notes to unaudited condensed consolidated financial
statements.


4


Patriot
Scientific Corporation


Condensed
Consolidated Statements of Cash Flows


(Unaudited)


Three
      months endedAugust
      31, 2008
            
            
            August
      31, 2007Operating
      activities:Net
      income (loss)
            
            $
            3,209,513
            
            
            $
            (1,962,386
            )Adjustments
      to reconcile net income (loss) to net cash used in operating
      activities:Minority
      interest in variable interest entity
            
            
            (78,636
            )
            
            
            -Amortization
      and depreciation
            
            
            9,887
            
            
            
            11,322Non-cash
      compensation relating to issuance of stock options and vesting
      of  warrants
            
            
            114,875
            
            
            
            282,913Accrued
      interest income added to investments and notes receivable
            
            
            (7,389
            )
            
            
            (267
            )Equity
      in (earnings) loss of affiliated companies
            
            
            (6,558,770
            )
            
            
            1,200,542Loss
      on sale of assets
            
            
            -
            
            
            
            345Write-off
      of patent costs
            
            
            21,527
            
            
            
            -Deferred
      income taxes
            
            
            (1,605,545
            )
            
            
            (9,955,821
            )Gain
      on VIE sale of portion of subsidiary interest
            
            
            -
            
            
            
            (150,000
            )Reversal
      of tax effect of exercise of options
            
            
            -
            
            
            
            (25,645
            )Changes
      in operating assets and liabilities:Accounts
      receivable
            
            
            254,877
            
            
            
            (125,228
            )Receivable
      from affiliated company
            
            
            721
            
            
            
            -Inventory
            
            
            (353,743
            )
            
            
            (137,404
            )Prepaid
      expenses and other current assets
            
            
            (1,243
            )
            
            
            131,568Prepaid
      income taxes
            
            
            222,311
            
            
            
            2,070,981Accounts
      payable and accrued expenses
            
            
            37,308
            
            
            
            (1,147,570
            )Income
      taxes payable
            
            
            3,749,353
            
            
            
            7,677,916Net
      cash used in operating activities
            
            
            (984,954
            )
            
            
            (2,128,734
            )Investing
      activities:Proceeds
      from sales of short-term investments
            
            
            278,856
            
            
            
            2,725,793Purchases
      of short-term investments
            
            
            (70,286
            )
            
            
            (3,072,781
            )Purchases
      of property and equipment
            
            
            (2,736
            )
            
            
            (8,178
            )Proceeds
      from VIE sale of portion of subsidiary interest
            
            
            -
            
            
            
            100,000Repayment
      of note receivable
            
            
            50,000
            
            
            
            -Purchases
      of convertible notes receivable
            
            
            (667,750
            )
            
            
            -Investments
      in affiliated companies
            
            
            (1,546,500
            )
            
            
            -Distributions
      from affiliated company
            
            
            5,852,056
            
            
            
            -Net
      cash provided by (used in) investing activities
            
            
            3,893,640
            
            
            
            (255,166
            )Financing
      activities:Proceeds
      from exercise of common stock warrants and options
            
            
            -
            
            
            
            8,000Repurchase
      of warrants
            
            
            -
            
            
            
            (921,857
            )Payments
      on note payable
            
            
            (70,296
            )
            
            
            -Repurchase
      of common stock for treasury
            
            
            (504,771
            )
            
            
            (2,725,793
            )Net
      cash used in financing activities
            
            
            (575,067
            )
            
            
            (3,639,650
            )Net
      increase (decrease) in cash and cash equivalents
            
            
            2,333,619
            
            
            
            (6,023,550
            )Cash
      and cash equivalents, beginning of period
            
            
            6,424,015
            
            
            
            21,605,428Cash
      and cash equivalents, end of period
            
            $
            8,757,634
            
            
            $
            15,581,878Supplemental
      Disclosure of Cash Flow Information:Cash
      payments for interest
            
            $
            4,622
            
            
            $
            237Cash
      payments for income taxes
            
            $
            25,500
            
            
            $
            -Supplemental
      Disclosure of  Non-Cash Investing and Financing
      Activities:Cashless
      exercise of stock options
            
            $
            -
            
            
            $
            10Note
      receivable issued in connection with VIE sale of portion of subsidiary
      interest
            
            $
            -
            
            
            $
            50,000Conversion
      of note receivable to preferred stock – Avot Media, Inc.
            
            $
            250,000
            
            
            $
            -Insurance
      premium financed with a note payable
            
            $
            210,888
            
            
            $
            -Deferred
      tax benefit related to unrealized loss on investments in marketable
      securities charged to other comprehensive income
            
            $
            (60,995
            )
            
            $
            -




See
accompanying notes to unaudited condensed consolidated financial
statements.




5




Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements






1.  Basis
of Presentation and Summary of Significant Accounting Policies





The
unaudited condensed consolidated financial statements of Patriot Scientific
Corporation (the “Company”, “we”, “us” or “our”) presented herein have been
prepared pursuant to the rules of the Securities and Exchange Commission (“SEC”)
for quarterly reports on Form 10-Q and do not include all of the information and
footnotes required by accounting principles generally accepted in the United
States of America. These financial statements should be read in conjunction with
our audited consolidated financial statements and notes thereto included in our
Report on Form 10-K for our fiscal year ended May 31, 2008.





In the
opinion of management, the interim condensed consolidated financial statements
reflect all adjustments of a normal recurring nature necessary for a fair
presentation of the results for the interim periods
presented.  Operating results for the three month period ended August
31, 2008 are not necessarily indicative of the results that may be expected for
the year ending May 31, 2009.





Basis
of Consolidation


The
condensed consolidated balance sheets at August 31, 2008 and May 31, 2008 and
the condensed consolidated statements of operations for the three months ended
August 31, 2008 and 2007 include our accounts and those of our majority owned
inactive subsidiaries, Metacomp, Inc. and Plasma Scientific Corporation and all
variable interest entities (“VIE”s) for which we are the primary beneficiary.
All significant intercompany accounts and transactions have been
eliminated.





Consolidation
of Affiliate


In
January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB
Interpretation 46, Consolidation of Variable Interest
Entities, an Interpretation of ARB No. 51 (“FIN 46”). In December 2003,
the FASB modified FIN 46 (“FIN 46(R)”). FIN 46 provides a new framework for
identifying VIEs and determining when a company should include the assets,
liabilities, noncontrolling interests and results of activities of a VIE in its
consolidated financial statements.





A VIE is
a corporation, partnership, limited liability corporation, trust or any other
legal structure used to conduct activities or hold assets that either (1) has an
insufficient amount of equity to carry out its principal activities without
additional subordinated financial support, (2) has a group of equity owners that
are unable to make significant decisions about its activities, or (3) has a
group of equity owners that do not have the obligation to absorb losses or the
right to receive returns generated by its operations.





FIN 46
requires a VIE to be consolidated if a party with an ownership, contractual or
other financial interest in the VIE is obligated to absorb a majority of the
risk of loss from the VIE’s activities, is entitled to receive a majority of the
VIE’s residual returns (if no party absorbs a majority of the VIE’s losses), or
both. A variable interest holder that consolidates the VIE is called the primary
beneficiary. Upon consolidation, the primary beneficiary generally must
initially record all of the VIE’s assets, liabilities, and noncontrolling
interests at fair value and subsequently account for the VIE as if it were
consolidated based on majority voting interest.





FIN 46
was effective immediately for VIEs created after January 31, 2003. The
provisions of FIN 46(R) were adopted as of December 31, 2003, for our interests
in all VIEs. Beginning with the quarter ended May 31, 2007, we consolidated
Holocom, Inc. (formerly known as Scripps Secured Data, Inc.) (“Holocom”) as
Holocom was deemed a VIE and we determined that we were the primary beneficiary
of Holocom.


6


Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements
   Investments in Marketable
Securities


We
account for our investments in marketable securities in accordance with
Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments
in Debt and Equity Securities, and FASB Staff Position (“FSP”) SFAS No.
115-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain
Investments.  We determine the appropriate classification of
our investments at the time of purchase and reevaluate such designation at each
balance sheet date.  Our investments in marketable securities have
been classified and accounted for as available-for-sale based on management’s
investment intentions relating to these
securities.  Available-for-sale marketable securities are stated at
market value based on market quotes.  Unrealized gains and losses, net
of deferred taxes, are recorded as a component of other comprehensive income
(loss).  We follow the guidance provided by Emerging Issues Task Force
(“EITF”) Issue No. 03-1, The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments, to assess whether our investments with unrealized loss
positions are other than temporarily impaired.  Realized gains and
losses and declines in value judged to be other than temporary are determined
based on the specific identification method and are reported in other income
(expense), net in the condensed consolidated statements of
operations.





Investments
in Affiliated Companies


We have a
50% interest in Phoenix Digital Solutions, LLC (“PDS”) (see Note 9). This
investment is accounted for using the equity method of accounting since the
investment provides us the ability to exercise significant influence, but not
control, over the investee. Significant influence is generally deemed to exist
if we have an ownership interest in the voting stock of the investee of between
20% and 50%, although other factors, such as representation on the investee’s
board of directors, are considered in determining whether the equity method of
accounting is appropriate. Under the equity method of accounting, the
investment, originally recorded at cost, is adjusted to recognize our share of
net earnings or losses of the investee and is recognized in the consolidated
statements of operations in the caption “Equity in earnings (loss) of affiliated
companies”.





We have a
37.40% interest in Talis Data Systems, LLC (“Talis”) (see Note 9).  We
account for our investment using the equity method of accounting pursuant to
paragraph 8 of AICPA Statement of Position 78-9, Accounting for Investments in Real
Estate Ventures (which has applicability to non-real estate entities as
well) as our membership share of this limited liability company is more than
minor.  Under the equity method of accounting, the investment,
originally recorded at cost, is adjusted to recognize our share of net earnings
or losses of the investee and is recognized in the consolidated statement of
operations in the caption “Equity in earnings (loss) of affiliated
companies”.





We own
37.1% of the preferred stock of Avot Media, Inc. (“Avot”) (see Note
9).  This investment is accounted for at cost since we do not have the
ability to exercise significant influence over the operating and financial
policies of Avot.





We review
our investments in these affiliated companies to determine whether events or
changes in circumstances indicate that the carrying amounts may not be
recoverable. The primary factors we consider in our determination are the
financial condition, operating performance and near term prospects of the
investees. If the decline in value is deemed to be other than temporary, we
would recognize an impairment loss.





Comprehensive
Income


Comprehensive
income includes unrealized gains and losses which are excluded from the
condensed consolidated statements of operations in accordance with SFAS No. 130,
Reporting Comprehensive
Income.  For the three months ended August 31, 2008, this
amount included unrealized losses on investments classified as
available-for-sale.  The amount is presented net of tax-related
benefits of $60,995.


7




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements
  Revenue
Recognition


We
recognize revenue from the sale of our product upon shipment to the customer, at
which time title transfers and we have no further obligations. Fees for
maintenance or support are recorded on a straight-line basis over the underlying
period of performance. Revenue from technology license agreements is recognized
at the time we enter into a contract, determine the license method
(paid-in-advance or on-going royalty), and provide the customer with the
licensed technology, if applicable.





Holocom
recognizes revenue upon shipment of its product or upon receipt of its product
by the customer when shipped FOB destination and recognizes revenue on its
short-term installation contracts as time and materials costs are
incurred.





Holocom
maintains agreements with stocking distributors. These agreements provide for a
limited product warranty for a period of one year from the date of sale to the
end user. The warranty does not cover damage to the product after it has been
delivered to the distributor. Holocom’s stocking distributor agreements also
allow limited rights to periodic stock rotation.  These rotation
rights allow for the exchange of a percentage of distributor inventory for
replacement products of the distributor’s choosing. At August 31, 2008, Holocom
has evaluated the potential for rotated product and has provided for the
estimated impact in the accounting records.





Sales
through large distributors account for the majority of Holocom’s product
revenues, with a majority of sales to Anixter and Graybar Electric Company, Inc.
during the three months ended August 31, 2008.





Shipping
and Handling


EITF
Issue No. 00-10, Accounting
for Shipping and Handling Fees and Costs,requires shipping and
handling fees billed to customers to be classified as revenue and shipping and
handling costs to be classified as either cost of sales or disclosed in the
notes to the financial statements. Holocom includes shipping and handling fees
billed to customers in net sales. Shipping and handling costs associated with
inbound freight are included in cost of sales.





Net
Income (Loss) Per Share


We apply
SFAS No. 128, Earnings Per
Share, for the calculation of "Basic" and "Diluted" earnings (loss) per
share. Basic earnings (loss) per share includes no dilution and is computed by
dividing income (loss) available to common stockholders by the weighted average
number of common shares outstanding for the period. Diluted earnings (loss) per
share reflects the potential dilution of securities that could share in the
earnings (loss) of an entity.  At August 31, 2008, potential common
shares of 7,260,000 related to our outstanding warrants and options were not
included in the calculation of diluted income per share as they had an
anti-dilutive effect.  At August 31, 2007, all potential common shares
related to our outstanding warrants and options totaling 9,820,871 shares were
not included in the calculation of diluted loss per share as they had an
anti-dilutive effect.





Three
      Months Ended August 31, 2008Numerator
      (Income)
            
            
            Denominator
      (Shares)
            
            
            
            Per
      Share AmountBasic
      EPS:Net
      income
            
            $
            3,209,513
            
            
            
            388,132,502
            
            
            $
            0.01Diluted
      EPS:Effect
      of dilutive securities:Options
      and warrants
            
            
            -
            
            
            
            518,094Income
      available to common shareholders
            
            $
            3,209,513
            
            
            
            388,650,596
            
            
            $
            0.01





8




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Net Income Per Share,
continued





Three
      Months Ended August 31, 2007Numerator
      (Loss)
            
            
            Denominator
      (Shares)
            
            
            Per
      Share AmountBasic
      EPS:Net
      loss
            
            $
            (1,962,386
            )
            
            
            390,455,132
            
            
            $
            (0.01
            )Diluted
      EPS:Effect
      of dilutive securities:Options
      and warrants
            
            
            -
            
            
            
            -Loss
      available to common shareholders
            
            $
            (1,962,386
            )
            
            
            390,455,132
            
            
            $
            (0.01
            )





Minority
Interest


Minority
interest in our consolidated financial statements results from the accounting
for the acquisition of a noncontrolling interest in Holocom. Noncontrolling
interest represents a partially owned subsidiary’s income, losses, and
components of other comprehensive income which should be attributed to the
controlling and noncontrolling interests or other parties with a right or
obligation that affects the attribution of comprehensive income or loss, on the
basis of their contractual rights or obligations, if any, otherwise, on the
basis of ownership interests.





The
noncontrolling interest in Holocom, which we are required to consolidate as we
are the primary beneficiary, had been reduced to zero due to the initial
allocation of losses prior to the period in which we were required to
consolidate. If a noncontrolling interest has been reduced to zero, the primary
beneficiary must absorb any losses that are in excess of the value of the
noncontrolling interest’s equity. For the period in which we are required to
consolidate, March 27, 2007 through May 31, 2007 we absorbed $169,913 of
Holocom’s losses as we are the primary beneficiary.  For the fiscal
year ended May 31, 2008, Holocom had net income of $285,319 after
taxes.  Under the provisions of FIN 46 (R), we are able to recover our
absorbed losses before allocating income to the noncontrolling
interest.  At May 31, 2008, the minority interest presented in our
consolidated financial statements is $115,406, the amount of Holocom’s fiscal
2008 net income after tax less our absorbed losses during fiscal
2007.





For the
three months ended August 31, 2008, the minority interest was allocated
($78,636) which represents the amount of Holocom’s first quarter net loss after
taxes on a consolidated basis.  The minority interest in the loss for
the quarter is deducted from the May 31, 2008 balance of $115,406 for a total of
$36,770 as presented in our condensed consolidated balance sheet at August 31,
2008.





Stock-Based
Compensation


Stock-based
compensation expense recognized during the period is based on the value of the
portion of share-based payment awards that is ultimately expected to vest during
the period. Stock-based compensation expense recognized in our condensed
consolidated statement of operations for the three months ended August 31, 2007
included compensation expense for the share-based payment awards granted
subsequent to May 31, 2007 based on the grant date fair value estimated in
accordance with the provisions of SFAS No. 123(R),Share-Based Payment.
Stock-based compensation expense recognized in our condensed consolidated
statement of operations for the three months ended August 31, 2008 included
compensation expense for share-based payment awards granted prior to
May 31, 2008 based on the grant date fair value estimated in accordance
with the provisions of SFAS No. 123(R). As stock-based compensation expense
recognized in the condensed consolidated statements of operations is based on
awards ultimately expected to vest, it has been reduced for estimated
forfeitures. SFAS


9




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Stock-Based
Compensation (continued)





No.
123(R) requires forfeitures to be estimated at the time of grant and revised, if
necessary, in subsequent periods if actual forfeitures differ from those
estimates. The estimated average forfeiture rate for the three months ended
August 31, 2008 and 2007 of approximately 5% was based on historical
forfeiture experience and estimated future employee forfeitures. The estimated
pricing term of option grants for the three months ended August 31, 2008 and
2007 was five years.





Summary
of Assumptions and Activity





The fair
value of stock-based awards to employees and directors is calculated using the
Black-Scholes option pricing model, even though this model was developed to
estimate the fair value of freely tradable, fully transferable options without
vesting restrictions, which differ significantly from our stock options. The
Black-Scholes model also requires subjective assumptions, including future stock
price volatility and expected time to exercise, which greatly affect the
calculated values. The expected term of options granted is derived from
historical data on employee exercises and post-vesting employment termination
behavior. The risk-free rate selected to value any particular grant is based on
the U.S. Treasury rate that corresponds to the pricing term of the grant
effective as of the date of the grant. The expected volatility for the three
months ended August 31, 2008 and 2007 is based on the historical volatilities of
our common stock.  These factors could change in the future, affecting
the determination of stock-based compensation expense in future
periods.








Three
      Months Ended
              August
      31,
              2008
              (Unaudited)
            
            Three
      Months Ended
              August
      31,
              2007
              (Unaudited)Expected
      term
            
            
            N/A
            
            5
            yearsExpected
      volatility
            
            
            N/A
            
            127-128
            %Risk-free
      interest rate
            
            
            N/A
            
            4.26
      – 4.96
            %Expected
      dividends
            
            
            N/A
            
            2.82
            %





10




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Stock-Based
Compensation (continued)





A summary
of option activity as of August 31, 2008 and changes during the three months
then ended, is presented below:





Shares
            
            
            Weighted
      Average
              Exercise
              Price
            
            
            Weighted
      Average Remaining Contractual Term
              (Years)
            
            
            Aggregate
      Intrinsic
              ValueOptions
      outstanding at June 1, 2008
            
            
            8,195,000
            
            
            $
            0.44Options
      granted
            
            
            -
            
            
            $
            -Options
      exercised
            
            
            -
            
            
            $
            -Options
      forfeited
            
            
            (35,000
            )
            
            $
            0.74Options
      outstanding at August 31, 2008
            
            
            8,160,000
            
            
            $
            0.44
            
            
            
            3.55
            
            
            $
            142,400Options
      vested and expected to vest at August 31, 2008
            
            
            5,875,602
            
            
            $
            0.45
            
            
            
            3.18
            
            
            $
            142,400Options
      exercisable at August 31, 2008
            
            
            4,272,042
            
            
            $
            0.46
            
            
            
            2.74
            
            
            $
            142,400




The
weighted average grant date fair value of options granted during the three
months ended August 31, 2007 was $0.36 per option.  There were no
option grants during the three months ended August 31, 2008. The total intrinsic
value of options exercised during the three months ended August 31, 2007 was
$478,750, based on the differences in market prices on the dates of exercise and
the option exercise prices.  There were no options
exercised during the three months ended August 31, 2008.





The
aggregate intrinsic value represents the differences in market price at the
close of the quarter ($0.24 per share on August 29, 2008) and the exercise price
of outstanding, in-the-money options (those options with exercise prices below
$0.24) on August 29, 2008.





As of
August 31, 2008, there was approximately $870,000 of total unrecognized
compensation cost related to employee stock option compensation
arrangements.  That cost is expected to be recognized on a
straight-line basis over the next 48 months.  Approximately $583,000
of the total unrecognized compensation cost relates to 2,000,000 performance
options granted to our CEO and 200,000 performance options granted to our V.P of
Business Development.  We are not currently recognizing compensation
cost relating to these option grants as we have determined that it is not
currently probable that the vesting conditions in the grants will be
met.  When such vesting conditions are probable to be met, we will
record the compensation cost for the grants.


11




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Stock-Based
Compensation, continued





The
following table summarizes employee and director stock-based compensation
expense related to stock options under SFAS No. 123(R) for the three months
ended August 31, 2008 and 2007, which was recorded as
follows:




Three
              Months
              Ended
              August 31,
              2008
            
            
            Three
              Months
              Ended
              August 31,
              2007Selling,
      general and administrative expense
            
            $
            107,476
            
            
            $
            282,913








Recent
Accounting Pronouncements





In
September 2006, the FASB issued SFAS No. 157, Fair Value
Measurements.  SFAS No. 157 defines fair value, establishes a
framework for measuring fair value in generally accepted accounting principals
and expands disclosures about fair value measurements.  The statement does
not require new fair value measurements, but is applied to the extent that other
accounting pronouncements require or permit fair value measurements.  The
statement emphasizes that fair value is a market-based measurement that should
be determined based on the assumptions that market participants would use in
pricing an asset or liability.  Companies that have assets and liabilities
measured at fair value will be required to disclose information that enables the
users of its financial statements to access the inputs used to develop those
measurements.  The reporting entity is encouraged, but not required, to
combine the fair value information disclosed under this statement with the fair
value information disclosed under other accounting pronouncements.  SFAS
No. 157 is effective for fiscal years beginning after November 15, 2007. In
February 2008, the FASB released FASB Staff Position 157-2, Effective Date of FASB StatementNo. 157,which
delayed the effective date of SFAS No. 157 for all nonfinancial assets and
nonfinancial liabilities, except those that are recognized or disclosed at fair
value in the financial statements on a recurring basis (at least annually) until
the fiscal year beginning June 1, 2009.  On June 1, 2008, we adopted
SFAS No. 157 for financial assets and liabilities.  The adoption did
not have a material effect on our results of operations and financial
position.  We are in the process of evaluating the impact of adoption
of SFAS No. 157 for nonfinancial assets and liabilities, but do not anticipate
that the adoption will have a material impact on our consolidated financial
statements.





In
February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial
Assets and Financial Liabilities. SFAS No. 159 permits entities to choose
to measure at fair value many financial instruments and certain other items that
are not currently required to be measured at fair value. The objective is to
improve financial reporting by providing entities with the opportunity to
mitigate volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting
provisions. SFAS No. 159 also establishes presentation and disclosure
requirements designed to facilitate comparisons between entities that choose
different measurement attributes for similar types of assets and liabilities.
SFAS No. 159 does not affect any existing accounting literature that
requires certain assets and liabilities to be carried at fair value.
SFAS No. 159 does not establish requirements for recognizing and
measuring dividend income, interest income, or interest expense. This Statement
does not eliminate disclosure requirements included in other accounting
standards.  We have elected not to measure eligible financial assets
and liabilities at fair value.  Accordingly, the adoption of SFAS No.
159 did not have a material impact on our results of operations and financial
position.


12




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Recent
Accounting Pronouncements (continued)





In
December 2007, the FASB issued SFAS No. 141(R), Business Combinations. SFAS
No. 141(R) requires acquiring entities in a business combination to recognize
the assets acquired and liabilities assumed in the transaction; establishes the
acquisition-date fair value as the measurement objective for all assets acquired
and liabilities assumed; and requires the acquirer to disclose to investors the
information it needs to evaluate and understand the nature and financial effect
of the business combination. SFAS No. 141(R) is effective in fiscal years
beginning after December 15, 2008. We expect to adopt SFAS No. 141(R) on June 1,
2009.  We are currently assessing the impact the adoption of SFAS No.
141(R) will have on our consolidated financial statements.





In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements. SFAS No. 160 requires entities to
report noncontrolling (minority) interests in subsidiaries as equity in the
consolidated financial statements. SFAS No. 160 is effective in fiscal
years beginning after December 15, 2008. We expect to adopt SFAS No. 160 on June
1, 2009.  We are currently assessing the impact the adoption of SFAS
No. 160 will have on our consolidated financial statements.





In
March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities, an amendment of
FASB Statement No. 133 Accounting for Derivative
Instruments and Hedging Activities (“SFAS No. 161”) requires
entities to provide greater transparency about how and why an entity uses
derivative instruments, how derivative instruments and related hedged items are
accounted for under SFAS No. 133, and how derivative instruments and
related hedged items affect an entity’s financial position, results of
operations, and cash flows. The statement is effective for financial statements
issued for fiscal years and interim periods beginning after November 15,
2008.  We expect to adopt SFAS No. 161 on June 1, 2009. We are
currently assessing the impact the adoption of SFAS No. 161 will have on our
consolidated financial statements.





In
April 2008, the FASB issued FSP No. 142-3, Determination of the Useful Life of
Intangible Assets,which amends the factors that must be considered in
developing renewal or extension assumptions used to determine the useful life
over which to amortize the cost of a recognized intangible asset under SFAS
No. 142, Goodwill and
Other Intangible Assets. The FSP requires an entity to consider its own
assumptions about renewal or extension of the term of the arrangement,
consistent with its expected use of the asset, and is an attempt to improve
consistency between the useful life of a recognized intangible asset under SFAS
No. 142 and the period of expected cash flows used to measure the fair
value of the asset under SFAS No. 141, Business Combinations. The
FSP is effective for fiscal years beginning after December 15, 2008, and
the guidance for determining the useful life of a recognized intangible asset
must be applied prospectively to intangible assets acquired after the effective
date. The FSP is not expected to have a significant impact on
our consolidated financial statements.





In
May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted
Accounting Principles . The statement is intended to improve financial
reporting by identifying a consistent hierarchy for selecting accounting
principles to be used in preparing financial statements that are prepared in
conformance with generally accepted accounting principles. Unlike Statement on
Auditing Standards (“SAS”) No. 69, The Meaning of Present in Conformity
With GAAP, SFAS No. 162 is directed to the entity rather than the
auditor. The statement is effective 60 days following the SEC’s approval of
the Public Company Accounting Oversight Board (“PCAOB”) amendments to AU
Section 411, The Meaning
of  Present Fairly in Conformity with GAAP, and is not expected
to have any impact on our consolidated financial
statements.


13




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Recent
Accounting Pronouncements (continued)





In
June 2008, the FASB issued FSP EITF No. 03-6-1, Determining Whether Instruments
Granted in Share-Based Payment Transactions Are Participating Securities.
Under the FSP, unvested share-based payment awards that contain rights to
receive non-forfeitable dividends (whether paid or unpaid) are participating
securities, and should be included in the two-class method of computing EPS. The
FSP is effective for fiscal years beginning after December 15, 2008, and
interim periods within those years, and is not expected to have a significant
impact on our consolidated financial statements.





2.
Cash, Cash Equivalents and Short-Term Investments





We
consider all highly liquid investments with original maturities of three months
or less to be cash equivalents.





Restricted
cash and cash equivalents at August 31, 2008 consist of two savings accounts
required to be held as collateral for corporate credit card
accounts.





At August
31, 2008, PTSC’s short-term investments in the amount of $79,529 consist of
accrued interest receivable on our auction rate securities which is receivable
semi-annually according to the terms specified in each auction rate security
instrument.  At August 31, 2008, Holocom’s short-term investments
consist of a certificate of deposit in the amount of $10,232 with a maturity
date of December 11, 2008.  These values are reported at cost, which
approximate fair market value.





3.  Fair
Value Measurements





Effective
June 1, 2008, we adopted the provisions of SFAS No. 157 to account for our
financial assets and liabilities.  SFAS No. 157 defines fair value,
establishes a framework for measuring fair value, and expands disclosures about
fair value measurements. The SFAS No. 157 framework for measuring fair value
requires an entity to maximize the use of observable inputs and minimize the use
of unobservable inputs when measuring fair value. We determine fair value based
on quoted prices when available or through the use of alternative approaches,
such as discounting the expected cash flows using market interest rates
commensurate with the credit quality and duration of the investment or
valuations by third party professionals. SFAS No. 157’s hierarchy defines three
levels of inputs that may be used to measure fair value:





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; and





Level 3:
Prices or valuation techniques that require inputs that are both significant to
the fair value measurement and unobservable (i.e. supported by little or no
market activity).


14




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Fair
Value Measurements (continued)





The
following table represents our financial instruments subject to SFAS No. 157 and
the valuation approach applied to each class of security:





Quoted
      Prices in
              Active
      Markets
              Level
      1
            
            
            Significant
              Other
              Observable
              Inputs
              Level
      2
            
            
            Significant
              Unobservable
              Inputs
              Level
      3
            
            
            Balance
      as of
              August
      31, 2008Auction
      rate securities
            
            $
            —
            
            
            $
            —
            
            
            $
            12,457,505
            
            
            $
            12,457,505




The
valuation of these securities is based on Level 3 unobservable inputs which
consist of recommended fair values provided by Houlihan Smith & Company
Inc.  As a result of the estimated fair value, we have determined
a temporary impairment in the valuation of these securities of
$522,024.  We have recorded an unrealized loss of $309,321 in
accumulated other comprehensive loss at August 31, 2008, which represents the
gross valuation adjustment of $522,024, net of the related tax benefit of
$212,703. These securities are held “available-for-sale” in conformity with SFAS
No. 115 and the unrealized loss is included in other comprehensive income in the
current period. Due to the uncertainty related to the liquidity in the auction
rate security market, we have classified these auction rate securities as
long-term assets on the condensed consolidated balance sheets.





For those
financial instruments with significant Level 3 inputs, the following table
summarizes the activity for the period by investment type:




(Unaudited)
            
            Fair Value Measurements Using
              Significant
              Unobservable
      Inputs (Level 3)Description
            
            Auction
              Rate
              Securities
            
            
            TotalBeginning
      balance
            
            $
            —
            
            
            $
            —Transfers
      in to Level 3
            
            
            12,900,000
            
            
            
            12,900,000Earned
      income (included in current assets)
            
            
            79,529
            
            
            
            79,529Total
      realized/unrealized losses:Included
      in earnings
            
            
            —
            
            
            
            —Included
      in comprehensive income (loss)
            
            
            (522,024
            )
            
            
            (522,024
            )Purchases,
      issuances and settlements
            
            
            —
            
            
            
            —Ending
      balance
            
            $
            12,457,505
            
            
            $
            12,457,505Total
      amount of unrealized losses for the period included in other comprehensive
      income (loss) attributable to the change in fair market
      value relating to assets still held at the reporting
    date
            
            $
            (149,699
            )
            
            $
            (149,699
            )




All
realized gains or losses related to financial instruments whose fair value is
determined based on Level 3 inputs are included in other income. All unrealized
gains or losses related to financial instruments whose fair value is determined
based on Level 3 inputs are included in other comprehensive income
(loss).


15




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


4.
Accounts Receivable





Trade
accounts receivable at August 31, 2008 is $283,623, of which $257,593 is held by
Holocom.  No allowance for doubtful accounts was necessary at August
31, 2008.  At May 31, 2008, trade accounts receivable was $538,500, of
which $511,541 was held by Holocom.  No allowance for doubtful
accounts was necessary at May 31, 2008.





At August
31, 2008 and May 31, 2008, accounts receivable from our investee PDS was $6,780
and $7,501, respectively.  These balances represent reimbursements we
submit to PDS for our legal and related costs incurred in various legal matters
of which we are listed as co-defendant with TPL.





5.
Notes Receivable





On May 30
and August 8, 2008, we purchased secured convertible promissory notes from
Crossflo Systems, Inc., a California corporation (“Crossflo”) with a face amount
of $400,000 and $417,750, respectively.  Interest accrued on the notes
at a rate of 5.25% per annum and was due with principal at the earlier of (i)
September 30, 2008, (ii) consummation of a equity financing by Crossflo which
closed on or before September 30, 2008, in which Crossflo sold and issued shares
of its convertible preferred stock resulting in aggregate gross proceeds to
Crossflo of at least $2.5 million (a “Qualified Financing”), or (iii) upon or
after the occurrence of an event of default, as defined.  The notes
were secured by substantially all assets of Crossflo.





The
Crossflo notes receivable were convertible at our option, at any time prior to
September 30, 2008, into shares of Crossflo’s Series F convertible preferred
stock equal to 4% of Crossflo’s then issued and outstanding equity securities.
In addition, the entire principal was automatically convertible into shares of
Crossflo’s Series F convertible preferred stock at the closing of a Qualified
Financing. The number of shares of Series F convertible preferred stock to be
issued upon automatic conversion of the principal amount was the greater of (i)
4% of Crossflo’s then issued and outstanding equity securities, and (ii) the
principal amount divided by the per share purchase price paid by the investors
participating in the Qualified Financing. Upon an event of default, as defined,
the principal amount of the notes may be converted into shares of Crossflo’s
Series F convertible preferred stock equal to 4% of Crossflo’s then issued and
outstanding equity securities. Upon maturity on September 30, 2008, the
principal amount of the notes will automatically be converted into shares of
Crossflo’s Series F convertible preferred stock equal to 4% of Crossflo’s then
issued and outstanding equity securities.





Upon
conversion of the principal amount of the notes pursuant to the above, we are
entitled to receive shares of Crossflo’s common stock equal to all accrued and
unpaid interest divided by $0.20.





In
connection with our purchase of the secured convertible promissory notes from
Crossflo, we also received warrants to purchase 200,000 and 208,875 shares,
respectively, of Crossflo’s common stock at $0.20 per
share.  Notwithstanding the foregoing, in the event a Qualified
Financing is not consummated prior to September 30, 2008, the warrant will
instead be exercisable into 1,000,000 and 1,044,375 shares, respectively, of
Crossflo’s common stock at $0.20 per share.  The warrant is
exercisable until the earlier of (i) October 11, 2012, (ii) the closing of an
underwritten public offering by Crossflo pursuant to a registration statement
under the Securities Act, (iii) the closing of a merger or other reorganization
by Crossflo with another entity, or (iv) the closing of a sale of all or
substantially all of the assets of Crossflo.  The value attributed to
the warrants was insignificant, and accordingly, the principal amount of the
loans have been recorded as notes receivable at May 31, 2008 and August 31,
2008.





As of
August 31, 2008, the balance of the notes receivable is $405,408, and $419,192,
respectively, including accrued interest receivable of $5,408 and $1,442,
respectively, recognized during the period ended May 30, 2008 through August 31,
2008.


16




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Notes
Receivable (continued)





At May
31, 2008, the balance of the note receivable was $400,115, including accrued
interest receivable of $115 recognized during the year ended May 31,
2008.





On August
5, 2008, we announced our intent to acquire Crossflo for $10 million comprised
of cash and stock with an effective completion date of September 1, 2008,
subject to approval by Crossflo’s shareholders.  On September 1, 2008,
according to provisions of the Merger Agreement, the principal amounts of our
secured convertible promissory notes were offset against the shares of stock we
provided at closing (see Note 15) and the warrants associated with the notes
were cancelled.





On August
14, 2008, we purchased a convertible note receivable from Avot Media, Inc. for
$250,000.  We converted the note principal on August 22, 2008 (see
Note 9).  At August 31, 2008, accrued interest on the note was
$243.





6.
Inventory





Inventory
at August 31, 2008 and May 31, 2008, consisted of raw materials of $353,752 and
$142,410, respectively,  and finished goods of $388,132 and $245,731,
respectively.





7.
Investments in Marketable Securities





The
following table summarizes unrealized losses on our investments in marketable
securities based on the valuation by Houlihan Smith & Company Inc. at August
31, 2008:





As
      of August 31, 2008Cost
            
            
            Gross
              Unrealized
              Losses
            
            
            Estimated
              Fair
              ValueShort-termAccrued
      interest - auction rate securities
            
            $
            79,529
            
            
            $
            —
            
            
            $
            79,529Long-termAuction
      rate securities
            
            
            12,900,000
            
            
            
            (522,024
            )
            
            
            12,377,976Total
            
            $
            12,979,529
            
            
            $
            (522,024
            )
            
            $
            12,457,505





As of
August 31, 2008, we held auction rate securities with a par value totaling $12.9
million that failed to sell at auction.  In the event we need to
access funds invested in these auction rate securities we would not be able to
liquidate these securities until (i) a future auction of these securities is
successful, (ii) they are refinanced and redeemed by the issuers, or (iii) a
buyer is found outside of the auction process.  The investments
consist of student loan auction rate instruments issued by various state
agencies pursuant to the Federal Family Educational Loan Program
(“FFELP”).  These investments are of high credit quality and the AAA
credit ratings of the investments have been reaffirmed since August
2008.  These instruments are collateralized in excess of the
underlying obligations, are insured by the various state educational agencies,
and are guaranteed by the Department of Education as an insurer of last
resort.  We have the intent and the ability to hold these investments
until the anticipated recovery period.


17




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Investments
in Marketable Securities (continued)





Due to
the uncertainty surrounding the timing of a market recovery, we have classified
our auction rate securities as long- term investments in our consolidated
balance sheet as of August 31, 2008.  As a result of temporary
declines in the fair value of our auction rate securities, which we attribute to
liquidity issues rather than credit issues, we have recorded an unrealized loss
of $309,321 in other comprehensive income at August 31, 2008, which represents
the gross valuation adjustment of $522,024, net of the related tax benefit of
$212,703.





We will
continue to evaluate the fair value of our investments in auction rate
securities each reporting period for a potential other-than-temporary
impairment.





During
June 2008, we obtained a credit facility for as long as needed, which provides
for financing up to 50% of the par value balance of our outstanding auction rate
securities. The facility is collateralized by the full value of the outstanding
auction rate securities, required no origination fee, and if drawn upon will
bear interest at the federal funds rate plus 3%.





8.
License Agreements





In
February 2005, we entered into two separate licensing agreements with one
customer for our patent portfolio and Ignite microprocessor technology. The
aggregate amount of the two licenses was $3,050,000, of which $2,950,000 was for
licensing fees and $100,000 was for maintenance services. Maintenance under the
agreement is expected to be provided over a period not to exceed four years.
Maintenance revenue recognized during the three months ended August 31, 2008 and
2007 was $6,250 and $6,250, respectively. The payment terms of the agreements
required aggregate payments of $300,000 at the time of execution, three
quarterly payments of $750,000 each on April 1, August 15, and November 15, 2005
and one final payment of $500,000 on February 15, 2006. The $500,000 payment due
on February 15, 2006 was paid in March 2006. Total payments received in fiscal
2005 amounted to $1,050,000, and total payments received in fiscal 2006 amounted
to $2,000,000. The agreements also provide for the future payment of royalties
to us based on sales of product using the Ignite licensed technology. In
connection with this license agreement, we became obligated to the co-inventor
of the patent portfolio technology for $207,600 pursuant to a July 2004
agreement under which we were obligated to pay a percentage of all patent
portfolio licensing proceeds to the co-inventor. The amount due under that
license was payable in four installments of $51,900. The co-inventor of the
patent portfolio technology filed a lawsuit against us seeking damages and/or
enforcement of the July 2004 agreement. We challenged the enforceability of the
agreement by counterclaim in that action. On February 14, 2007, a settlement of
the litigation was finalized. Terms of the settlement required us to pay
$3,400,000 in cash on February 14, 2007 and $3,000,000 on May 1, 2007, which
amounted to approximately the debt claimed by the co-inventor to be owed to him
under the July 2004 agreement. In addition, the settlement required us to make a
donation of $15,000 on February 14, 2007 on behalf of Russell H. Fish III
(“Fish”) to Maasai Power and Education Project, Inc., and to pay Fish the
equivalent of 4% of 50% of the next $100 million of gross license fees as they
are collected by PDS and as distributions are made to us, after excluding the
first $20 million collected by PDS after December 1, 2006. Our commitment to
make payments to Fish related to such future license revenues was limited to $2
million.  In January 2008, we made the final payment under the Fish
settlement agreement.


18




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


9.
Investments in Affiliated Companies





Phoenix
Digital Solutions, LLC





On June
7, 2005, we entered into a Master Agreement (the “Master Agreement”) with
Technology Properties Limited, a California corporation (“TPL”), and Charles H.
Moore (“Moore”), the co-inventor of the technology which is the subject of the
MMP Portfolio of microprocessor patents, pursuant to which the parties resolved
all legal disputes between them. Pursuant to the Master Agreement, we and TPL
entered into the Limited Liability Company Operating Agreement of PDS (the “LLC
Agreement”) into which we and Moore contributed our rights to certain of our
technologies.





We and
TPL each own 50% of the membership interests of PDS, and each of us has the
right to appoint one member of the three member management committee. The two
appointees are required to select a mutually acceptable third member of the
management committee. Pursuant to the LLC Agreement, we and TPL agreed to
establish a working capital fund for PDS of $4,000,000, of which our
contribution was $2,000,000. The working capital fund increases to a maximum of
$8,000,000 as license revenues are achieved. We and TPL are obligated to fund
future working capital requirements at the discretion of the management
committee of PDS in order to maintain working capital of not more than
$8,000,000. Neither we nor TPL are required to contribute more than $2,000,000
in any fiscal year. Distributable cash and allocation of profits and losses will
be allocated to the members in the priority defined in the LLC Agreement. PDS
has committed to pay a quarterly amount ranging between $500,000 and $1,000,000
(based upon a percentage of the working capital fund balance of PDS) for
supporting efforts to secure licensing agreements by the other member on behalf
of PDS. During the three months ended August 31, 2008 and 2007, PDS paid
$947,425 and $873,731, respectively, to TPL pursuant to this
commitment.





We are
accounting for our investment in PDS under the equity method of accounting, and
accordingly have recorded our share of PDS’ net income during the three months
ended August 31, 2008 of $6,621,859 as an increase in our investment and our
share of PDS’ net loss during the three months ended August 31, 2007 of
$1,200,542 as a decrease in our investment. Cash distributions received from PDS
during the three months ended August 31, 2008 of $5,852,056 have been recorded
as a reduction in our investment.  No distributions were received
during the three months ended August 31, 2007. Our investment in PDS is
$3,291,793 at August 31, 2008 and has been recorded as “Investments in
Affiliated Companies”.  We have recorded our share of PDS’ net income
as “Equity in Earnings (Loss) of Affiliated Companies” in the accompanying
consolidated statements of operations for the three months ended August 31, 2008
and we have recorded our share of PDS’ net loss as “Equity in Earnings (Loss) of
Affiliated Companies” for the three months ended August 31, 2007.





During
the three months ended August 31, 2008 and 2007, TPL entered into licensing
agreements with third parties, pursuant to which PDS received aggregate proceeds
of $16,275,000 and $1,500,000, respectively.





At August
31, 2008, PDS had accounts payable balances of approximately $2,357,000 and
$10,000 to TPL and PTSC, respectively.  At May 31, 2008, PDS had
accounts payable balances of approximately $3,197,000 and $7,500 to TPL and
PTSC, respectively.





PDS’
condensed balance sheets at August 31, 2008 and May 31, 2008 and statements of
operations for the three months ended August 31, 2008 and 2007 are as
follows:


19




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Investments
in Affiliated Companies (continued)





Condensed
Balance Sheets





ASSETS:


August
      31,
              2008
            
            
            May
      31,
              2008Cash
            
            $
            8,962,235
            
            
            $
            8,260,288Total
      assets
            
            $
            8,962,235
            
            
            $
            8,260,288





LIABILITIES
AND MEMBERS’ EQUITY:




August
      31,
              2008
            
            
            May
      31,
              2008Accounts
      payable and accrued expenses
            
            $
            2,366,859
            
            
            $
            3,204,519Income
      taxes payable
            
            
            11,790
            
            
            
            11,790Members’
      equity
            
            
            6,583,586
            
            
            
            5,043,979Total
      liabilities and members’ equity
            
            $
            8,962,235
            
            
            $
            8,260,288





Condensed
Statements of Operations





Three
      Months Ended
              August
      31,2008
            
            
            2007Revenues
            
            $
            16,275,000
            
            
            $
            1,500,000Operating
      expenses
            
            
            1,942,560
            
            
            
            3,966,543Operating
      income (loss)
            
            
            14,332,440
            
            
            
            (2,466,543
            )Interest
      income
            
            
            28,639
            
            
            
            65,460Net
      income (loss)
            
            $
            14,361,079
            
            
            $
            (2,401,083
            )





Talis
Data Systems, LLC





On May
16, 2008, we paid $400,000 to acquire a 15.09% share in Talis, a company that
produces multi-domain computer and network security products to government,
military, and enterprise customers. Talis develops and markets PCs incorporating
its Datagent security device, a patented, hardware based data security solution
that avoids the vulnerability of software–based approaches.





On August
1, 2008, we increased our investment in Talis to 37.4% as a result of purchasing
additional shares offered by Talis for $300,000 as well as acquiring shares from
minority shareholders for $196,500.  We also acquired all of the Talis
shares previously held by Holocom for $100,000 in cash and a reduction on their
outstanding line of credit of $219,000.


20




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Investments
in Affiliated Companies (continued)





We are
accounting for our investment in Talis under the equity method of
accounting.  We have recorded our share of Talis’ net loss of $63,091
during the three months ended August 31, 2008 as a decrease in our
investment.  Our investment in Talis on a consolidated basis is
$825,033 at August 31, 2008 and has been recorded as “Investments in Affiliated
Companies”.  We have recorded our share of Talis’ net loss as “Equity
in Earnings (Loss) of Affiliated Companies” in the accompanying consolidated
statement of operations for the three months ended August 31, 2008.





Avot
Media, Inc.





During
the quarter ended August 31, 2008, we invested an aggregate of $1,300,000,
including conversion of  a note receivable in the amount of $250,000,
to obtain 14,444,444 shares of Series B preferred stock issued by Avot,
representing 53.3% of the Series B preferred stock and 37.1% of all Avot’s
preferred shares issued and outstanding.  The Series B preferred
shares are convertible at our option into shares of Avot’s common stock
utilizing a conversion rate which consists of the original issue price of the
Series B shares divided by the conversion price of $0.09 per
share.  The conversion price is subject to adjustment from time to
time for recapitalizations and as otherwise set forth in Avot’s Articles of
Incorporation.  Each share of preferred stock will automatically
convert to common shares, utilizing the conversion rate: (i) immediately prior
to the closing of a firm commitment underwritten initial public offering (“IPO”)
provided that (a) the offering price per share is not less than $1.00, (b) the
aggregate gross proceeds to Avot are not less than $25,000,000 and (c) Avot’s
common stock will be listed or admitted to trading on any national securities
association registered pursuant to Section 15A of the Securities Exchange Act of
1934, as amended, upon effectiveness of the IPO, or (ii) upon receipt by Avot of
written request for such conversion from the holders of a majority of the
preferred stock then outstanding.  All preferred shares are entitled
to receive non-cumulative dividends if and when declared by the Board of
Directors of Avot.  The Series B preferred shares are entitled to
receive a liquidation preference of $0.09 per share adjusted from time to time
for recapitalizations, plus an amount equal to all declared but unpaid
dividends.





We
reviewed the Series B Preferred Stock Purchase Agreement and related agreements
in addition to evaluating our voting rights for our investment in the preferred
stock of Avot, and as such we have concluded that we do not have the ability to
exercise significant control over Avot.  As a result, we are
accounting for our investment in Avot at cost.  Our investment in Avot
is $1,300,000 and has been recorded as “Investments in Affiliated Companies” on
our condensed consolidated balance sheet at August  31,
2008.





10.
Consolidated Variable Interest Entity





On
February 2, 2007, we invested an aggregate of $370,000 in Holocom for 2,100,000
shares of convertible preferred stock. This represents all of Holocom’s
preferred stock and a 46% ownership interest in Holocom, a California
corporation that manufactures products that protect information transmitted over
secure networks. The investment consisted of certain assets contributed by us to
Holocom valued at $250,000 and cash of $120,000. The shares are convertible at
our option into shares of Holocom’s common stock on a one-to-one basis. The
convertible preferred stock entitles us to receive non-cumulative dividends at
the per annum rate of $0.04 per share, when and if declared by the Board of
Directors of Holocom. The investment in Holocom’s convertible preferred stock
also entitles us to a liquidation preference of $0.40 per share, plus an amount
equal to all declared but unpaid dividends.


21




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Consolidated
Variable Interest Entity (continued)





On March
27, 2007, we entered into an 18-month revolving line of credit with Holocom for
a maximum amount of $500,000. The line of credit matured on September 27, 2008.
If we did not provide notice to Holocom at least 90 days prior to the maturity
date, the maturity date would have automatically extended 12 months. On June 18,
2008, we gave Holocom notice under terms of the line of credit that we would not
be extending the maturity date by the additional twelve month period provided
for in the line of credit. As a result, the line of credit would have
terminated, and full payment of any outstanding balance would have been due on
September 27, 2008.  On August 29, 2008 Holocom paid $75,000, the
remaining balance due on the line of credit and provided us notice effectively
terminating the line of credit on August 29, 2008.





During
July 2008, Holocom obtained a credit facility for up to $300,000 from a third
party, at an interest rate based on the Wall Street Journal Prime plus 1%
(floating) with a floor of 6%.  The credit facility term extends to
May 1, 2009, and is guaranteed by us.





As a
result of our guarantee on the third party credit facility, we maintain a
variable interest in Holocom, a variable interest entity, and we have determined
that we are the primary beneficiary as we absorb more than half of the variable
interest entity’s expected losses. FIN 46(R) requires us to consolidate Holocom
as long as we are deemed to be the primary beneficiary. The equity interests of
Holocom not owned by us are reported as a minority interest in our August 31,
2008 and May 31, 2008 condensed consolidated balance sheets.  As of
May 31, 2007, the noncontrolling interest in Holocom, which we are required to
consolidate as we are the primary beneficiary, was reduced to zero due to the
initial allocation of losses prior to the period in which we were required to
consolidate. If a noncontrolling interest has been reduced to zero, the primary
beneficiary must absorb any losses that are in excess of the value of the
noncontrolling interest’s equity. For the period in which we were initially
required to consolidate, March 27, 2007 through May 31, 2007 we absorbed
$169,913 of Holocom’s losses as we are the primary beneficiary.  For
the fiscal year ended May 31, 2008, Holocom  had net income of
$285,319 after taxes.  Under the provisions of FIN 46 (R), we are able
to recover our absorbed losses before allocating income to the noncontrolling
interest.  At May 31, 2008 the minority interest presented in our
consolidated financial statements is $115,406, the amount of Holocom’s fiscal
2008 net income after taxes less our absorbed losses during fiscal
2007.  For the three months ended August 31, 2008,  the
minority interest was allocated ($78,636) which represents the amount of
Holocom’s first quarter net loss on a consolidated basis.  The
minority interest in the loss for the quarter is deducted from the May 31, 2008
balance of $115,406 for a total of $36,770 as presented in our condensed
consolidated balance sheet at August 31, 2008.





Prior to
initial consolidation, we recognized a $126,746 impairment loss on our
investment for the losses of Holocom for the period February 2007 through March
26, 2007.





Upon
initial consolidation of the variable interest entity, on March 27, 2007,
$251,146 of current assets, $43,199 of net property and equipment, $47,240 of
other assets, $98,331 of current liabilities and no minority interest were
included on the consolidated balance sheet.





During
the three months ended August 31, 2007, Holocom sold a membership interest in
DataSecurus, LLC  (now known as Talis) to an unrelated third party for
$100,000 in cash and a $50,000 note receivable due June 1, 2008.  On
June 1, 2008, Holocom assigned this note receivable to us and we agreed to
reduce the amount of our line of credit with Holocom by the amount of the
note.  On June 26, 2008 we were paid in full by the third party
debtor.


22




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Consolidated
Variable Interest Entity (continued)





Holocom
has a 2007 Stock Option Plan that covers its employees, directors, and
consultants and provides for the granting of options to acquire up to 500,000
shares of Holocom’s common stock.  The options under this plan are not
tied to our common stock and do not have a dilutive effect on our
shareholders.  Any option granted under the plan must be exercised
within ten years of the date they are granted.  During the three
months ended August 31, 2008, Holocom granted options to purchase 42,500 shares
of its common stock at $0.12 per share under this plan and 36,750 shares have
been forfeited/cancelled.  At August 31, 2008, options to purchase
360,250 shares of Holocom’s common stock are outstanding, 95,250 of the
outstanding options are exercisable due to vesting provisions within the
options.





The
weighted average grant date fair value of Holocom’s options granted during the
three months ended August 31, 2008 was $0.08 per option.





As of
August 31, 2008, there was approximately $13,907 of total unrecognized
compensation cost related to employee stock option compensation
arrangements.  That cost is expected to be recognized by Holocom on a
straight-line basis over the next 34 months.





During
the three months ended August 31, 2008, Holocom recognized $6,706 of employee,
consultant and director stock-based compensation expense related to stock
options under SFAS No. 123(R).





11.   Note
Payable





On June
18, 2008, we financed a portion of our Directors and Officers insurance premium
in the amount of $210,888.  The financed balance includes interest
charges of $4,487 at an annual percentage rate of 5.16%.  The note is
due on March 1, 2009 and requires monthly payments of $23,432.  At
August 31, 2008 the balance on the note was $140,592.





12.   Stockholders’
Equity





Comprehensive Income
(Loss)




Comprehensive
income (loss) includes unrealized gains and losses on certain investments
classified as available-for-sale, net of tax, which are excluded from
our condensed consolidated statements of operations in accordance with SFAS
No. 130, Reporting
Comprehensive Income. Comprehensive income (loss) for the three months
ended August 31, 2008 and 2007 was as follows:




Three Months Ended
              August 31,2008
            
            
            2007Net
      income (loss)
            
            $
            3,209,513
            
            
            $
            (1,962,386
            )Unrealized
      holding losses on investments, net of taxes
            
            
            (88,704
            )
            
            
            —Total
      comprehensive income (loss)
            
            $
            3,120,809
            
            
            $
            (1,962,386
            )





Share
Repurchases





During
July 2006 we commenced our Board of Director approved stock buyback program in
which we repurchase our outstanding common stock from time to time on the open
market.  As part of the program we purchased 2,367,160 and 4,961,640
shares of our common stock at an aggregate cost of $504,771 and $2,725,793
during the three months ended August 31, 2008 and 2007,
respectively.


23




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Stockholders’
Equity (continued)





Equity
Transactions





The
following table summarizes equity transactions during the three months ended
August 31, 2008:




Common
      Stock
            
            
            Additional
      Paid-in
            
            
            AccumulatedShares
            
            
            Amounts
            
            
            Capital
            
            
            Deficit
            
            
            Treasury
      StockBalance
      June 1, 2008
            
            
            389,414,915
            
            
            $
            4,109
            
            
            $
            70,004,814
            
            
            $
            (33,763,357
            )
            
            $
            (12,723,172
            )Non-cash
      compensation
            
            
            -
            
            
            
            -
            
            
            
            114,875
            
            
            
            -
            
            
            
            -Repurchase
      of common stock for treasury
            
            
            (2,367,160
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (504,771
            )Net
      income
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            3,209,513
            
            
            
            -Balance
      August 31, 2008
            
            
            387,047,755
            
            
            $
            4,109
            
            
            $
            70,119,689
            
            
            $
            (30,553,844
            )
            
            $
            (13,227,943
            )





Stock Optionsand Warrant
Activity




As of
August 31, 2008, we had 100,000 options outstanding pursuant to our 1996 Stock
Option Plan exercisable at $0.07 per share expiring in 2009; 849,000 options
outstanding pursuant to our 2001 Stock Option Plan exercisable at a range of
$0.10 to $0.86 per share expiring through 2013; 2,973,000 options outstanding
pursuant to our 2003 Stock Option Plan exercisable at a range of $0.05 to $0.40
per share expiring through 2013; and 4,238,000 options outstanding pursuant to
our 2006 Stock Option Plan exercisable at a range of $0.36 to $0.70 per share
expiring through 2013.  Some of the options outstanding under these
plans are not presently exercisable and are subject to meeting vesting
criteria.





During
the three months ended August 31, 2008, we recorded $114,182 of non-cash
compensation expense related to vesting of stock options, including $6,706
related to Holocom.





As of
August 31, 2008, we had warrants outstanding to purchase 550,000 common shares
at exercise prices ranging from $0.20 to $1.00 per share, expiring at various
dates through 2013.  During the three months ended August 31, 2008, we
issued 250,000 warrants to purchase shares of common stock at $0.23 per share to
our institutional investor relations firm; the warrants are subject to vesting
criteria.  No warrants were exercised and no warrants expired during
the three months ended August 31, 2008.





During
the three months ended August 31, 2008, we recorded $693 of non-cash
compensation expense related to vesting of warrants.





13.  Commitments
and Contingencies





Litigation





Patent
Litigation





On
February 8, 2008, we, TPL and Alliacense Ltd. were named as defendants in three
separate lawsuits filed in the United States District Court for the Northern
District of California by Asustek Computer, Inc., HTC Corporation, and Acer,
Inc., and affiliated entities of each of them. On February 13, 2008, the Asustekclaims were amended
to include claims against MCM Portfolio, LLC (Alliacense and MCM Portfolio are
TPL-related entities), which do not involve us.


24




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Commitments
and Contingencies (continued)





The Asustekcase seeks
declaratory relief that its products do not infringe enforceable claims of the
'336, '584 and '749 patents. The Asustekcase also seeks a
similar declaration with respect to two patents owned by TPL that are not a part
of the MMP Portfolio, and as such we are not engaged in this aspect of the
litigation and defense. The Acercase seeks declaratory
relief that its products do not infringe enforceable claims of the '336, '584
and '749 patents. The HTCcase similarly seeks declaratory relief that its products do not infringe
enforceable claims of those three patents and the '148 patent.





On April
25, 2008, we and TPL filed five patent infringement lawsuits in the Eastern
District of Texas against HTC, Acer and Asustek. These suits allege infringement
by HTC and Acer with respect to the '336, '749, '584 and '148 patents; and by
Asustek with respect to the '336, '749 and '584 patents. On June 4, 2008, we and
TPL filed patent infringement lawsuits against those parties in the Eastern
District of Texas with respect to the  '890 patent of the MMP
Portfolio.  The Asustekaction in the Eastern
District of Texas is inclusive of matters with respect to two patents owned by
TPL that are not  a part of the MMP Portfolio, and accordingly we are
not engaged in this aspect of the litigation and defense (collectively, these
cases are referred to as the "T-3 Litigation”).





Motions
to dismiss or transfer the Northern District of California actions to the
Eastern District of Texas were heard on September 19, 2008 by U.S. District
Judge Jeremy Fogel and are presently under submission.  Following
Judge Fogel's ruling, we expect to learn where the T-3 Litigation will
proceed.  The discovery  phase has not yet begun in any of
the cases.





401(k)
Plan





We have a
retirement plan that complies with Section 401(k) of the Internal Revenue Code.
All employees are eligible to participate in the plan. We match 50% of each
participant’s voluntary contributions, subject to a maximum contribution of 6%
of the participant’s compensation. Participants vest 33% per year over a three
year period in our contributions. Our matching contributions during the three
months ended August 31, 2008 and 2007 were $2,038 and $928,
respectively.





Guarantees and
Indemnities





We have
made certain guarantees and indemnities, under which we may be required to make
payments to a guaranteed or indemnified party. We indemnify our directors,
officers, employees and agents to the maximum extent permitted under the laws of
the State of Delaware and California for Holocom. In connection with our
facility leases, we have indemnified our lessors for certain claims arising from
the use of the facilities. The duration of the guarantees and indemnities
varies, and in many cases is indefinite. These guarantees and indemnities do not
provide for any limitation of the maximum potential future payments we could be
obligated to make. Historically, we have not been obligated to make any payments
for these obligations and no liabilities have been recorded for these guarantees
and indemnities in the accompanying consolidated balance sheets.





14.
Segment Information





Holocom
began operations in February 2007 and we consolidated Holocom in our
consolidated financial statements in March 2007. Holocom is an operating segment
under SFAS No. 131, Disclosures About Segments of an
Enterprise, as revenue is 10% or more of the total revenue of all
operating segments.


25




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Segment
Information (continued)





Holocom
is engaged in the business of developing and manufacturing network-security
hardware for sale to government, military, and other high-security facilities.
There is no inter-segment revenue, and the accounting policies for segment
reporting are the same as for us as a whole.





The “all
other” category includes the results for Patriot Scientific
Corporation.





Operating
segment net revenue, operating loss and income (loss) before taxes for the three
months ended August 31, 2008 and 2007 were as follows:





Three
      Months EndedAugust
      31, 2008
            
            
            August
      31, 2007Net
      revenue:Holocom
            
            $
            1,319,366
            
            
            $
            511,864All
      other
            
            
            39,280
            
            
            
            9,505Total
      net revenue
            
            $
            1,358,646
            
            
            $
            521,369






Three
      Months EndedAugust
      31, 2008
            
            
            August
      31, 2007Operating
      income (loss):Holocom
            
            $
            117,453
            
            
            $
            (145,629
            )All
      other
            
            
            (1,273,865
            )
            
            
            (1,472,727
            )Total
      operating loss
            
            $
            (1,156,412
            )
            
            $
            (1,618,356
            )Income
      (loss) before taxes:Holocom
            
            $
            114,558
            
            
            $
            4,749All
      other
            
            
            5,396,024
            
            
            
            (2,199,704
            )Total
      income before taxes
            
            $
            5,510,582
            
            
            $
            (2,194,955
            )





All sales
were to unaffiliated customers within the United States.





Accounts
receivable concentration information for Holocom as of August 31, 2008 and May
31, 2008 and sales concentration information for the three months ended August
31, 2008 and 2007 were as follows:




Three
      months ended
              August
      31, 2008
            
            
            August
      31, 2008
            
            
            Three
      months ended
              August
      31, 2007
            
            
            May
      31, 2008Sales
            
            
            %
      of sales
            
            
            %
      of A/R
            
            
            Sales
            
            
            %
      of sales
            
            
            %
      of A/RAnixter
            
            $
            793,953
            
            
            
            60
            %
            
            
            62
            %
            
            $
            341,070
            
            
            
            73
            %
            
            
            16
            %Graybar
      Electric Company, Inc.
            
            $
            361,313
            
            
            
            27
            %
            
            
            6
            %
            
            
            -----
            
            
            
            ----
            
            
            
            -----





26




Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


15.  Subsequent
Events





During
the period September 1, 2008 through October 3, 2008, we purchased 1,469,950
shares of our common stock at an aggregate cost of $302,837 pursuant to our
stock buyback program.





On
September 1, 2008 we purchased Crossflo for $10 million in cash and stock. 
The average closing price of our common stock as required to be calculated in
the Agreement and Plan of Merger was $0.24389 per share.  In connection
with the transaction we paid $1,955,741 in cash and issued 17,583,235 shares of
our common stock with a fair market value of $4,288,375 to Crossflo’s preferred
shareholders; we issued 2,844,630 shares of our common stock with a fair market
value of $693,777 to our escrow agent, Union Bank of California, to be held
until the conditions specified in the Escrow Agreement associated with the
Agreement and Plan of Merger are satisfied; we paid $437,388 in cash and issued
5,104,196 shares of our common stock with a fair market value of $1,244,862 to
Crossflo’s convertible note holders; we paid $85,548 in cash and issued
1,456,394 shares of our common stock with a fair market value of $355,200 to
Crossflo’s appointed broker in connection with the closing of the acquisition;
and, we accrued $57,093 to Crossflo’s legal counsel for work performed in
affecting the transaction.





The
consideration paid to the convertible note holders, the appointed broker,
Crossflo’s legal counsel, and a working capital deduction of $64,252, all served
to reduce the consideration available for distribution to Crossflo’s preferred
shareholders. Prior to the closing of the transaction, we held $817,750 of
Crossflo convertible notes which were discharged as additional consideration for
the transaction.




27




Item
2. Management’s Discussion and Analysis of Financial Condition and Results of
Operations





THE
FOLLOWING DISCUSSION INCLUDES FORWARD-LOOKING STATEMENTS WITH RESPECT TO OUR
FUTURE FINANCIAL PERFORMANCE. ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE
CURRENTLY ANTICIPATED AND FROM HISTORICAL RESULTS DEPENDING UPON A VARIETY OF
FACTORS, INCLUDING THOSE DESCRIBED BELOW UNDER THE SUB-HEADING, "RISK FACTORS".
SEE ALSO OUR ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED MAY 31,
2008.





Overview





In June
2005, we entered into a series of agreements with TPL and others to facilitate
the pursuit of infringers of our intellectual property. We intend to continue
our joint venture with TPL to pursue license agreements with infringers of our
technology. We believe that utilizing the option of working through TPL, as
compared to creating and using a Company licensing team for those activities,
avoids a competitive devaluation of our principal assets and is a prudent way to
achieve the desired results as we seek to obtain fair value from users of our
intellectual property.





With the
proceeds generated by these licensing efforts, we are undertaking to make
investments in technologies, and acquisitions of companies operating in the
electronics technology market sector by way of i) selective expansion of our IP
portfolio, ii) pursuit of strategic minority investments in certain early-stage
revenue or technology ventures that represent a technology or capability of
interest to us, and iii) full M&A transactions.





Critical
Accounting Policies and Estimates





Our
condensed consolidated financial statements have been prepared in accordance
with accounting principles generally accepted in the United States of America,
which require us to make estimates and judgments that significantly affect the
reported amounts of assets, liabilities, revenues and expenses, and related
disclosure of contingent assets and liabilities. Actual results could differ
from those estimates, and such differences could affect the results of
operations reported in future periods. We believe the following critical
accounting policies affect our most significant estimates and judgments used in
the preparation of our condensed consolidated financial statements.





1.           Revenue
Recognition





Accounting
for revenue recognition is complex and affected by interpretations of guidance
provided by several sources, including the Financial Accounting Standards Board
(“FASB”) and the Securities and Exchange Commission (“SEC”). This guidance is
subject to change. We follow the guidance established by the SEC in Staff
Accounting Bulletin No. 104, as well as generally accepted criteria for revenue
recognition, which require that, before revenue is recorded, there is persuasive
evidence of an arrangement, the fee is fixed or determinable, collection is
reasonably assured, and delivery to our customer has occurred. Applying these
criteria to certain of our revenue arrangements requires us to carefully analyze
the terms and conditions of our license agreements. Revenue from our technology
license agreements is recognized at the time we enter into a contract, determine
the license model (paid-in-advance or on-going royalty), and provide our
customer with the licensed technology, if applicable. These criteria are
generally met during the fiscal quarter of license announcement for paid-
in-advance licenses, or the subsequent quarter immediately following. We believe
that this is the point at which we have performed all of our obligations under
the agreement; however, this remains a highly interpretive area of accounting
and future license agreements may result in a different method of revenue
recognition. To date all of our technology licenses have been paid-in-advance,
however, on-going royalty license terms may be opted for by future licensees of
our technology. Fees for maintenance or support of our licenses are recorded on
a straight-line basis over the underlying period of
performance.


28


Our
consolidated variable interest entity recognizes revenue upon shipment of its
product both from its warehouse  and  when it is received by
the customer, depending on the shipping method, and recognizes revenue on its
short-term installation contracts as time and materials costs are
incurred.





2.           Assessment
of Contingent Liabilities





We are
involved in various legal matters, disputes, and patent infringement claims
which arise in the ordinary course of our business. We accrue for estimated
losses at the time when we can make a reliable estimate of such loss and it is
probable that it has been incurred. By their very nature, contingencies are
difficult to estimate. We continually evaluate information related to all
contingencies to determine that the basis on which we have recorded our
estimated exposure is appropriate.





3.           Stock
Options and Warrants





On June
1, 2006, we adopted the provisions of Statement of Financial Accounting
Standards (“SFAS”) No. 123(R), Share-Based Payment, which
establishes standards for the accounting of transactions in which an entity
exchanges its equity instruments for goods or services, primarily focusing on
accounting for transactions where an entity obtains employee services in
share-based payment transactions. SFAS No. 123(R) requires a public entity
to measure the cost of employee services received in exchange for an award of
equity instruments, including stock options, based on the grant-date fair value
of the award and to recognize it as compensation expense over the period the
employee is required to provide service in exchange for the award, usually the
vesting period.  Stock-based awards to non-employees are accounted for
using the fair value method in accordance with SFAS No. 123, Accounting for Stock Based
Compensation.





In
November 2005, FASB issued FASB Staff Position (“FSP”)No. FAS 123R-3, Transition Election Related to
Accounting for Tax Effects of Share-Based Payment Awards (“FAS
123R-3”).  We have elected to adopt the alternative transition method
provided in FAS 123R-3.  The alternative transition method includes a
simplified method to establish the beginning balance of the additional paid-in
capital pool (“APIC pool”) related to the tax effects of employee share-based
compensation, which is available to absorb tax deficiencies recognized
subsequent to the adoption of SFAS No. 123(R).




Stock-based
compensation expense recognized during the period is based on the value of the
portion of share-based payment awards that is ultimately expected to vest during
the period. Stock-based compensation expense recognized in our condensed
consolidated statement of operations for the three months ended August 31, 2007
included compensation expense for the share-based payment awards granted
subsequent to May 31, 2007 based on the grant date fair value estimated in
accordance with the provisions of SFAS No. 123(R). Stock-based compensation
expense recognized in our condensed consolidated statement of operations for the
three months ended August 31, 2008 included compensation expense for share-based
payment awards granted prior to May 31, 2008 based on the grant date fair
value estimated in accordance with the provisions of SFAS No. 123(R). As
stock-based compensation expense recognized in the condensed consolidated
statements of operations is based on awards ultimately expected to vest, it has
been reduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures to
be estimated at the time of grant and revised, if necessary, in subsequent
periods if actual forfeitures differ from those estimates. The estimated average
forfeiture rate for the three months ended August 31, 2008 and 2007 of
approximately 5% was based on historical forfeiture experience and estimated
future employee forfeitures. The estimated pricing term of option grants for the
three months ended August 31, 2008 and 2007 was five years.





4.           Income
Taxes





We must
assess the likelihood that we will be able to recover our deferred tax assets.
If recovery is not likely, we must increase our provision for taxes by recording
a valuation allowance against the deferred tax assets that we estimate will not
ultimately be recoverable. We believe that a substantial majority of the
deferred tax assets recorded on our balance sheet will ultimately be recovered.
However, should there be a change in our ability to recover the deferred tax
assets; the tax provision would increase in the period in which we determined
that the recovery was not probable.


29


Additionally,
we adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income
Taxes – An Interpretation of FASB Statement No. 109,or FIN 48, on June
1, 2007, the first day of fiscal 2008.  FIN 48 seeks to reduce the
diversity in practice associated with certain aspects of measurement and
recognition in accounting for income taxes.  FIN 48 prescribes a
recognition threshold and measurement requirement for the financial statement
recognition of a tax position that has been taken or is expected to be taken on
a tax return and also provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure and
transition.  Under FIN 48 we may only recognize tax positions that
meet a “more likely than not” threshold.





5.           Investments
in Affiliated Companies





We have a
50% interest in PDS. We account for our investment using the equity method of
accounting since the investment provides us the ability to exercise significant
influence, but not control, over the investee. Significant influence is
generally deemed to exist if we have an ownership interest in the voting stock
of the investee of between 20% and 50%, although other factors, such as
representation on the investee’s Board of Directors, are considered in
determining whether the equity method of accounting is appropriate. Under the
equity method of accounting, the investment, originally recorded at cost, is
adjusted to recognize our share of net earnings or losses of the investee and is
recognized in the consolidated statement of operations in the caption “Equity in
earnings of affiliated companies”.





We have a
37.4% interest in Talis.  We account for our investment using the
equity method of accounting pursuant to paragraph 8 of AICPA Statement of
Position 78-9, Accounting for
Investments in Real Estate Ventures(which has applicability to non-Real
Estate accounting matters as well) as our membership share of this limited
liability company is more than minor.  Under the equity method of
accounting, the investment, originally recorded at cost, is adjusted to
recognize our share of net earnings or losses of the investee and is recognized
in the consolidated statement of operations in the caption “Equity in earnings
of affiliated companies”.





We own
37.1% of the preferred stock of Avot.  This investment is accounted
for at cost since we do not have the ability to exercise significant influence
over the operating and financial policies of Avot.





We review
our investments in these affiliated companies to determine whether events or
changes in circumstances indicate that the carrying amounts may not be
recoverable. The primary factors we consider in our determination are the
financial condition, operating performance and near term prospects of the
investees. If the decline in value is deemed to be other than temporary, we
would recognize an impairment loss.





6.           Variable
Interest Entity





We own
100% of the preferred stock of Holocom. On March 27, 2007 we entered into an 18
month revolving line of credit with Holocom for a maximum amount of $500,000
which matured on September 27, 2008.  The line of credit was paid in
full on August 31, 2008.  During July 2008, Holocom obtained a credit
facility from a third party which we guaranteed. The line of credit and the
subsequent guaranty by us caused us to have a variable interest in Holocom, a
variable interest entity, and we have determined that we are the primary
beneficiary as we absorb more than half of the variable interest entity’s
expected losses. FASB Interpretation 46, Consolidation of Variable Interest
Entities, an Interpretation of ARB No. 51(“FIN 46”) as modified by FASB
in December of 2003 (“FIN 46(R)”), requires us to consolidate Holocom as long as
we are deemed to be the primary beneficiary.





We
reevaluate our primary beneficiary position at each of our balance sheet dates
using the guidance in FIN  46(R). If we are no longer deemed to be the
primary beneficiary of the variable interest entity, we will discontinue
consolidation.


30


Results
of Operations





Comparison
of the Three Months Ended August 31, 2008 and Three Months Ended August 31,
2007.





Three
      months endedAugust
      31, 2008
            
            
            August
      31, 2007Holocom:
            
            Dollars
            
            
            %
      of Revenue
            
            
            Dollars
            
            
            %
      of RevenueRevenues
      - Product sales and other
            
            $
            1,319,366
            
            
            
            100.0
            %
            
            $
            511,864
            
            
            
            100.0
            %Cost
      of sales
            
            
            584,253
            
            
            
            44.3
            %
            
            
            151,535
            
            
            
            29.6
            %Gross
      profit
            
            $
            735,113
            
            
            
            55.7
            %
            
            $
            360,329
            
            
            
            70.4
            %PTSC:Revenues
      - Product sales and other
            
            $
            39,280
            
            
            
            100.0
            %
            
            $
            9,505
            
            
            
            100.0
            %Cost
      of sales
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Gross
      profit
            
            $
            39,280
            
            
            
            100.0
            %
            
            $
            9,505
            
            
            
            100.0
            %





Our
revenues increased from approximately $521,000 for the three months ended August
31, 2007 to approximately $1,359,000 for the three months ended August 31, 2008.
Our revenue amounts do not include  a loss of approximately $1,201,000
from our investment in PDS for the three months ended August 31, 2007, or income
of approximately $6,621,800 from our investment in PDS for the three months
ended August 31, 2008 and a loss of approximately $63,000 from our investment in
Talis for the three months ended August 31, 2008.  During the three
months ended August 31, 2008 and 2007, we recorded sales amounting to
approximately $1,319,000 and $512,000, respectively, by our consolidated
variable interest entity, Holocom, with cost of sales amounting to approximately
$584,000 and $152,000, respectively. The increase in sales for Holocom during
the three months ended August 31, 2008 as compared to the three months ended
August 31,  2007 is primarily due to increased sales to
distributors.  During the three months ended August 31, 2008 and 2007,
we recognized maintenance fee revenues totaling approximately
$6,250  and $6,250 in connection with an agreement with AMD
Corporation during the 2005 fiscal year. The agreement called for maintenance
fees totaling $100,000 connected with a license agreement for our Ignite
technology; the license fee revenue is being recognized as revenue evenly over
the four year period of the license. In addition during the three months ended
August 31, 2008, we recorded sales of approximately $33,000 from the sale of
microprocessor chips that we no longer market. Inventory associated with the
sales of these microprocessor chips is carried at zero value.  The
sales of microprocessor chips during August 2008 were the final sales of our
inventory on hand.  During the three months ended August 31, 2007, we
recorded sales of approximately $3,300 relating to the microprocessor
chips.





Three
      months endedAugust
      31, 2008
            
            
            August
      31, 2007Selling,
      general and administrative
            
            $
            1,930,805
            
            
            $
            1,958,190





Selling,
general and administrative expenses decreased from approximately $1,958,000 for
the three months ended August 31, 2007 to approximately $1,931,000 for the three
months ended August 31, 2008.  Legal expenses decreased by
approximately $95,000 for the three months ended August 31, 2008 compared with
the three months ended August 31, 2007 and accounting expenses increased by
approximately $117,000 for the three months ended August 31, 2008 compared with
the three months ended August 31, 2007.  The increase in accounting
expenses was primarily due to the cost of Holocom’s audit of internal control
over financial reporting of approximately $60,000, such costs were not incurred
during the three months ended August 31, 2007 and costs of approximately $45,000
relating to the Crossflo transaction of which we capitalized at closing on
September 1, 2008.  Salary costs and related expenses included
non-cash expenses associated with the fair value of options granted during the
period in accordance with SFAS No. 123R.  During the three months
ended August 31, 2008, no options were granted.  The vesting on
existing grants resulted in non-cash compensation expense of approximately
$107,500.  During the three months ended August 31, 2007, 325,000
options were granted to employees and directors resulting in non-cash
compensation expense of approximately $113,000. Additional non-cash compensation
for the three months ended August 31, 2007 amounted to approximately $170,000
for vesting of employee stock options in accordance with SFAS 123(R). Board of
director fees amounting to approximately $102,000 were paid during the three
months ended August 31, 2008 as compared to $98,000 paid for the three months
ended August 31, 2007.  Other salary expenses increased by
approximately $49,000 for the three months ended August 31, 2008 as compared
with the three months ended August 31, 2007 consisting of approximately $46,000
relating to Holocom.  Public and investor relations expenses decreased
by approximately $36,500 for the three months ended August 31, 2008 as compared
with the three months ended August 31, 2007 due to changes in our investor and
public relations firms and one-time fees for services incurred in the three
months ended August 31, 2007.


31





Three
      months endedAugust
      31, 2008
            
            
            August
      31, 2007Settlement
      and license expense
            
            $
            -
            
            
            $
            30,000





Settlement
and license expenses amounting to $30,000 were recorded for the three months
ended August 31, 2007 relating to royalties payable resulting from an agreement
with Fish (see Note 8 to our condensed consolidated financial statements for
more information).





Three
      months endedz
            August
      31, 2008
            
            
            August
      31, 2007Other
      income (expense):Interest
      and other income
            
            $
            112,846
            
            
            $
            474,525Loss
      on sale of assets
            
            
            -
            
            
            
            (345
            )Interest
      expense
            
            
            (4,622
            )
            
            
            (237
            )Gain
      on sale of subsidiary interest
            
            
            -
            
            
            
            150,000Equity
      in earnings (loss) of affiliated companies
            
            
            6,558,770
            
            
            
            (1,200,542
            )Total
      other income (expense), net
            
            $
            6,666,994
            
            
            $
            (576,599
            )





Our other
income and expenses for the three months ended August 31, 2008 included equity
in the earnings of PDS consisting of net income after expenses in the amount of
approximately $6,621,800 and our share of loss in Talis consisting of
approximately $63,000 after expenses.  For the three months ended
August 31, 2007, our other income and expenses included our share of loss in PDS
of approximately $1,201,000. Our investments in PDS and Talis are accounted for
in accordance with the equity method of accounting for investments. Total other
income and expense for the three months ended August 31, 2008 amounted to net
other income of approximately $6,667,000 compared with total other income and
expense for the three months ended August 31, 2007 of net other expense
amounting to approximately $577,000. Interest income and other income decreased
from approximately $475,000 for the three months ended August 31, 2007 to
approximately $113,000 for the three months ended August 31, 2008 due to
declines in interest rates for our cash, cash equivalents and short term
investment accounts. During the three months ended August 31, 2007, Holocom
recognized $150,000 of other income in connection with the sale of a portion of
its interest in Talis to a third party.





During
the three months ended August 31, 2007, we recorded a benefit for income taxes
of approximately $233,000 related to federal and California
taxes.  During the three months ended August 31, 2008, we recorded a
provision for income taxes of approximately $2,380,000 related to federal and
California taxes.





We
recorded a net loss for the three months ended August 31, 2007 of $1,962,386
compared with net income of $3,209,513 for the three months ended August 31,
2008.


32


Liquidity
and Capital Resources





Liquidity





Our cash
and short-term investment balances increased from approximately $6,722,000 as of
May 31, 2008  to approximately $8,847,000 as of August 31, 2008. We
also have restricted cash balances amounting to approximately $51,000 as of May
31, 2008 and approximately $51,000 as of August 31, 2008. Total current assets
increased from approximately $9,851,000 as of May 31, 2008 to approximately
$11,689,000 as of August 31, 2008. Total current liabilities amounted to
approximately $930,000 and approximately $4,857,000 as of May 31, 2008 and
August 31, 2008, respectively. The change in our current position as of August
31, 2008 as compared with May 31, 2008 results in part from our receipt of
approximately $5,852,000 in distributions from PDS and from recording a
liability for income taxes of approximately $3,749,000.





During
June 2008, we obtained a credit facility for as long as needed, which provides
for financing up to 50% of the par value balance of our outstanding auction rate
securities. The facility is collateralized by the full value of the outstanding
auction rate securities, required no origination fee, and if drawn upon will
bear interest at the federal funds rate plus 3%.





Cash
Flows From Operating Activities





Cash used
in operating activities for the three months ended August 31, 2008 was
approximately $985,000 as compared with cash used in operating activities for
the three months ended August 31, 2007 of approximately $2,129,000. The
principal components of the current period amount were: net income of
approximately $3,210,000 and a change in income taxes payable of approximately
$3,749,000.  These increases were partially offset by: equity in
earnings of affiliates of $6,559,000 and change in deferred taxes of
approximately $1,606,000.





Cash
Flows From Investing Activities





Cash
provided by investing activities was approximately $3,894,000 for the three
months ended August 31, 2008 as compared to cash used in investing activities of
approximately $255,000 for the three months ended August 31, 2007. The increase
was primarily due to distributions received from PDS for the three months ended
August 31, 2008 of approximately $5,852,000.  There were no
distributions received during the three months ended August 31,
2007.  Cash used during the three months ended August 31, 2008
included approximately $668,000 in purchases of Crossflo and Avot convertible
notes, approximately $1,050,000 in purchases of Avot preferred stock and
approximately $497,000 in purchases of Talis LLC membership units.





Cash
Flows From Financing Activities





Cash used
in financing activities for the three months ended August 31, 2008 was
approximately $575,000 as compared to approximately $3,640,000 for the three
months ended August 31, 2007.   For the three months ended August
31, 2008, cash of approximately $505,000 was used to purchase common stock for
treasury and cash of approximately $70,000 was used to pay our note
payable.





Capital
Resources





Our
current position as of August 31, 2008 is expected to provide the funds
necessary to support our operations through at least the next twelve
months.


33


Contractual
Obligations and Commitments





A summary
of our outstanding contractual obligations at August 31, 2008 is as
follows:




Contractual
              Cash
      Obligations
            
            Total
      Amounts
              Committed
            
            
            1-3
              YearsOperating
      leases - facilities
            
            $
            143,430
            
            
            $
            143,430





Recent
Accounting Pronouncements





In
September 2006, the FASB issued SFAS No. 157, Fair Value
Measurements.  SFAS No. 157 defines fair value, establishes a
framework for measuring fair value in generally accepted accounting principals
and expands disclosures about fair value measurements.  The statement does
not require new fair value measurements, but is applied to the extent that other
accounting pronouncements require or permit fair value measurements.  The
statement emphasizes that fair value is a market-based measurement that should
be determined based on the assumptions that market participants would use in
pricing an asset or liability.  Companies that have assets and liabilities
measured at fair value will be required to disclose information that enables the
users of its financial statements to access the inputs used to develop those
measurements.  The reporting entity is encouraged, but not required, to
combine the fair value information disclosed under this statement with the fair
value information disclosed under other accounting pronouncements.  SFAS
No. 157 is effective for fiscal years beginning after November 15, 2007. In
February 2008, the FASB released FASB Staff Position 157-2, Effective Date of FASB StatementNo. 157,which
delayed the effective date of SFAS No. 157 for all nonfinancial assets and
nonfinancial liabilities, except those that are recognized or disclosed at fair
value in the financial statements on a recurring basis (at least annually) until
the fiscal year beginning June 1, 2009.  On June 1, 2008, we adopted
SFAS No. 157 for financial assets and liabilities.  The adoption did
not have a material effect on our results of operations and financial
position.  We are in the process of evaluating the impact of adoption
of SFAS No. 157 for nonfinancial assets and liabilities, but do not anticipate
that the adoption will have a material impact on our consolidated financial
statements.





In
February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial
Assets and Financial Liabilities. SFAS No. 159 permits entities to choose
to measure at fair value many financial instruments and certain other items that
are not currently required to be measured at fair value. The objective is to
improve financial reporting by providing entities with the opportunity to
mitigate volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting
provisions. SFAS No. 159 also establishes presentation and disclosure
requirements designed to facilitate comparisons between entities that choose
different measurement attributes for similar types of assets and liabilities.
SFAS No. 159 does not affect any existing accounting literature that
requires certain assets and liabilities to be carried at fair value.
SFAS No. 159 does not establish requirements for recognizing and
measuring dividend income, interest income, or interest expense. This Statement
does not eliminate disclosure requirements included in other accounting
standards.  We have elected not to measure eligible financial assets
and liabilities at fair value.  Accordingly, the adoption of SFAS No.
159 did not have a material impact on our results of operations and financial
position.





In
December 2007, the FASB issued SFAS No. 141(R), Business Combinations. SFAS
No. 141(R) requires acquiring entities in a business combination to recognize
the assets acquired and liabilities assumed in the transaction; establishes the
acquisition-date fair value as the measurement objective for all assets acquired
and liabilities assumed; and requires the acquirer to disclose to investors the
information it needs to evaluate and understand the nature and financial effect
of the business combination. SFAS No. 141(R) is effective in fiscal years
beginning after December 15, 2008. We expect to adopt SFAS No. 141(R) on June 1,
2009.  We are currently assessing the impact the adoption of SFAS No.
141(R) will have on our consolidated financial statements.


34


In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements. SFAS No. 160 requires entities to
report noncontrolling (minority) interests in subsidiaries as equity in the
consolidated financial statements. SFAS No. 160 is effective in fiscal
years beginning after December 15, 2008. We expect to adopt SFAS No. 160 on June
1, 2009.  We are currently assessing the impact the adoption of SFAS
No. 160 will have on our consolidated financial statements.





In
March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities, an amendment of
FASB Statement No. 133 Accounting for Derivative
Instruments and Hedging Activities (“SFAS No. 161”) requires
entities to provide greater transparency about how and why an entity uses
derivative instruments, how derivative instruments and related hedged items are
accounted for under SFAS No. 133, and how derivative instruments and
related hedged items affect an entity’s financial position, results of
operations, and cash flows. The statement is effective for financial statements
issues for fiscal years and interim periods beginning after November 15,
2008.  We expect to adopt SFAS No. 161 on June 1, 2009. We are
currently assessing the impact the adoption of SFAS No. 161 will have on our
consolidated financial statements.





In
April 2008, the FASB issued FSP No. 142-3, Determination of the Useful Life of
Intangible Assetswhich amends the factors that must be considered in
developing renewal or extension assumptions used to determine the useful life
over which to amortize the cost of a recognized intangible asset under SFAS
No. 142, Goodwill and
Other Intangible Assets. The FSP requires an entity to consider its own
assumptions about renewal or extension of the term of the arrangement,
consistent with its expected use of the asset, and is an attempt to improve
consistency between the useful life of a recognized intangible asset under SFAS
No. 142 and the period of expected cash flows used to measure the fair
value of the asset under SFAS No. 141, Business Combinations. The
FSP is effective for fiscal years beginning after December 15, 2008, and
the guidance for determining the useful life of a recognized intangible asset
must be applied prospectively to intangible assets acquired after the effective
date. The FSP is not expected to have a significant impact on
our consolidated financial statements.





In
May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted
Accounting Principles (“SFAS No. 162”). The statement is intended to
improve financial reporting by identifying a consistent hierarchy for selecting
accounting principles to be used in preparing financial statements that are
prepared in conformance with generally accepted accounting principles. Unlike
Statement on Auditing Standards (“SAS”) No. 69, The Meaning of Present in Conformity
With GAAP, SFAS No. 162 is directed to the entity rather than the
auditor. The statement is effective 60 days following the SEC’s approval of
the Public Company Accounting Oversight Board (“PCAOB”) amendments to AU
Section 411, The Meaning
of  Present Fairly in Conformity with GAAP, and is not expected
to have any impact on our consolidated financial statements.





In
June 2008, the FASB issued FSP EITF No. 03-6-1, Determining Whether Instruments
Granted in Share-Based Payment Transactions Are Participating Securities.
Under the FSP, unvested share-based payment awards that contain rights to
receive non-forfeitable dividends (whether paid or unpaid) are participating
securities, and should be included in the two-class method of computing EPS. The
FSP is effective for fiscal years beginning after December 15, 2008, and
interim periods within those years, and is not expected to have a significant
impact on our consolidated financial statements.





Risk
Factors





We urge
you to carefully consider the following discussion of risks as well as other
information regarding our common stock. We believe the following to be our most
significant risk factors as of the date this report is being filed. The risks
and uncertainties described below are not the only ones we
face.


35


We Have Reported Substantial Income In The First
Quarter Of Fiscal 2009, And For The Fiscal Years 2008, 2007 and 2006 Which May
Not Be Indicative Of Our Future Income





During
the first quarter of fiscal 2009, and for the fiscal years 2008, 2007 and 2006,
we entered into license agreements, directly and through our joint venture with
TPL. Because of the uncertain nature of the negotiations that lead to license
revenues, pending litigation with companies which we allege have infringed on
our patent portfolio, the possibility of legislative action regarding patent
rights, petitions with the U. S. Patent and Trademark Office to re-examine
certain of our patents, and the possible effect of new judicial interpretations
of patent laws, we cannot predict the amount of future revenues from such
agreements, or whether there will be future revenues from license agreements at
all.





We
Are Dependent Upon A Joint Venture For Substantially All Of Our Income In Which
Our Role Is Of A Passive Nature





In June
of 2005, we entered into a joint venture with TPL, pursuant to which TPL is
responsible for the licensing and enforcement of our microprocessor patent
portfolio. This joint venture has been the source of virtually all of our income
since June of 2005. Therefore, in light of the absence of significant revenue
from other sources, we should be regarded as entirely dependent on the success
or failure of the licensing and prosecution efforts of TPL on behalf of the
joint venture.





We
May Not Be Successful In Identifying Acquisition Candidates And If We Undertake
Acquisitions, They Could Increase Our Costs Or Liabilities And Impair Our
Revenue And Operating Results.




One of
our strategies is to pursue growth through acquisitions. We may not be able to
identify suitable acquisition candidates at prices that we consider appropriate.
If we do identify an appropriate acquisition candidate, we may not be able to
successfully negotiate the terms of the acquisition or finance the acquisition
on terms that are satisfactory to us. Negotiations of potential acquisitions and
the integration of acquired business operations could disrupt our business
by diverting management attention from day-to-day operations. Acquisitions of
businesses or other material operations may require debt or equity financing,
resulting in leverage or dilution of ownership. We may encounter increased
competition for acquisitions, which may increase the price of our
acquisitions.




Integration
of acquisitions requires significant management time and financial resources.
Any failure to properly integrate and manage businesses we acquire could
seriously harm our operating results. In addition, acquired companies
may not perform as well as we expect, and we may fail to realize
anticipated benefits. In connection with acquisitions, we may issue common stock
that would dilute our current stockholders’ ownership and incur debt and other
costs which may cause our quarterly operating results to vary significantly. The
dilution of our current stockholders’ ownership may be exacerbated if our per
share stock price is depressed and common stock is issued in connection with
acquisitions.




If we are
unable to successfully integrate companies we may acquire, our revenue and
operating results could suffer. The integration of such businesses into our
operations may result in unforeseen operating difficulties, may absorb
significant management attention and may require significant financial resources
that would otherwise be available for other business purposes. These
difficulties of integration may require us to coordinate geographically
dispersed organizations, integrate personnel with disparate business backgrounds
and reconcile different corporate cultures. In addition, we may not be
successful in achieving anticipated synergies from these
acquisitions.  We may experience increased attrition, including, but
not limited to, key employees of the acquired companies, during and following
the integration of acquired companies that could reduce our future
revenue.




In
addition, we may need to record write-downs from future impairments of
identified intangible assets and goodwill, which could reduce our future
reported earnings. Acquired companies may have liabilities or adverse operating
issues that we fail to discover through due diligence prior to the acquisition.
In particular, to the extent that prior owners of any acquired businesses or
properties failed to comply with or otherwise violated applicable laws or
regulations, or failed to fulfill their contractual obligations to their
customers or clients, we, as the successor owner, may be financially responsible
for these violations and failures and may suffer reputational harm or otherwise
be adversely affected. The discovery of any material liabilities associated with
our acquisitions could cause us to incur additional expenses and cause a
reduction in our operating profits.


36


Changes
In Our Relationships With Companies In Which We Hold Less Than A Majority
Interest Could Change The Way We Account For Such Interests In The
Future.





We hold a
minority interest in Holocom to which we have guaranteed third party debt. Under
the applicable provisions of accounting principles generally accepted in the
United States of America, including FIN 46(R), we currently consolidate the
financial statements and results of operations of this company into our
consolidated financial statements and results of operations, and record the
equity interest that we do not own as a minority interest. For our
investments  accounted for under the equity method (PDS and Talis), we
record as part of other income or expense our share of the increase or decrease
in the equity of these companies in which we have invested. Our investment in
Avot is recorded at cost basis.  It is possible that, in the future,
our relationships and/or our interests in or with this consolidated entity,
equity method investees and cost basis investee could change. Such potential
future changes could result in deconsolidation or consolidation of such
entities, as the case may be, which could result in changes in our reported
results.





A
Successful Challenge To Our Intellectual Property Rights Would Have A
Significant And Adverse Effect On Us





A
successful challenge to our ownership of our technology or the proprietary
nature of our intellectual property would materially damage our business
prospects. We rely on a combination of patents, trademarks, copyrights, trade
secret laws, confidentiality procedures and licensing arrangements to protect
our intellectual property rights. We currently have seven U.S. patents, one
European patent, and one Japanese patent issued. Any issued patent may be
challenged and invalidated. Patents may not be issued for any of our pending
applications. Any claims allowed from existing or pending patents may not be of
sufficient scope or strength to provide significant protection for our products.
Patents may not be issued in all countries where our products can be sold so as
to provide meaningful protection or any commercial advantage to us. Our
competitors may also be able to design around our patents.





Vigorous
protection and pursuit of intellectual property rights or positions characterize
the fiercely competitive semiconductor industry, which has resulted in
significant and often protracted and expensive litigation. Therefore, our
competitors and others may assert that our technologies or products infringe on
their patents or proprietary rights. Persons we believe are infringing our
patents are likely to vigorously defend their actions and assert that our
patents are invalid. Problems with patents or other rights could result in
significant costs, limit future license revenue, and impair or hinder our
acquisition strategy. If infringement claims against us are deemed valid or if
our infringement claims are successfully opposed, we may not be able to obtain
appropriate licenses on acceptable terms or at all. Litigation could be costly
and time-consuming but may be necessary to protect our future patent and/or
technology license positions or to defend against infringement
claims.  Parties have petitioned the U. S. Patent and Trademark Office
to re-examine certain of our patents. An adverse decision in litigation or in
the re-examination process would have a very significant and adverse effect on
our business.





On
December 18, 2007 we announced that a resolution was reached in two patent
infringement lawsuits in the U.S. District Courts in the Eastern District of
Texas and the Northern District of California.  There are no
assurances that the resolution will favorably impact, or that it will not
impair, our ability to assert our technology rights in the future.





During
the quarter ended February 29, 2008, we were named as co-defendants in three
separate lawsuits regarding the MMP Portfolio.  See footnote 13 to our
condensed consolidated financial statements and Part II, Item 1. Legal
Proceedings in this Report on Form 10-Q.


37


If A Large Number Of Our Shares Are
Sold All At Once Or In Blocks, The Market Price Of Our Shares Would
Most Likely
Decline





Shareholders
who acquired common stock through the exercise of warrants are not restricted in
the price at which they can sell their shares. Shares sold at a price below the
current market price at which the common stock is trading may cause the market
price to decline.





A
Significant Portion Of Our Investments Are Currently Illiquid Which May Impact
Our Acquisition Strategy And/Or Operating Results





Our
long-term investment in marketable securities balance consists of auction rate
securities with a par value of $12.9 million, which at present are highly
illiquid. In the event we need immediate access to these funds, we will not be
able to sell these investments at par value. These instruments are expected to
remain illiquid until a future auction of these investments is successful,
buyers are found outside of the auction process, or they are redeemed by the
issuing agencies. We have partially offset the consequences of this illiquidity
by securing a line of credit collateralized by the auction rates securities. In
the event these securities are deemed to be permanently impaired, we will be
required to take a charge to operations in recognition of this
impairment.





The
Market For Our Stock Is Subject To Rules Relating To Low-Priced Stock (“Penny
Stock”) Which May Limit Our Ability To Raise Capital





Our
common stock is currently listed for trading in the Financial Industry
Regulatory Authority (“FINRA”) Over-The-Counter Bulletin (“OTC”) Board Market
and is subject to the “penny stock rules” adopted pursuant to Section 15(g) of
the Exchange Act. In general, the penny stock rules apply to non-NASDAQ or
non-national stock exchange companies whose common stock trades at less than
$5.00 per share or which have tangible net worth of less than $5,000,000
($2,000,000 if the company has been operating for three or more years). Such
rules require, among other things, that brokers who trade “penny stock” on
behalf of persons other than “established customers” complete certain
documentation, make suitability inquiries of investors and provide investors
with certain information concerning trading in the security, including a risk
disclosure document, quote information, broker’s commission information and
rights and remedies available to investors in penny stocks. Many brokers have
decided not to trade “penny stock” because of the requirements of the penny
stock rules, and as a result, the number of broker-dealers willing to act as
market makers in such securities is limited. The “penny stock rules,” therefore,
may have an adverse impact on the market for our common stock and may affect our
ability to raise additional capital if we decide to do so.





Our
Share Price Could Decline As A Result Of Short Sales





When an
investor sells stock that he does not own, it is known as a short sale. The
seller, anticipating that the price of the stock will go down, intends to buy
stock to cover his sale at a later date. If the price of the stock goes down,
the seller will profit to the extent of the difference between the price at
which he originally sold it less his later purchase price. Short sales enable
the seller to profit in a down market. Short sales could place significant
downward pressure on the price of our common stock. Penny stocks which do not
trade on an exchange, such as our common stock, are particularly susceptible to
short sales.





Our
Future Success Depends In Significant Part Upon The Continued Services Of Our
Key Senior Management





Our
future success depends in significant part upon the continued services of our
key senior management personnel. The competition for highly qualified personnel
is intense, and we may not be able to retain our key managerial employees or
attract and retain additional highly qualified technical and managerial
personnel in the future. None of our employees are represented by a labor union,
and we consider our relations with our employees to be good. None of our
employees are covered by key man life insurance policies.


38


Item
3. Quantitative and Qualitative Disclosures About Market Risk





Interest
rate risk





The
primary objective of our investment activities is to maintain surplus cash in
accounts that provide a high level of funds accessibility in large, respected
financial institutions with asset safety as a primary consideration.
Accordingly, we maintain our cash and cash equivalents with high quality
financial institutions. Amounts deposited with these institutions may exceed
federal depository insurance limits.





Cash
and Cash Equivalents





We
maintain cash and cash equivalents in institutional money market accounts. In
general, money market funds are not subject to interest rate risk because the
interest paid on these funds fluctuates with the prevailing interest
rate.





Our
commercial checking account is linked to a sweep account. This sweep account is
maintained by our financial institution in an offshore account located in the
Cayman Islands. This sweep account is a deposit liability of our financial
institution, the funds are not insured by the Federal Deposit Insurance
Corporation (“FDIC”), in liquidation the funds have a lesser preference than
deposits held in the United States, and the funds are subject to cross-border
risks.





Auction
Rate Securities





Our
exposure to market risk for changes in interest rates relates primarily to our
auction rate securities.  During the quarter ended February 29, 2008,
investment banks were reporting an inability to successfully obtain subscribers
for high credit quality auction rate securities.  As of August 31,
2008, we held such auction rate securities with a par value totaling $12.9
million that failed to sell at auction. In the event we need to access funds
invested in these auction rate securities we will not be able to liquidate these
securities until a future auction of these securities is successful, they are
refinanced and redeemed by the issuers, or a buyer is found outside of the
auction process.  The investments consist of student loan auction rate
instruments issued by various state agencies pursuant to the Federal Family
Educational Loan Program (“FFELP”).  These investments are of high
credit quality and the AAA credit ratings of the investments have been
reaffirmed since August 2008.  These instruments are collateralized in
excess of the underlying obligations, are insured by the various state
educational agencies, and are guaranteed by the Department of Education as an
insurer of last resort.





At August
31, 2008, the fair value of our auction rate securities was estimated at $12.4
million based on a valuation by Houlihan Smith & Company, Inc.  We
recorded the net temporary valuation adjustment of $309,321 in other
comprehensive income, which represents the gross valuation adjustment of
$522,024, net of the related tax benefit of $212,703.  We have
concluded that the unrealized losses on these investments are temporary because
(i) we believe that the decline in market value and absence of liquidity that
has occurred is due to general market conditions, (ii) the auction rate
securities continue to be of a high credit quality and interest is paid as due
and (iii) we have the intent and ability to hold these investments until a
recovery in market value occurs.  Since this valuation adjustment is
deemed to be temporary, it did not affect our earnings for the three months
ended August 31, 2008.





We are
not currently able to predict how long these investments will remain illiquid,
and as such, they have been classified as long-term investments in marketable
securities in the accompanying consolidated balance sheet at August 31,
2008.





The fair
value of our long-term investments in marketable securities could change
significantly in the future and we may be required to record
other-than-temporary impairment charges or additional unrealized losses in
future periods.


39


We do not
believe that the illiquidity of these investments will materially impact our
ability to fund our working capital needs, capital expenditures or other
business requirements.





During
June 2008 we obtained a credit facility which provides for financing up to 50%
of the par value balance of our outstanding auction rate securities. The
facility is collateralized by the full value of the outstanding auction rate
securities, required no origination fee, and if drawn upon will bear interest at
the federal funds rate plus 3%.





Item
4. Controls and Procedures





We
consolidate Holocom, a variable interest entity as defined in FIN 46(R)
that we do not control or manage and consequently, our disclosure controls and
procedures with respect to this entity are necessarily limited to oversight or
monitoring controls that we have implemented to provide reasonable assurance
that the objectives of our disclosure controls and procedures as described above
are met.





As of May
31, 2008, we carried out an evaluation, under the supervision and with the
participation of our management, including our Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures (as defined in Rule 13(a)-15(e) of the
Exchange Act).  Based on that evaluation, our Chief Executive Officer
and Chief Financial Officer concluded that, as of May 31, 2008 our disclosure
controls and procedures were not effective to provide reasonable assurance that
the information required to be disclosed in the reports we file and submit under
the Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the Securities and Exchange Commission’s rules and forms,
as a result of the material weakness identified and discussed
below.





As of May
31, 2008, a material weakness existed relating to Holocom’s information
technology general controls, including ineffective controls relating to
following:





·
            There
      is no IT security policy,


·
            There
      is no change management policy,


·
            There
      is no evidence of changes which have been
  performed,


·
            There
      is no physical security over servers, firewall, router and
      switches,


·
            There
      is no documentation of the granting of user access rights
      process,


·
            There
      is no documentation of the user access termination
  process,


·
            The
      firewall configuration does not reflect Holocom’s current
      usage,


·
            Remote
      access is not well controlled,


·
            Two
      of five systems did not have recent antivirus signature
    files,


·
            The
      antivirus software is not installed on the
  server,


·
            All
      named users, plus the CIO using the administrator account, have full
      access to all areas of QuickBooks,


·
            All
      authenticated users are allowed full access to the files in the Finance
      directory,


·
            The
      domain administrator list is not limited to the minimum appropriate
      personnel,


·
            Passwords
      are only required to be five characters which is deemed insufficient for
      good security,


·
            There
      is no evidence of the CIO’s weekly backup review occurring, and management
      is not being notified of failures,


·
            There
      are no stored backup tapes off-site or in a media safe,
  and


·
            There
      are no regularly run test
restorations.


40


Remediation
of Previously Reported Material Weakness





During
the quarter ended August 31, 2008, we completed remediation of the material
weakness relating to Holocom’s information technology controls.  In
connection with the remediation process we implemented the
following:




-
            Enhanced
      procedures and documentation addressing the unique issues contributing to
      the original assessment of the material
  weakness.




-
            More
      robust on-going management review of factors that impact information
      technology controls.






Through
these steps, we believe we have addressed the deficiencies that affected our
internal control over financial reporting as of May 31, 2008, and we intend to
continue to evaluate and strengthen our systems of internal control over
financial reporting.




Quarterly
Evaluation of Disclosure Controls and Procedures





As
required by Rule 13a-15(e) under the Exchange Act, as of August 31,
2008, the end of the period to which this quarterly report relates, we have
carried out an evaluation of the effectiveness of the design and operation of
our disclosure controls and procedures.  This evaluation was carried
out under the supervision and with the participation of our management,
including our Chief Executive Officer and our Chief Financial
Officer.





Disclosure
controls and procedures are controls and other procedures that are designed to
ensure that information required to be disclosed in our report filed or
submitted under the Exchange Act is recorded, processed, summarized and
reported, within the time periods specified in the Securities and Exchange
Commission’s rules and forms.  Disclosure controls and procedures
include, without limitation, controls and procedures designed to ensure that
information required to be disclosed in our reports filed under the Exchange Act
is accumulated and communicated to management, including the Chief Executive
Officer and Chief Financial Officer as appropriate, to allow timely decisions
regarding required disclosure. Management recognizes that any controls and
procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving their objectives, and management necessarily
applies its judgment in evaluating the cost-benefit relationship of possible
controls and procedures.  Based on the evaluation of our disclosure
controls and procedures as of August 31, 2008, our Chief Executive Officer
and Chief Financial Officer concluded that, as of such date, our disclosure
controls and procedures were effective.




Changes
in Internal Control over Financial Reporting




Management
has implemented changes that have materially affected or are reasonably likely
to affect Holocom’s internal control over financial reporting during the quarter
ended August 31, 2008 as further described above in “Remediation of Previously
Reported Material Weakness,” and concluded that the previously reported material
weakness no longer exists as of August 31, 2008.




PART
II- OTHER INFORMATION





Item
1. Legal Proceedings





Patent
Litigation





On
February 8, 2008, we, TPL and Alliacense Ltd. were named as defendants in three
separate lawsuits filed in the United States District Court for the Northern
District of California by Asustek Computer, Inc., HTC Corporation, and Acer,
Inc., and affiliated entities of each of them. On February 13, 2008, the Asustekclaims were amended
to include claims against MCM Portfolio, LLC (Alliacense and MCM Portfolio are
TPL-related entities), which do not involve us.


41


The Asustekcase seeks
declaratory relief that its products do not infringe enforceable claims of the
'336, '584 and '749 patents. The Asustekcase also seeks a
similar declaration with respect to two patents owned by TPL that are not a part
of the MMP Portfolio, and as such we are not engaged in this aspect of the
litigation and defense. The Acercase seeks declaratory
relief that its products do not infringe enforceable claims of the '336, '584
and '749 patents. The HTCcase similarly seeks declaratory relief that its products do not infringe
enforceable claims of those three patents and the '148 patent.





On April
25, 2008, we and TPL filed five patent infringement lawsuits in the Eastern
District of Texas against HTC, Acer and Asustek. These suits allege infringement
by HTC and Acer with respect to the '336 '749 '584 and '148 patents; and by
Asustek with respect to the '336, '749 and '584 patents. On June 4, 2008, we and
TPL filed patent infringement lawsuits against those parties in the Eastern
District of Texas with respect to the ‘890 patent of the MMP
Portfolio.  The Asustekaction in the Eastern
District of Texas is inclusive of matters with respect to two patents owned by
TPL that are not  a part of the MMP Portfolio, and accordingly we are
not engaged in this aspect of the litigation and defense (collectively, these
cases are referred to as the "T-3" Litigation).





Motions
to dismiss or transfer the Northern District of California actions to the
Eastern District of Texas were heard on September 19, 2008 by U.S. District
Judge Jeremy Fogel and are presently under submission.  Following
Judge Fogel's ruling, we expect to learn where the T-3 litigation will
proceed.  The discovery phase has not yet begun in any of the
cases.





Item
1A. Risk Factors





There are
no material changes from the risk factors contained in our 10-K for the year
ended May 31, 2008.  Please see Part I, Item 2, above, for our risk
factors.





Item
2. Unregistered Sales of Equity Securities and Use of Proceeds





None.





Item
3. Defaults Upon Senior Securities





None.





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





None.





Item
5. Other Information





None.





Item
6. Exhibits





Those
exhibits marked with an asterisk (*) refer to exhibits filed herewith. The other
exhibits are incorporated herein by reference, as indicated in the following
list.




Exhibit No.
            Document2.1
            Agreement
      to Exchange Technology for Stock in the Company, incorporated by reference
      to Exhibit 2.1 to Form 8-K dated August 10, 1989 (Commission
      file No. 33-23143-FW)2.2
            Assets
      Purchase Agreement and Plan of Reorganization dated June 22, 1994,
      among the Company, nanoTronics Corporation and Helmut Falk, incorporated
      by reference to Exhibit 10.4 to Form 8-K dated July 6, 1994
      (Commission file No. 000-22182)






42


2.2.1
            Amendment
      to Development Agreement dated April 23, 1996 between the Company and
      Sierra Systems, incorporated by reference to Exhibit 2.2.1 to
      Pre-Effective Amendment No. 1 to Registration Statement on Form SB-2
      filed April 29, 1996 (Commission file No. 333-01765)2.3
            Form
      of Exchange Offer dated December 4, 1996 between the Company and
      certain shareholders of Metacomp, Inc., incorporated by reference to
      Exhibit 2.3 to Form 8-K filed January 9, 1997 (Commission file
      No. 000-22182)2.4
            Letter
      of Transmittal to Accompany Shares of Common Stock of Metacomp, Inc.
      Tendered Pursuant to the Exchange Offer dated December 4, 1996,
      incorporated by reference to Exhibit 2.4 to Form 8-K filed
      January 9, 1997 (Commission file No. 000-22182)2.5
            Agreement
      and Plan of Merger dated August 4, 2008, among the Company, PTSC
      Acquisition 1 Corp, Crossflo Systems, Inc. and the Crossflo principal
      officers, incorporated by reference to Exhibit 99.1 to Form 8-K filed
      August 11, 2008 (Commission file No. 000-22182)3.1
            Original
      Articles of incorporation of the Company’s predecessor, Patriot
      Financial Corporation, incorporated by reference to Exhibit 3.1 to
      registration statement on Form S-18, (Commission file No.
      33-23143-FW)3.2
            Articles of
      Amendment of Patriot Financial Corporation, as filed with the Colorado
      Secretary of State on July 21, 1988, incorporated by reference to
      Exhibit 3.2 to registration statement on Form S-18, (Commission file
      No. 33-23143-FW)3.3
            Certificate
      of Incorporation of the Company, as filed with the Delaware Secretary of
      State on March 24, 1992, incorporated by reference to
      Exhibit 3.3 to Form 8-K dated May 12, 1992 (Commission file No.
      33-23143-FW)3.3.1
            Certificate
      of Amendment to the Certificate of Incorporation of the Company, as filed
      with the Delaware Secretary of State on April 18, 1995, incorporated
      by reference to Exhibit 3.3.1 to Form 10-KSB for the fiscal year
      ended May 31, 1995 (Commission file No. 000-22182)3.3.2
            Certificate
      of Amendment to the Certificate of Incorporation of the Company, as filed
      with the Delaware Secretary of State on June 24, 1997, incorporated
      by reference to Exhibit 3.3.2 to Form 10-KSB for the fiscal year
      ended May 31, 1997, filed July 18, 1997 (Commission file No.
      000-22182)3.3.3
            Certificate
      of Amendment to the Certificate of Incorporation of the Company,
      as filed with the Delaware Secretary of State on April 28, 2000,
      incorporated by reference to Exhibit 3.3.3 to Registration Statement
      on Form S-3 filed May 5, 2000 (Commission file No.
      333-36418)3.3.4
            Certificate
      of Amendment to the Certificate of Incorporation of the Company, as filed
      with the Delaware Secretary of State on May 6, 2002, incorporated by
      reference to Exhibit 3.3.4 to Registration Statement on Form S-3
      filed June 27, 2002 (Commission file No. 333-91352)3.3.5
            Certificate
      of Amendment to the Certificate of Incorporation of the Company, as filed
      with the Delaware Secretary of State on October 16, 2003,
      incorporated by reference to Exhibit 3.3.5 to Registration Statement
      on Form SB-2 filed May 21, 2004 (Commission file No.
      333-115752)3.4
            Articles and
      Certificate of Merger of Patriot Financial Corporation into the Company
      dated May 1, 1992, with Agreement and Plan of Merger attached thereto
      as Exhibit A, incorporated by reference to Exhibit 3.4 to Form
      8-K dated May 12, 1992 (Commission file No. 33-23143-FW)3.5
            Certificate
      of Merger issued by the Delaware Secretary of State on May 8, 1992,
      incorporated by reference to Exhibit 3.5 to Form 8-K dated
      May 12, 1992 (Commission file No. 33-23143-FW)




43


3.6
            Certificate
      of Merger issued by the Colorado Secretary of State on May 12, 1992,
      incorporated by reference to Exhibit 3.6 to Form 8-K dated
      May 12, 1992 (Commission file No. 33-23143-FW)3.7
            Bylaws
      of the Company, incorporated by reference to Exhibit 3.7 to Form 8-K
      dated May 12, 1992 (Commission file No. 33-23143-FW)4.1
            Specimen
      common stock certificate, incorporated by reference to Exhibit 4.1
      Form 8-K dated May 12, 1992 (Commission file No.
      33-23143-FW)4.2
            1996
      Stock Option Plan of the Company dated March 25, 1996 and approved by
      the Shareholders on May 17, 1996, incorporated by reference to
      Exhibit 10.13 to Pre-Effective Amendment No. 2 to Registration
      Statement on Form SB-2 filed May 23, 1996 (Commission file No.
      333-01765)4.3
            2001
      Stock Option Plan of the Company dated February 21, 2001 incorporated
      by reference to Exhibit 4.19 to Registration Statement on Form S-8
      filed March 26, 2001 (Commission file No. 333-57602)4.4
            2003
      Stock Option Plan of the Company dated July 2, 2003 incorporated by
      reference to Exhibit 4.27 to Registration Statement on Form S-8 filed
      September 4, 2003 (Commission file No. 333-108489)4.5
            2006
      Stock Option Plan of the Company dated March 31, 2006 incorporated by
      reference to Exhibit 4.19 to Registration Statement on Form S-8 filed
      June 20, 2006 (Commission file No. 333-135156)10.1
            Employment
      Agreement dated September 17, 2007 by and between the Company and Clifford
      L. Flowers, incorporated by reference to Exhibit 10.1 to Form 8-K filed
      September 19, 2007 (Commission file No. 000-22182)10.2
            Employment
      Agreement dated February 29, 2008 by and between the Company and Frederick
      C. Goerner, incorporated by reference to Exhibit 99.1 to Form 8-K filed
      May 20, 2008 (Commission file No. 000-22182)23.1*
            Consent
      of Independent Valuation Firm31.1*
            Certification
      of Frederick C. Goerner, CEO, pursuant to Rule
      13a-14(a)/15d-14(a)31.2*
            Certification
      of Clifford L. Flowers, CFO, pursuant Rule
    13a-14(a)/15d-14(a)32.1*
            Certification
      of Frederick C. Goerner, CEO, pursuant to Section 1350 of Chapter 63 Title
      18 of the United States Code32.2*
            Certification
      of Clifford L. Flowers, CFO, pursuant to Section 1350 of Chapter 63 Title
      18 of the United States Code




44





SIGNATURES




Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.




DATED:  October 10,
      2008
              
              PATRIOT
      SCIENTIFIC CORPORATION/S/
      FREDERICK C. GOERNERFrederick
      C. GoernerChief
      Executive Officer







In
accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.




Signature
            
            Title
            
            Date/S/ FREDERICK C. GOERNER
            
            President
      and Chief Executive Officer
            
            October
      10, 2008Frederick
      C. Goerner/S/
      CLIFFORD L. FLOWERS
            
            Chief
      Financial Officer and
            
            October
      10, 2008Clifford
      L. Flowers
            
            Principal
      Accounting Officer/S/
      CARLTON M. JOHNSON
            
            Director
            
            October
      10, 2008Carlton
      M. Johnson/S/
      GLORIA H. FELCYN
            
            Director
            
            October
      10, 2008Gloria
      H. Felcyn/S/
      HELMUT FALK, JR.
            
            Director
            
            October
      10, 2008Helmut
      Falk, Jr./S/
      HARRY L. TREDENNICK
            
            Director
            
            October
      10, 2008Harry
      L. Tredennick/S/
      DONALD E. SCHROCK
            
            Director
            
            October
      10, 2008Donald
      E. Schrock





45