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, 2009




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)





(Registrant’s
telephone number, including area code): (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 has
submitted electronically and posted on its corporate Website, if any, every
Interactive Data File required to be submitted and posted pursuant to Rule 405
of Regulation S-T (§ 229.405 of this chapter) during the preceding 12 months (or
for such shorter period that the registrant was required to submit and post such
files). YES [_]  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 the 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 [_](do
      not check if smaller reporting company)
              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 7, 2009, 410,304,054 shares of common stock, par value $.00001 per share
were outstanding.









INDEX








PagePART
      I. FINANCIAL INFORMATIONITEM
      1. Financial StatementsCondensed
      consolidated Balance Sheets as of August 31, 2009 (unaudited) and May 31,
      2009
            3Condensed
      consolidated Statements of Operations for the three months ended August
      31, 2009 and August 31, 2008 (unaudited)
            4Condensed
      consolidated Statements of Cash Flows for the three months ended August
      31, 2009 and August 31, 2008 (unaudited)
            5Notes
      to condensed consolidated Financial Statements (unaudited)
            6-36ITEM
      2. Management’s Discussion and Analysis of Financial Condition and Results
      of Operations
            37-50ITEM
      3. Quantitative and Qualitative Disclosures About Market
    Risk
            50-51ITEM
      4. Controls and Procedures
            51PART
      II. OTHER INFORMATIONITEM
      1. Legal Proceedings
            52ITEM
      1A. Risk Factors
            52ITEM
      2. Unregistered Sales of Equity Securities and Use of
    Proceeds
            52-53ITEM
      3. Defaults Upon Senior Securities
            53ITEM
      4. Submission of Matters to a Vote of Security Holders
            53ITEM
      5. Other Information
            53ITEM
      6. Exhibits
            53-54SIGNATURES








2








PART
I- FINANCIAL INFORMATION





Item 1. Financial
Statements


Patriot
Scientific Corporation


Condensed
Consolidated Balance Sheets





August
      31, 2009
            
            
            May
      31, 2009ASSETS
            
            (Unaudited)Current
      assets:Cash
      and cash equivalents
            
            $
            8,203,033
            
            
            $
            6,206,868Restricted
      cash and cash equivalents
            
            
            52,230
            
            
            
            52,163Marketable
      securities
            
            
            20,746
            
            
            
            58,292Accounts
      receivable
            
            
            125,048
            
            
            
            168,402Accounts
      receivable - affiliated company
            
            
            3,345
            
            
            
            5,467Notes
      receivable
            
            
            503,444
            
            
            
            447,810Work-in-process
            
            
            89,065
            
            
            
            27,279Prepaid
      income taxes
            
            
            427,342
            
            
            
            506,526Current
      portion of deferred tax assets
            
            
            131,314
            
            
            
            285,472Prepaid
      expenses and other current assets
            
            
            279,462
            
            
            
            306,457Total
      current assets
            
            
            9,835,029
            
            
            
            8,064,736Marketable
      securities
            
            
            10,013,212
            
            
            
            10,598,389Property
      and equipment, net
            
            
            137,056
            
            
            
            85,475Goodwill
            
            
            1,739,249
            
            
            
            1,739,249Other
      intangible assets, net
            
            
            5,596,951
            
            
            
            5,803,639Deferred
      tax assets, net of current portion
            
            
            4,332,474
            
            
            
            2,843,677Other
      assets
            
            
            42,170
            
            
            
            51,507Investments
      in affiliated companies
            
            
            868,515
            
            
            
            4,540,280Total
      assets
            
            $
            32,564,656
            
            
            $
            33,726,952LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilities:Accounts
      payable
            
            $
            234,900
            
            
            $
            414,843Accrued
      expenses and other
            
            
            538,375
            
            
            
            593,330Deferred
      revenue
            
            
            24,074
            
            
            
            26,311Total
      current liabilities
            
            
            797,349
            
            
            
            1,034,484Distributions
      in excess of  investment in affiliated company
            
            
            907,412
            
            
            
            -Long
      term debt, including accrued interest
            
            
            3,062,217
            
            
            
            3,041,577Total
      long term liabilities
            
            
            3,969,629
            
            
            
            3,041,577Total
      liabilities
            
            
            4,766,978
            
            
            
            4,076,061Commitments and
      contingenciesStockholders’
      equity:Preferred
      stock, $0.00001 par value; 5,000,000 shares authorized: none
      outstanding
            
            
            -
            
            
            
            -Common
      stock, $0.00001 par value: 600,000,000 shares authorized: 438,067,618
      shares issued and 410,304,054 shares outstanding at August 31, 2009
      438,067,618 shares issued and 410,354,054 shares outstanding at May 31,
      2009
            
            
            4,380
            
            
            
            4,380Additional
      paid-in capital
            
            
            77,046,544
            
            
            
            77,008,332Accumulated
      deficit
            
            
            (34,866,927
            )
            
            
            (32,881,848
            )Common
      stock held in treasury, at cost – 27,763,564 shares and 27,713,564 shares
      at August 31, 2009 and May 31,
    2009,  respectively
            
            
            (13,856,172
            )
            
            
            (13,850,659
            )Accumulated
      other comprehensive loss
            
            
            (530,147
            )
            
            
            (629,314
            )Total
      stockholders’ equity
            
            
            27,797,678
            
            
            
            29,650,891Total
      liabilities and stockholders’ equity
            
            $
            32,564,656
            
            
            $
            33,726,952




See
accompanying notes to unaudited condensed consolidated financial
statements.
  3





Patriot
Scientific Corporation
 Condensed
Consolidated Statements of Operations


(Unaudited)





Three
      months endedAugust
      31, 2009
            
            
            August
      31, 2008Revenues:Product
      sales and other
            
            $
            -
            
            
            $
            1,358,646License
      and service revenue
            
            
            97,035
            
            
            
            -Total
      revenues
            
            
            97,035
            
            
            
            1,358,646Cost
      of sales:Product
      sales and other
            
            
            -
            
            
            
            584,253License
      and service revenue
            
            
            31,983
            
            
            
            -Amortization
      of purchased intangibles
            
            
            206,688
            
            
            
            -Total
      cost of sales
            
            
            238,671
            
            
            
            584,253Gross
      profit (loss)
            
            
            (141,636
            )
            
            
            774,393Operating
      expenses:Research
      and development
            
            
            314,197
            
            
            
            -Selling,
      general and administrative
            
            
            1,927,795
            
            
            
            1,930,805Total
      operating expenses
            
            
            2,241,992
            
            
            
            1,930,805Operating
      loss
            
            
            (2,383,628
            )
            
            
            (1,156,412
            )Other
      income (expense):Interest
      and other income
            
            
            42,928
            
            
            
            112,846Impairment
      of investment in affiliated company
            
            
            (680,292
            )
            
            
            -Interest
      expense
            
            
            (20,640
            )
            
            
            (4,622
            )Equity
      in earnings (loss) of affiliated companies
            
            
            (264,558
            )
            
            
            6,558,770Total
      other income (expense), net
            
            
            (922,562
            )
            
            
            6,666,994Income
      (loss) before income taxes and minority interest
            
            
            (3,306,190
            )
            
            
            5,510,582Provision
      (benefit) for income taxes
            
            
            (1,321,111
            )
            
            
            2,379,705Minority
      interest
            
            
            -
            
            
            
            (78,636
            )Net
      income (loss)
            
            $
            (1,985,079
            )
            
            $
            3,209,513Basic
      income (loss) per common share
            
            $
            -
            
            
            $
            0.01Diluted
      income (loss) per common share
            
            $
            -
            
            
            $
            0.01Weighted
      average number of common shares outstanding - basic
            
            
            407,484,967
            
            
            
            388,132,502Weighted
      average number of common shares outstanding - diluted
            
            
            407,484,967
            
            
            
            388,650,596





See
accompanying notes to unaudited condensed consolidated financial
statements.   4


Patriot
Scientific Corporation


Condensed
Consolidated Statements of Cash Flows


(Unaudited)


Three
      months endedAugust
      31, 2009
            
            
            August
      31, 2008Operating
      activities:Net
      income (loss)
            
            $
            (1,985,079
            )
            
            $
            3,209,513Adjustments
      to reconcile net income (loss) to net cash used in operating
      activities:Minority
      interest in variable interest entity
            
            
            -
            
            
            
            (78,636
            )Amortization
      and depreciation
            
            
            222,402
            
            
            
            9,887Non-cash
      compensation relating to issuance of stock options and vesting
      of  warrants
            
            
            38,212
            
            
            
            114,875Accrued
      interest income added to investments and notes receivable
            
            
            (701
            )
            
            
            (7,389
            )Equity
      in loss (earnings) of affiliated companies
            
            
            264,558
            
            
            
            (6,558,770
            )Impairment
      of investment in affiliated company
            
            
            680,292
            
            
            
            -Write-off
      of patent costs
            
            
            -
            
            
            
            21,527Deferred
      income taxes
            
            
            (1,400,295
            )
            
            
            (1,605,545
            )Changes
      in operating assets and liabilities:Accounts
      receivable
            
            
            43,354
            
            
            
            254,877Receivable
      from affiliated company
            
            
            2,122
            
            
            
            721Inventory
            
            
            -
            
            
            
            (353,743
            )Work-in-process
            
            
            (61,786
            )
            
            
            -Prepaid
      expenses and other current assets
            
            
            36,332
            
            
            
            (1,243
            )Prepaid
      income taxes
            
            
            79,184
            
            
            
            222,311Accounts
      payable and accrued expenses
            
            
            (214,259
            )
            
            
            37,308Deferred
      revenue
            
            
            (2,237
            )
            
            
            -Income
      taxes payable
            
            
            -
            
            
            
            3,749,353Net
      cash used in operating activities
            
            
            (2,297,901
            )
            
            
            (984,954
            )Investing
      activities:Proceeds
      from sales of marketable securities
            
            
            787,546
            
            
            
            278,856Purchases
      of short-term investments
            
            
            -
            
            
            
            (70,286
            )Purchases
      of property and equipment
            
            
            (67,295
            )
            
            
            (2,736
            )Repayment
      of note receivable
            
            
            -
            
            
            
            50,000Purchases
      of convertible notes receivable
            
            
            -
            
            
            
            (667,750
            )Issuance
      of note receivable
            
            
            (55,000
            )
            
            
            -Investments
      in affiliated companies
            
            
            (32,500
            )
            
            
            (1,546,500
            )Distributions
      from affiliated company
            
            
            3,666,828
            
            
            
            5,852,056Net
      cash provided by investing activities
            
            
            4,299,579
            
            
            
            3,893,640Financing
      activities:Payments
      on note payable
            
            
            -
            
            
            
            (70,296
            )Repurchase
      of common stock for treasury
            
            
            (5,513
            )
            
            
            (504,771
            )Net
      cash used in financing activities
            
            
            (5,513
            )
            
            
            (575,067
            )Net
      increase in cash and cash equivalents
            
            
            1,996,165
            
            
            
            2,333,619Cash
      and cash equivalents, beginning of period
            
            
            6,206,868
            
            
            
            6,424,015Cash
      and cash equivalents, end of period
            
            $
            8,203,033
            
            
            $
            8,757,634Supplemental
      Disclosure of Cash Flow Information:Cash
      payments for interest
            
            $
            -
            
            
            $
            4,622Cash
      payments for income taxes
            
            $
            -
            
            
            $
            25,500Supplemental
      Disclosure of  Non-Cash Investing and Financing
      Activities:Conversion
      of note receivable to preferred stock – Avot Media, Inc.
            
            $
            -
            
            
            $
            250,000Insurance
      premium financed with a note payable
            
            $
            -
            
            
            $
            210,888Unrealized
      loss (recovery) on investments in marketable securities charged to other
      comprehensive income adjusted for deferred tax benefit
            
            $
            (164,823
            )
            
            $
            149,699




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”, “PTSC”, “Patriot”, “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,
2009.





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 period presented.  Operating results for the three month
period ended August 31, 2009 are not necessarily indicative of the results that
may be expected for the year ending May 31, 2010.  We have evaluated
subsequent events through October 9, 2009, the filing date of this Form 10-Q,
and determined that no subsequent events have occurred that would require
recognition in the condensed consolidated financial statements or disclosure in
the notes thereto other than as disclosed in the accompanying notes.





Basis
of Consolidation





The
condensed consolidated balance sheets at August 31, 2009 and May 31, 2009 and
the condensed consolidated statement of operations for the three months ended
August 31, 2009 include our accounts and those of our wholly owned subsidiary
Patriot Data Solutions Group, Inc. (“PDSG”) and our inactive subsidiary Plasma
Scientific Corporation.  All significant intercompany accounts and
transactions have been eliminated.





The
condensed consolidated statement of operations for the three months ended August
31, 2008 includes 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 were 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(R) 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.


6


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Consolidation of Affiliate
(continued)





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.  During July 2008, Holocom obtained a credit facility for
up to $300,000 from a third party, the credit facility term extended to May 1,
2009, and was guaranteed by us.  As a result of our guarantee on the
third party credit facility, we maintained a variable interest in
Holocom.  Upon expiration of the credit facility on May 1, 2009 we
deconsolidated Holocom as we are no longer deemed to be the primary
beneficiary.  We are now recording our investment in Holocom under the
cost method (see Note 11).





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 Positions (“FSP”) SFAS No.
115-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investmentsand SFAS 115-2 and SFAS 124-2 Recognition and Presentation of
Other-Than-Temporary Impairments.  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 valuation by Houlihan Smith & Company,
Inc.  Unrealized gains and losses, net of deferred taxes, are recorded
as a component of other comprehensive income (loss).  We follow the
guidance provided by SFAS 115-2 and SFAS 124-2, 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 11). 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 condensed
consolidated statements of operations in the caption “Equity in earnings (loss)
of affiliated companies.”





We have a
39.4% interest in Talis Data Systems, LLC (“Talis”) (see Note
11).  Prior to the write down of our investment in Talis we were
accounting for our investment using the equity method of accounting pursuant to
paragraph 8 of AICPA Statement of Position (“SOP”) 78-9, Accounting for Investments in Real
Estate Ventureswhich has applicability to non-real estate entities as
well.  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 condensed consolidated
statements of operations in the caption “Equity in earnings (loss) of affiliated
companies.”





7


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Investments
in Affiliated Companies (continued)





We own
37.1% of the preferred stock of Avot Media, Inc. (“Avot”) (see Note
11).  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 own
100% of the preferred stock of Holocom.  This investment has
historically been accounted for at cost since we do not have the ability to
exercise significant influence over the operating and financial policies of
Holocom. Due to a re-consideration event on May 1, 2009, this investment is
carried at cost plus the effects of deconsolidation of this variable interest
entity on our August 31, 2009 condensed consolidated balance sheet.





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.





The
inability of Talis to meet its business plan and to raise capital and the
general economic environment were indicators of impairment on our investment;
accordingly at August 31, 2009, management obtained a third party valuation of
Talis from Vantage Point Advisors, Inc.  Based on the results of the
valuation, it was determined that our investment in Talis was impaired by
approximately $680,000.  We have recorded this as an impairment of
investment in affiliated company on our condensed consolidated statement of
operations for the three months ended August 31, 2009.





Comprehensive
Income (Loss)





Comprehensive
income (loss) 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, 2009, this
amount included unrealized losses on investments classified as
available-for-sale.  The amount is presented net of tax-related
benefits of $65,656.





Revenue
Recognition





Historically
we recognized revenue from the sale of our microprocessor chips upon shipment to
the customer, at which time title transferred and we had no further
obligations.  We discontinued the sale of our microprocessor chips
during the first fiscal quarter of fiscal 2009. Revenue from technology license
agreements is recognized at the time a contract is entered into, the license
method is determined (paid-in-advance or on-going royalty), and the customer is
provided with the licensed technology, if applicable.  Fees for
maintenance or support are recorded on a straight-line basis over the underlying
period of performance.





PDSG
sells software and services to end users primarily through relationships with
systems integrators and prime contractors.  PDSG recognizes revenue in
accordance with American Institute of Certified Public Accountants (“AICPA”)
Statement of Position (“SOP”) No. 97-2,Software Revenue
Recognition, and all related amendments and
interpretations.  PDSG’s revenue is derived primarily from the
following sources: (i) software licensing, (ii) related professional
services, and (iii) post contract customer support (“PCS”)
agreements.  PCS agreements typically include software updates, on a
when and if available basis, telephone and Internet access to technical support
personnel. Software updates provide customers with rights to unspecified
software product upgrades and to maintenance releases and patches released
during the term of the support period. Revenue for support services is
recognized on a straight-line basis over the support period.





8


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Revenue
Recognition (continued)





When a
sale involves multiple elements, PDSG allocates the entire fee from the
arrangement to each respective element based on its Vendor Specific Objective
Evidence (“VSOE”) of fair value and recognizes revenue when each element’s
revenue recognition criteria are met. VSOE of fair value for each element is
established based on the price charged when the same element is sold
separately.  PDSG has not yet demonstrated VSOE for the professional
services that are rendered in conjunction with its software license sales. 
Accordingly, we have combined their presentation on our condensed consolidated
statements of operations under the caption “License and service revenue.”





The
majority of PDSG’s contracts with customers, including systems integrators and
prime contractors, are multiple element arrangements which contain professional
services that are considered essential to the functionality of the other
elements of the arrangement.  PDSG accounts for revenue on these
arrangements according to the provisions of SOP 81-1,Accounting for Performance of
Construction-Type and Certain Production-Type Contracts. Under SOP 81-1,
PDSG recognizes revenue based on progress towards contract completion measured
by actual hours incurred in relation to the estimate of total expected hours.
PDSG measures SOP 81-1 revenues by applying the contract-specific estimated
percentage of completion to the total contract amount for software and
professional services.  PDSG routinely updates the estimates of future
hours for agreements in process and reports any cumulative effects of such
adjustments in current operations. PDSG immediately recognizes any loss expected
on these contracts when it is projected that loss is probable.





In
certain situations where PDSG’s customer contracts contain acceptance criteria
or other conditions that are deemed adverse to the probability for collection,
revenues recognized are limited by the amount of cash already
collected.





Prior to
its deconsolidation, Holocom recognized revenue upon shipment of its product or
upon receipt of its product by the customer when shipped FOB destination and
recognized revenue on its short-term installation contracts as time and
materials costs were incurred.





Holocom
maintained agreements with stocking distributors. These agreements provided for
a limited product warranty for a period of one year from the date of sale to the
end user. The warranty did not cover damage to the product after it was
delivered to the distributor. Holocom’s stocking distributor agreements also
allowed limited rights to periodic stock rotation.  These rotation
rights allowed for the exchange of a percentage of distributor inventory for
replacement products of the distributor’s choosing.





Research
and Development





Research
and development costs are expensed as incurred and primarily include payroll and
related benefit costs and contractor fees.





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 included shipping and handling fees
billed to customers in net sales. Shipping and handling costs associated with
inbound freight and unreimbursed shipping to customers were included in cost of
sales.





9


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





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.  For the three months ended August 31,
2009, all potential common shares related to our outstanding warrants and
options totaling approximately 10,760,000 shares were not included in the
calculation of diluted loss per share as they had an anti-dilutive
effect.  For the three months ended August 31, 2008, approximately
7,260,000 potentially dilutive common shares 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.





In
connection with our acquisition of Crossflo Systems, Inc. (“Crossflo”), which is
now a part of PDSG, we issued escrow shares that are contingent upon certain
representations and warranties made by Crossflo at the time of the merger
agreement (see Note 15).  In accordance with SFAS No. 128, we exclude
these escrow shares from the basic earnings (loss) per share calculations and
include the escrowed shares in the diluted earnings per share
calculations.





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





Minority
Interest





Minority
interest in our condensed consolidated financial statements resulted 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 (loss) 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.


For the
three months ended August 31, 2008, the minority interest allocated ($78,636)
represented the  entire amount of Holocom’s first quarter net loss
after taxes on a consolidated basis.





10


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Stock-Based
Compensation





Stock-based
compensation expense recognized during the period is based on the grant date
fair value of the portion of share-based payment awards ultimately expected to
vest during the period in accordance with the provisions of SFAS No.
123(R),Share-Based Payment.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,
2009 of approximately 5% was based on historical forfeiture experience and
estimated future employee forfeitures. The estimated expected term of option
grants for the three months ended August 31, 2009 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, 2009 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,
              2009
              (Unaudited)
            
            Three
      Months Ended
              August
      31,
              2008
              (Unaudited)Expected
      term
            5
      years
            
            
            N/AExpected
      volatility
            117
            %
            
            
            N/ARisk-free
      interest rate
            2.55
            %
            
            
            N/A





11


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements




Stock-Based
Compensation (continued)


A summary
of option activity as of August 31, 2009 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, 2009
            
            
            10,210,000
            
            
            $
            0.39Options
      granted
            
            
            70,000
            
            
            $
            0.12Options
      exercised
            
            
            -
            
            
            $
            -Options
      forfeited
            
            
            (70,000
            )
            
            $
            0.23Options
      outstanding at August 31, 2009
            
            
            10,210,000
            
            
            $
            0.39
            
            
            
            2.93
            
            
            $
            50,450Options
      vested and expected to vest at August 31, 2009
            
            
            8,093,311
            
            
            $
            0.39
            
            
            
            2.77
            
            
            $
            50,450Options
      exercisable at August 31, 2009
            
            
            5,876,222
            
            
            $
            0.44
            
            
            
            2.31
            
            
            $
            27,200




The
weighted average grant date fair value of options granted during the three
months ended August 31, 2009 was $0.08.  There were no option grants
during the three months ended August 31, 2008.  There were no options exercised during the three months ended
August 31, 2009 or 2008.


The
aggregate intrinsic value represents the differences in market price at the
close of the quarter ($0.15 per share on August 31, 2009) and the exercise price
of outstanding, in-the-money options (those options with exercise prices below
$0.15) on August 31, 2009.


As of
August 31, 2009, there was $854,007 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 45
months.  Approximately $550,000 of the total unrecognized compensation
cost relates to 2,000,000 performance options granted to our CEO.  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.  On October 5, 2009, our CEO was terminated (see Note 17), the
2,000,000 performance options were not vested at that time and were
cancelled.





12


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 for Patriot and employee stock-based compensation for PDSG related to
stock options under SFAS No. 123(R) for the three months ended August 31, 2009
and 2008, which was recorded as follows:


Three
      Months Ended
            
            
            Three
      Months EndedAugust
      31, 2009
            
            
            August
      31, 2008Research
      and development - PDSG
            
            $
            1,181
            
            
            $
            -Selling,
      general and administrative expense - PDSG
            
            
            14,827
            
            
            
            -Selling,
      general and administrative expense - Patriot
            
            
            20,124
            
            
            
            107,476Total
            
            $
            36,132
            
            
            $
            107,476





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).





Recent
Accounting Pronouncements





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.  The adoption of this standard did
not have a material impact 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.  The adoption of this
standard did not have a material impact 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 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. The adoption of this
standard did not have a material impact on our consolidated financial
statements.





13


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Recent
Accounting Pronouncements (continued)





In
April 2008, the FASB issued FSP No. 142-3, Determination of the Useful Life of
Intangible Assets.The FSP 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 adoption of this FSP did not have a
material 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.  The adoption of this FSP did not have a material impact on our
consolidated financial statements.





In April
2009, the FASB issued FSP No. FAS 115-2 and FAS 124-2,Recognition and Presentation of
Other-Than-Temporary Impairments. This FSP provides additional guidance
designed to create greater clarity and consistency in accounting and presenting
impairment losses on securities. The FSP is intended to bring greater
consistency to the timing of impairment recognition, and provide greater clarity
to investors about the credit and noncredit components of impaired debt
securities that are not expected to be sold. The measure of impairment in
comprehensive income remains fair value. The FSP also requires increased and
more timely disclosures regarding expected cash flows, credit losses, and an
aging of securities with unrealized losses. The FSP is effective for interim and
annual reporting periods ending after June 15, 2009.  The adoption of
this FSP did not have a material impact on our consolidated financial
statements.





In June
2009, the FASB issued SFAS No. 167, Amendments to FASB Interpretation
No. 46(R).  The objective


of this
statement is to improve financial reporting by enterprises involved with
variable interest entities.  The statement is effective as of the
beginning of each reporting entity’s first annual reporting period that begins
after November 15, 2009.  We expect to adopt this standard on June 1,
2010 and do not expect the standard to have a material impact on our
consolidated financial statements.





In June
2009, the FASB issued SFAS No. 168, The FASB Accounting Standards
CodificationTM and the Hierarchy of Generally Accepted Accounting Principles – a
Replacement of FASB Statement No. 162.The Codification will
become the source of authoritative U.S. GAAP.  The statement is
effective for financial statements issued for interim and annual periods ending
after September 15, 2009.  We expect to adopt this standard with the
filing of our Quarterly Report on Form 10-Q for the period ended November 30,
2009 and do not expect the standard to have a material impact on our
consolidated financial statements.





In
July 2009, the FASB issued EITF 09-3, Applicability of AICPA Statement of
Position 97-2 to Certain Arrangements That Contain Software Elements,
which amends the scope of AICPA Statement of Position (SOP) 97-2, Software Revenue Recognitionand EITF 03-5, Applicability of AICPA Statement of
Position  97-2 to Non-Software Deliverables in an Arrangement
Containing More-Than-Incidental Softwareto exclude  all
tangible products containing both software and non-software components that
function together to deliver the product’s essential functionality.  EITF
09-3 is effective for revenue arrangements entered into or materially modified
in fiscal years beginning on or after June 15, 2010 and shall be applied on
a prospective basis.
Earlier application is permitted as of the beginning of an entity’s fiscal year
provided it has not previously issued financial statements for any period within
that year. We expect to adopt EITF 09-3 on June 1, 2011 and do not expect EITF
09-3 to have a material impact on our consolidated financial statements.


14


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Recent
Accounting Pronouncements (continued)





In
September 2009, the FASB ratified EITF 08-1,Revenue Arrangements with Multiple
Deliverables, which requires companies to allocate revenue in
arrangements involving multiple deliverables based on the estimated selling
price of each deliverable, even though such deliverables are not sold separately
either by  the company itself or other vendors. EITF 08-1 eliminates
the requirement that all undelivered elements must have objective and reliable
evidence of fair value before a company can recognize the portion of the overall
arrangement fee that is attributable to items that already have been delivered.
As a result, the new guidance may allow some companies to recognize revenue on
transactions that involve multiple deliverables earlier than under current
requirements. EITF 08-1 is effective for revenue arrangements entered into or
materially modified in fiscal years beginning on or after December 15, 2009.
Early adoption is permitted at the beginning of a company’s fiscal year. We
expect to adopt EITF 08-1 on June 1, 2010 and do not expect EITF 08-1 to have a
material impact on our consolidated financial statements.





2.
Acquisitions





Crossflo





On
September 1, 2008, we acquired all of the outstanding shares of
Crossflo.  The results of Crossflo’s operations have been included in
our condensed consolidated financial statements since that
date.  Crossflo markets data sharing services and products primarily
to the public safety/government sector.  Crossflo’s flagship product
is the Crossflo DataExchange (“CDX”).  CDX is a commercial
off-the-shelf middleware designed for interagency and cross-domain data sharing
which  allows end users to selectively share information and rapidly
connect disparate data sources across multiple platforms.  Crossflo is
expected to be a leading provider of data sharing solutions for the markets it
targets.





The
aggregate purchase price was $10,257,604, including $2,850,790 of cash, $824,600
of convertible notes and common stock valued at $6,582,214.  The value
of the 26,988,455 shares issued was based on the average closing price of our
common stock on the Electronic Bulletin Board as reported by NASDAQ over the ten
trading days immediately preceding September 1, 2008.





This
transaction was accounted for in accordance with SFAS No. 141, Business Combinations, and we
have allocated the total purchase price to tangible and identifiable intangible
assets acquired and liabilities assumed based on their estimated fair
values.





Purchase
      consideration:Price
      per share
            
            $
            0.24389Number
      of common shares issued
            
            
            26,988,455Value
      of shares issued
            
            
            6,582,214Cash
      paid, including acquisition costs
            
            
            2,850,790Principal
      and interest on convertible notes
            
            
            824,600$
            10,257,604





15


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Acquisitions
(continued)





Allocation
      of purchase consideration:Tangible
      assets acquired:Cash
            
            $
            272,509Accounts
      receivable
            
            
            101,179Work-in-process
            
            
            11,658Deferred
      tax assets
            
            
            2,173,443Property
      and equipment
            
            
            49,399Prepaid
      expenses and other
            
            
            36,590Identifiable
      intangible assets acquired:Customer
      contracts – open orders
            
            
            63,600Maintenance
      agreements
            
            
            75,400Technologies
      and processes
            
            
            5,932,400Goodwill
            
            
            1,668,630Total
      assets acquired
            
            
            10,384,808Liabilities
      assumed:Current
      liabilities
            
            
            (127,204
            )$
            10,257,604





The fair
values assigned to identifiable intangible assets acquired were based on an
appraisal performed by an independent third party using estimates and
assumptions determined by management.  The fair values of the customer
contracts, maintenance agreements and technologies and processes were determined
using an income approach.





None of
our acquired intangible assets were assigned to research and development
assets.  The acquired intangible assets of $6,071,400 have a
weighted-average useful life of approximately 8 years.  The intangible
assets that make up that amount include customer contracts of $63,600 (0.75 year
weighted-average useful life), maintenance agreements of $75,400 (4 year
weighted-average useful life) and technologies and processes of $5,932,400 (8
year weighted-average useful life).





Goodwill
in the amount of $1,668,630 was assigned to the Crossflo
segment.  This amount is not deductible for income tax
purposes.  During the fiscal year ended May 31, 2009 goodwill was
impaired by approximately $236,000.





The
deferred tax asset is a result of purchase accounting.  The deferred
tax asset results from Crossflo’s net operating loss carryforwards that can be
used to offset consolidated taxable income in future periods, offset by the
deferred tax liability which is the result of future amortization expenses
attributable to the acquired intangible assets which will not be deductible for
income tax purposes.





16


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Acquisitions
(continued)





The
deferred tax asset was calculated as follows:





Net
      Operating
              Loss
      Carryforward
            
            
            Tax
              Rate
            
            
            Deferred
              Tax
      AssetFederal
            
            $
            11,995,697
            
            
            
            35%
            
            
            $
            4,198,494California
            
            
            7,810,697
            
            
            
            5.746%
            
            
            
            448,802$
            19,806,394
            
            
            
            
            
            
            $
            4,647,296





The
deferred tax liability was calculated as follows:





Identifiable
      intangible assets acquired
            
            $
            6,071,400Tax
      rate
            
            
            40.746%$
            2,473,853





The terms
of the merger agreement provided that additional purchase consideration of
2,844,630 shares of  our common stock (“Escrow Shares”) be deposited
with a third party escrow agent.  Per the Escrow Agreement, one year
following the closing date, the Escrow Shares shall be disbursed first to:
Patriot to cover transaction expenses incurred in excess of estimated
transaction expenses at closing and for damages incurred as a result of any
breach of Crossflo’s representations, warranties and covenants made at closing,
next to the former stockholders of Crossflo in accordance with terms of the
Escrow Agreement, lastly any shares remaining in the account shall be returned
to Patriot.  In the event that there is not an adequate number of
shares remaining in the escrow account one year from closing to satisfy
distribution to Crossflo stockholders in accordance with the terms of the Escrow
Agreement, Patriot is required to make up any difference in
cash.  Please see Note 15 for the status of the escrow
shares.





Proforma
Financial Information





The
financial information in the table below summarizes the combined results of
operations of Patriot and Crossflo, on a pro forma basis, as though the
companies had been combined as of the beginning of the periods presented. The
pro forma financial information is presented for informational purposes only and
is not indicative of the results of operations that would have been achieved if
the acquisition had taken place at the beginning of the periods presented. Such
pro forma financial information is based on the historical financial statements
of Patriot and Crossflo. This pro forma financial information is based on
estimates and assumptions, which have been made solely for purposes of
developing such pro forma information, including, without limitation, purchase
accounting adjustments. The pro forma financial information presented below also
includes amortization based on the valuation of Crossflo’s identifiable
intangible assets resulting from the acquisition. The pro forma financial
information does not reflect any synergies or operating cost reductions that may
be achieved from the combined operations.





Three
      Months EndedAugust 31,
              2008Revenue
            
            $
            1,000,017Net
      income (loss)
            
            $
            2,308,193Earnings
      per common share—basic
            
            $
            0.01Earnings
      per common share—diluted
            
            $
            0.01





17


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Acquisitions
(continued)





Verras
Medical, Inc.





On
December 1, 2008, Crossflo acquired the assets of Verras Medical, Inc.
(“Verras”).  Verras does business as Iameter and under the Iameter
name provides a healthcare software tool called SherlockTM for hospitals and
physician groups to assess the quality of care delivery against state and
federal healthcare standards to help realize quality improvements and reduced
costs.





The
aggregate purchase price was $536,225, including $503,071 of cash and $33,154 of
note receivable conversion.





This
transaction was accounted for in accordance with SFAS No. 141, Business Combinations, and we
have allocated the total purchase price to tangible and identifiable intangible
assets acquired based on their estimated fair values.





Purchase
      consideration:Cash
      paid, including acquisition costs
            
            $
            103,071Non-interest
      bearing payable
            
            
            400,000Conversion
      of note receivable into cash consideration
            
            
            33,154$
            536,225





Allocation
      of purchase consideration:Tangible
      assets acquired:Cash
            
            $
            4,247Accounts
      receivable
            
            
            25,000Property
      and equipment
            
            
            3,466Identifiable
      intangible assets acquired:Customer
      relationships
            
            
            36,000Trademarks/names
            
            
            110,000Technology
            
            
            161,000Goodwill
            
            
            196,512Total
      assets acquired
            
            $
            536,225





The fair
values assigned to identifiable intangible assets acquired were based on an
appraisal performed by an independent third party using estimates and
assumptions determined by management.  The fair values of the customer
relationships, trademarks/names and technology were determined using an income
approach.





Pursuant
to the purchase agreement, Crossflo paid Verras $80,288 on December 3, 2008, and
the remaining $400,000 is due in four equal installments on the three, six, nine
and twelve month anniversaries of the closing date.  The remaining
liability of $200,000 under this agreement is included in accrued expenses on
our condensed consolidated balance sheet at August 31, 2009.  On
September 1, 2009, Crossflo paid Verras $100,000 pursuant to the
agreement.




18


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Acquisitions
(continued)





None of
our acquired intangible assets were assigned to research and development
assets.  The acquired intangible assets of $307,000 have a
weighted-average useful life of approximately 7 years.  The intangible
assets that make up that amount include customer relationships of $36,000 (5
year weighted-average useful life), trademarks/names of $110,000 (10 year
weighted-average useful life) and technology of $161,000 (5 year
weighted-average useful life).





Goodwill
in the amount of $196,512 was assigned to Verras.  This amount will be
assigned a 15 year life and amortized for income tax purposes.





Proforma
Financial Information





Due to
the immaterial nature of Verras’ operations, no proforma financial statement
information will be presented.





Vigilys





On March
27, 2009, Crossflo acquired the VigilysTM Tactical Operating System (“Vigilys”)
business line from Kratos Defense & Security Solutions, Inc. for total cash
consideration of $197,004.





Allocation
      of purchase consideration:Identifiable
      intangible assets acquired:Customer
      relationships
            
            $
            29,000Trademarks/names
            
            
            14,500Technology
            
            
            43,500Goodwill
            
            
            110,004Total
      assets acquired
            
            $
            197,004





The fair
values assigned to identifiable intangible assets acquired were based on an
appraisal performed by an independent third party using estimates and
assumptions determined by management.  The fair values of the customer
relationships, trademarks/names and technology were determined using an income
approach.





None of
our acquired intangible assets were assigned to research and development
assets.  The acquired intangible assets of $87,000 have a
weighted-average useful life of approximately 7 years.  The intangible
assets that make up that amount include customer relationships of $29,000 (5
year weighted-average useful life), trademarks/names of $14,500 (10 year
weighted-average useful life) and technology of $43,500 (5 year weighted-average
useful life).





Goodwill
in the amount of $110,004 was assigned to Vigilys.  This amount will
be assigned a 15 year life and amortized for income tax purposes.





Proforma
Financial Information





Due to
the immaterial nature of Vigilys’ operations, no proforma financial statement
information will be presented





19


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





3.
Goodwill and Other Intangible Assets





In
accordance with SFAS No. 142, goodwill originating from acquisitions will not be
amortized and will be tested for impairment on an annual basis and between
annual tests based on certain circumstances.





Purchased
intangible assets are being amortized over a period of 9 months to 10
years.





The
following table presents details of our other intangible assets and related
accumulated amortization balances, which were recorded as a result of business
combinations and asset purchases:





Net
      Carrying ValueEstimated
            
            Allocated
            
            
            Accumulated
            
            
            August
      31,Life
      in Years
            
            Value
            
            
            Amortization
            
            
            2009Customer
      contracts  – open orders
            0.75
            
            $
            63,600
            
            
            $
            (63,600
            )
            
            $
            -Customer
      relationships
            5.00
            
            
            65,000
            
            
            
            (7,815
            )
            
            
            57,185Maintenance
      agreements
            4.00
            
            
            75,400
            
            
            
            (18,852
            )
            
            
            56,548Trademarks/names
            10.00
            
            
            124,500
            
            
            
            (8,858
            )
            
            
            115,642Technologies
      and processes
            5.00–8.00
            
            
            6,136,900
            
            
            
            (769,324
            )
            
            
            5,367,576$
            6,465,400
            
            
            $
            (868,449
            )
            
            $
            5,596,951





Net
      Carrying ValueEstimated
            
            Allocated
            
            
            Accumulated
            
            
            May
      31,Life
      in Years
            
            Value
            
            
            Amortization
            
            
            2009Customer
      contracts  – open orders
            0.75
            
            $
            63,600
            
            
            $
            (63,600
            )
            
            $
            -Customer
      relationships
            5.00
            
            
            65,000
            
            
            
            (4,566
            )
            
            
            60,434Maintenance
      agreements
            4.00
            
            
            75,400
            
            
            
            (14,139
            )
            
            
            61,261Trademarks/names
            10.00
            
            
            124,500
            
            
            
            (5,744
            )
            
            
            118,756Technologies
      and processes
            5.00–8.00
            
            
            6,136,900
            
            
            
            (573,712
            )
            
            
            5,563,188$
            6,465,400
            
            
            $
            (661,761
            )
            
            $
            5,803,639





We have
included the amortization expense on intangible assets that relate to products
sold in cost of sales.  We have included amortization expense
associated with Holocom’s patents in selling, general and administrative expense
on our condensed consolidated statement of operations for the period ended
August 31, 2008.  The amortization expense related to intangible
assets was as follows:








Three
      Months Ended
            
            
            Three
      Months EndedAugust
      31, 2009
            
            
            August
      31, 2008Amortization
      of intangible assets included in:Cost
      of sales
            
            $
            206,688
            
            
            $
            -Selling,
      general and administrative expense
            
            
            -
            
            
            
            759Total
            
            $
            206,688
            
            
            $
            759





20


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Goodwill and Other Intangible
Assets (continued)





At August
31, 2009 the estimated future amortization expense of intangible assets is
estimated to be as follows:





Year2010
      (remaining nine months)
            
            $
            620,0642011
            
            
            826,7522012
            
            
            826,7522013
            
            
            812,6052014
            
            
            785,806Thereafter
            
            
            1,724,972Total
      expected future amortization
            
            $
            5,596,951





The
carrying amount of goodwill was $1,739,249 at August 31, 2009 and May 31,
2009.





4.
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, 2009 and May 31, 2009 consist of two
savings accounts required to be held as collateral for corporate credit card
accounts.





At August
31, 2009 and May 31, 2009, our short-term investments in the amount of $20,746
and $58,292, respectively, 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.  This value is
reported at cost, which approximates fair market value.





5.  Fair
Value Measurements





Effective
June 1, 2008, we adopted the provisions of SFAS No. 157 Fair Value Measurementsto
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).





21


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, 2009Auction
      rate securities
            
            $
            —
            
            
            $
            —
            
            
            $
            10,013,212
            
            
            $
            10,013,212





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 that
there is a temporary impairment in the valuation of these securities of
$886,788.  We have recorded an unrealized loss of $530,147 in
accumulated other comprehensive loss at August 31, 2009, which represents the
gross valuation adjustment of $886,788, net of the related tax benefit of
$356,641. 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, May 31, 2009
            
            $
            11,650,000
            
            
            $
            11,650,000Transfers
      in to Level 3
            
            
            —
            
            
            
            —Total
      realized/unrealized losses:
            
            
            —
            
            
            
            —Included
      in earnings
            
            
            —
            
            
            
            —Included
      in comprehensive income (loss)
            
            
            (886,788
            )
            
            
            (886,788
            )Settlements
            
            
            (750,000
            )
            
            
            (750,000
            )Ending
      balance, August 31, 2009
            
            $
            10,013,212
            
            
            $
            10,013,212Total
      recovery of previously unrealized losses for the three months ended August
      31, 2009 included in other comprehensive income (loss) attributable to the
      change in fair market value relating to assets still held at the reporting
      date
            
            $
            164,823
            
            
            $
            164,823





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).





22


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





6.
Accounts Receivable





Trade
accounts receivable consisted of the following:





August
      31, 2009
            
            
            May
      31, 2009PTSC
            
            $
            -
            
            
            $
            1,708PDSG
            
            
            125,048
            
            
            
            166,694Total
            
            $
            125,048
            
            
            $
            168,402





No
allowance for doubtful accounts was necessary at August 31, 2009 or May 31,
2009.





At August
31, 2009 and May 31, 2009, accounts receivable from our investee PDS was $3,345
and $5,467, 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.





7.
Notes Receivable





On
February 24, 2009, we received a promissory note receivable from Avot for
principal of $100,000.  Interest at the rate of 8% accrues on the note
until its maturity date of August 24, 2009.





On March
12, 2009, we entered into a secured revolving note receivable with Avot for
$500,000.  The note bears interest at a rate of 8% and is due December
12, 2009. The note is secured by the assets presently owned or acquired in the
future by Avot.  Upon entering into the secured revolving loan note,
the short term note we received from Avot on February 24, 2009 was cancelled and
the principal amount of $100,000 was classified as an initial advance on the
revolving loan note.  Under terms of the note, not more than one
request for advances shall be made within a single month.  On March
13, 2009, April 1, 2009, May 11, 2009 and June 22, 2009, we advanced $115,000,
$115,000, $115,000 and $55,000, respectively, to Avot under terms of the note.
At August 31, 2009 the balance of the note receivable was $503,444, including
accrued interest receivable of $3,444.





At May
31, 2009, the balance of the note receivable was $447,810, including accrued
interest receivable of $2,810 recognized during the year ended May 31,
2009.





8.
Work-In-Process





Work-in-process
at August 31, 2009  and May 31, 2009 consists of $89,065 and $27,279,
respectively,  which represents the excess of recognized revenue over
invoices to customers on PDSG’s current contracts in progress.





9.
Investments in Marketable Securities





The
following table shows the cost, gross unrealized losses and fair value of our
investments in marketable securities with unrealized losses that are not deemed
to be other-than-temporarily impaired, aggregated by investment category and
length of time that individual securities have been in a continuous unrealized
loss position at August 31, 2009 and May 31, 2009.  As stated in Note
5, the fair value of our  investments is based on valuations by
Houlihan Smith & Company, Inc. at August 31, 2009 and May 31,
2009:





23


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Investments in Marketable
Securities(continued)





As
      of August 31, 2009Twelve
      Months or GreaterCost
            
            
            Gross
              Unrealized
              Losses
            
            
            Estimated
              Fair
              ValueShort-termAccrued
      interest - auction rate securities
            
            $
            20,746
            
            
            $
            —
            
            
            $
            20,746Long-termAuction
      rate securities
            
            
            10,900,000
            
            
            
            (886,788
            )
            
            
            10,013,212Total
            
            $
            10,920,746
            
            
            $
            (886,788
            )
            
            $
            10,033,958





As
      of May 31, 2009Twelve
      Months or GreaterCost
            
            
            Gross
              Unrealized
              Losses
            
            
            Estimated
              Fair
              ValueShort-termAccrued
      interest - auction rate securities
            
            $
            58,292
            
            
            $
            —
            
            
            $
            58,292Long-termAuction
      rate securities
            
            
            11,650,000
            
            
            
            (1,051,611
            )
            
            
            10,598,389Total
            
            $
            11,708,292
            
            
            $
            (1,051,611
            )
            
            $
            10,656,681





Auction Rate
Securities.The unrealized losses on our auction rate
securities are caused by the uncertainty that these securities will settle or
that we may have to redeem them for less than par value in the event we needed
immediate access to these funds.  As of August 31, 2009 and May 31,
2009, we held auction rate securities with a par value totaling approximately
$10.9 million and $11.7 million, respectively, that failed to sell at
auction.  During June 2009, auction rate securities with a par value
of $750,000 were redeemed by the issuers at par value.  In September
2009, auction rate securities with a par value of $2,500,000 were redeemed by
the issuer at par value (see Note 17). 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 2009.  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 do not intend to sell our
auction rate securities before we are able to recover our cost basis and it is
more likely than not that we will not have to sell our auction rate securities
before recovery of our cost basis.


24


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 condensed
consolidated balance sheet as of August 31, 2009.  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 $530,147 in other comprehensive loss at August
31, 2009, which represents the gross valuation adjustment of $886,788, net of
the related tax benefit of $356,641.  At May 31, 2009, we recorded an
unrealized loss of $629,314 in accumulated other comprehensive loss, which
represents the gross valuation adjustment of $1,051,611, net of the related tax
benefit of $422,297.




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 from Wedbush Morgan Securities, Inc.
(“Wedbush”) 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 when drawn upon will bear interest at the
federal funds rate plus 3%.  On October 14, 2008, we borrowed
$3,000,000 on the credit facility, the proceeds of which is included in cash and
cash equivalents at August 31, 2009 (see Note 13).





10.
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 was expected to be provided over a period not to exceed four years;
which ended in February 2009. Maintenance revenue recognized during the three
months ended August 31, 2008 was approximately $6,250.





11.
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 TPL on
behalf of PDS. During the three months ended August 31, 2009 and 2008, PDS
expensed $500,000 and $947,425, respectively, pursuant to this
commitment.





25


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Investments
in Affiliated Companies (continued)





PDS
reimburses TPL for payment of all legal and third-party expert fees and other
related third-party costs and other expenses.  During the three months
ended August 31, 2009 and 2008, PDS expensed $2,295,208 and $954,637,
respectively, pursuant to the agreement.





On
November 13, 2008, the management committee of PDS resolved to pay TPL 3% of the
gross licensing revenue received by PDS for the period June 1, 2008 through May
31, 2009, as reimbursement for certain expenses incurred by TPL in connection
with TPL’s activities related to a possible amendment of patent laws in the
United States.  The aggregate reimbursement under this resolution was
not to exceed $1,000,000 for the period June 1, 2008 through May 31,
2009.  From November 2008 to May 31, 2009, PDS expensed $571,500
pursuant to this resolution.





On August
17, 2009, the management committee of PDS resolved to pay TPL $500,000 per
quarter beginning on June 1, 2009 and continuing through May 31, 2010 relating
to TPL’s special work and effort regarding the MMP litigation and U.S. Patent
Office re-examinations.  In the event that PDS has insufficient funds
to make such payments, we are required to advance half of the quarterly amount
to PDS.  Our advance to PDS will be without interest and must be
repaid to us no later than May 31, 2010.  On June 1, 2009, TPL
received $500,000 from PDS pursuant to this agreement, this amount is included
in the legal and third-party expert fees listed above.  As of the date
of this filing, we have not advanced any funds to PDS under this
resolution.





We are
accounting for our investment in PDS under the equity method of accounting, and
accordingly have recorded our share of PDS’ net loss during the three months
ended August 31, 2009 of $242,851 as a decrease in our investment and our share
of PDS’ net income during the three months ended August 31, 2008 of $6,621,859
as an increase in our investment.  Cash distributions received from
PDS during the three months ended August 31, 2009 and 2008 of $3,666,828 and
$5,852,056, respectively, have been recorded as a reduction in our investment.
During the three months ended August 31, 2009, PDS distributed earnings in
excess of the carrying amount of our investment of $907,412.  Such
amount has been recorded as “Distributions in excess of investment in affiliated
company” on our condensed consolidated balance sheet at August 31, 2009, due to
our and TPL’s obligation to fund the working capital of PDS at the discretion of
PDS’ management committee.  We have recorded our share of PDS’ net
loss for the three months ended August 31, 2009 and our share of PDS’ net income
for the three months ended August 31, 2008 as “Equity in Earnings (Loss) of
Affiliated Companies” in the accompanying condensed consolidated statements of
operations.





During
the three months ended August 31, 2009 and 2008, TPL entered into licensing
agreements with third parties, pursuant to which PDS received aggregate proceeds
of $2,327,655 and $16,275,000, respectively.





At August
31, 2009, PDS had accounts payable balances of approximately $1,892,900 and
$3,300  to TPL and PTSC, respectively.  At May 31, 2009, PDS
had accounts payable balances of approximately $1,482,000 and $5,500 to TPL and
PTSC, respectively.







26


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Investments
in Affiliated Companies (continued)


PDS’
condensed balance sheets at August 31, 2009 and May 31, 2009 and statements of
operations for the three months ended August 31, 2009 and 2008 are as
follows:


Condensed
Balance Sheets





ASSETS:


August
      31, 2009
            
            
            May
      31, 2009Cash
      and cash equivalents
            
            $
            81,419
            
            
            $
            1,343,582Licenses
      receivable
            
            
            -
            
            
            
            6,148,750Total
      assets
            
            $
            81,419
            
            
            $
            7,492,332





LIABILITIES
AND MEMBERS’ EQUITY (DEFICIT):


August
      31, 2009
              
              May
      31, 2009Accounts
      payable
              
              $
              1,896,242
              
              
              $
              1,487,799Members’
      equity (deficit)
              
              
              (1,814,823
              )
              
              
              6,004,533Total
      liabilities and members’ equity (deficit)
              
              $
              81,419
              
              
              $
              7,492,332




Condensed
Statements of Operations


Three
      Months Ended
              August
      31,2009
            
            
            2008Revenues
            
            $
            2,327,655
            
            
            $
            16,275,000Operating
      expenses
            
            
            2,813,664
            
            
            
            1,942,560Operating
      income (loss)
            
            
            (486,009
            )
            
            
            14,332,440Interest
      income
            
            
            307
            
            
            
            28,639Net
      income (loss)
            
            $
            (485,702
            )
            
            $
            14,361,079





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-domaincomputer and network
security products to government, military, and enterprise customers.Talis develops and markets
PCs incorporating the company's 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 as a result of purchasing
additional membership units offered by Talis for $300,000 as well as acquiring
membership units from minority members for $196,500.  We also acquired
all of the Talis membership units previously held by Holocom for $100,000 in
cash and a reduction on their outstanding line of credit of
$219,000.





During
the fourth quarter of fiscal year 2009, we purchased an additional 185,793
membership units of Talis for $269,399 which brought our ownership share of
Talis to 38.9% at May 31, 2009.  During June 2009, we purchased 22,414
membership units for $32,500 which brings our ownership share to
39.4%.





27


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Investments
in Affiliated Companies (continued)





The
inability of Talis to meet its business plan, to raise capital, and the general
economic environment were indicators of impairment on our investment,
accordingly at August 31, 2009, management obtained a third party valuation of
Talis from Vantage Point Advisors, Inc.  Based on the results of the
valuation, it was determined that our investment in Talis was impaired by
approximately $680,000.  We have recorded this as an impairment of
investment in affiliated company on our condensed consolidated statement of
operations for the three months ended August 31, 2009.





We were
accounting for our investment in Talis under the equity method of
accounting.  We had recorded our share of Talis’ net loss of $21,706
and $63,089 during the two months ended July 31, 2009 and three months ended
August 31, 2008, respectively, as a decrease in our investment.  Our
investment in Talis was $669,498 at May 31, 2009 and was recorded as
“Investments in Affiliated Companies” on our condensed consolidated balance
sheet.  We have recorded our share of Talis’ net loss as “Equity in
Earnings of Affiliated Companies” in the accompanying condensed consolidated
statements of operations for the two months ended July 31, 2009 and the three
month ended August 31, 2008.  The carrying value of our investment in
Talis after impairment is zero at August 31, 2009.





Due to
the immaterial nature of Talis’ operations, no condensed financial statement
information is presented herein.





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.





The
inability of Avot to meet its business plan, to raise capital, and the general
economic environment were indicators of impairment on our investment, and at May
31, 2009, management obtained a third party valuation of Avot from Vantage Point
Advisors, Inc.  Based on the results of the valuation, it was
determined that our investment in Avot was impaired by approximately
$867,000.





28


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Investments
in Affiliated Companies (continued)





Our
investment in Avot as impaired is $433,333 and has been recorded as “Investments
in Affiliated Companies” on our condensed consolidated balance sheets at August
31, 2009 and May 31, 2009.





During
March 2009, we entered into a revolving loan note with Avot (see Note
7).





Scripps
Secured Data, Inc. (d/b/a Holocom, Inc.)




On
February 2, 2007, we invested an aggregate of $370,000 in convertible preferred
stock, representing all of the issued preferred stock and a 46% ownership
interest, of and in Holocom, a California corporation that manufactures products
that protect information transmitted over secure networks. The investment
consisted of certain assets we contributed to Holocom valued at $250,000 and
cash of $120,000. The investment is represented by 2,100,00 shares of
convertible preferred stock, and 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.




We
reviewed the Preferred Stock Purchase Agreement and related agreements to
determine whether our convertible preferred stock investment in Holocom was in
substance an investment in common stock pursuant to EITF No. 02-14, Whether an Investor Should Apply the
Equity Method of Accounting to Investments Other Than Common Stock. We
determined that, because the liquidation preference is substantive, the
subordination characteristics of the preferred stock are not substantially
similar to the subordination characteristics of Holocom’s common stock. We also
evaluated our voting rights pursuant to other agreements with Holocom and, when
considered together with the guidance in EITF No. 02-14, we believe that we do
not have the ability to exercise significant influence over Holocom. As a
result, we are accounting for our investment in Holocom at cost.





During
March 2007, we entered into a revolving line of credit with Holocom which caused
us to have a variable interest in Holocom and we were required to consolidate
Holocom as a variable interest entity according to FIN46(R) (see Note
12).  Prior to initial consolidation, we recognized a $126,746
impairment loss on our preferred stock investment for the losses of Holocom for
the period February 2007 through March 26, 2007.  During May 2009, we
deconsolidated Holocom due to a re-consideration event (see Note
12).  At August 31, 2009 and May 31, 2009, our investment in Holocom
is $435,182 and has been recorded as “Investments in Affiliated Companies” on
our condensed consolidated balance sheets at August 31, 2009  and May
31, 2009.





12.
Formerly Consolidated Variable Interest Entity





As stated
in Note 11, in February 2007, we invested an aggregate of $370,000 in Holocom
for 2,100,000 shares of convertible preferred stock.  On March 27,
2007, we entered into an 18-month revolving line of credit with Holocom for a
maximum amount of $500,000.  As a result of the line of credit, we had
a variable interest in Holocom, a variable interest entity, and we had
determined that we were the primary beneficiary as we absorbed more than half of
the variable interest entity’s expected losses.  On August 29, 2008
Holocom paid the remaining balance due on the March 2007 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, the facility’s term extended to May 1, 2009, and
was guaranteed by us. As a result of our guarantee on the third party credit
facility, which we were not contractually required to provide, we maintained a
variable interest in Holocom as we are obligated under the guarantee to repay
the third party should Holocom default on the credit facility.  During
May 2009, Holocom paid the balance due


29


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Formerly
Consolidated Variable Interest Entity (continued)





on the
July 2008 facility, releasing our guarantee.  As a result of this
re-consideration event, we are no longer the sole source of financial support
and the primary beneficiary for Holocom; accordingly on May 1, 2009 we
deconsolidated Holocom from our financial results.





For the
three months ended August 31, 2008, the minority interest allocated ($78,636)
represented the  entire amount of Holocom’s first quarter net loss
after taxes on a consolidated basis.





13.   Notes
Payable





On
October 14, 2008, we borrowed $3,000,000 on our credit facility with Wedbush,
the proceeds of which is included in cash and cash equivalents at August 31,
2009 and May 31, 2009.  Per requirements of The Financial Industry
Regulatory Authority (“FINRA”), the credit facility is limited to 50% of the par
value of our outstanding auction rate securities.  As of the date of
this filing, the par value of our outstanding auction rate securities was
$8,400,000, which limits our credit facility to $4,200,000.  The
facility is collateralized by the full value of the outstanding auction rate
securities, requires no origination fee and bears interest at the federal funds
rate plus 3%.  At August 31, 2009 and May 31, 2009, the balance
included accrued interest on the credit facility of $62,217 and $41,577,
respectively, at an approximate rate of 3.25%.





14.   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, 2009 and 2008 was as follows:




Three Months EndedAugust 31,2009
              
              2008Net
      income (loss)
              
              $
              (1,985,079
              )
              
              
              3,209,513Unrealized
      holding gain (losses) on investments, net of taxes
              
              
              99,167
              
              
              
              (88,704
              )Total
      comprehensive income (loss)
              
              $
              (1,885,912
              )
              
              $
              3,120,809




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 50,000 and 2,367,160
shares of our common stock at an aggregate cost of $5,513 and $504,771 during
the three months ended August 31, 2009 and 2008, respectively.





30


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, 2009:




Common
      StockShares
              
              
              Amounts
              
              
              Additional
      Paid-in Capital
              
              
              Accumulated
      Deficit
              
              
              Treasury
      StockBalance
      June 1, 2009
              
              
              410,354,054
              
              
              $
              4,380
              
              
              $
              77,008,332
              
              
              $
              (32,881,848
              )
              
              $
              (13,850,659
              )Non-cash
      compensation
              
              
              - -
              
              
              
              -
              
              
              
              38,212
              
              
              
              -
              
              
              
              -Repurchase
      of common stock for treasury
              
              
              (50,000
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (5,513
              )Net
      loss
              
              
              - -
              
              
              
              -
              
              
              
              -
              
              
              
              (1,985,079
              )
              
              
              -Balance
      August 31, 2009
              
              
              410,304,054
              
              
              $
              4,380
              
              
              $
              77,046,544
              
              
              $
              (34,866,927
              )
              
              $
              (13,856,172
              )




Stock Optionsand Warrant
Activity





As of
August 31, 2009, 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; 2,873,000 options outstanding
pursuant to our 2003 Stock Option Plan exercisable at a range of $0.10 to $0.40
per share expiring through 2013; and 6,388,000 options outstanding pursuant to
our 2006 Stock Option Plan exercisable at a range of $0.08 to $0.70 per share
expiring through 2014.  Some of the options outstanding under these
plans are not presently exercisable and are subject to meeting vesting
criteria.





On June
1, 2009, we issued 70,000 stock options from our 2006 Stock Option Plan with an
exercise price of $0.12 to new PDSG employees.  These options are not
presently exercisable and are subject to meeting vesting criteria.





During
the three months ended August 31, 2009, we recorded $38,212 of non-cash
compensation expense related to vesting of stock options and warrants, including
$16,008 related to PDSG.  During the three months ended August 31,
2008, we recorded $114,875 of non-cash compensation expense related to vesting
of stock options and warrants, including $6,706 related to Holocom and none
relating to PDSG.





As of
August 31, 2009, 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.  No warrants were issued or exercised and no
warrants expired during the three months ended August 31, 2009.





15.  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.





31


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Commitments
and Contingencies (continued)





The Asustekcase sought
declaratory relief that its products do not infringe enforceable claims of the
'336 and '584 patents and US 5,440,749 (the “749 patent”). The Asustekcase also sought 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





The Acercase seeks declaratory
relief that its products do not infringe enforceable claims of the '336, '584,
‘749, '148 patents and US 5,530,890 (the “890 patent”). The HTCcase similarly seeks
declaratory relief that its products do not infringe enforceable claims of those
patents.  We allege counterclaims for patent infringement of the '336,
'749, '148 and '890 patents against Acer and HTC.  On June 16, 2009,
District Court Judge Jeremy Fogel stayed the HTCand Acer actions until September
18, 2009.  The stay has been extended through November 6,
2009.





On
December 1, 2008, we, TPL and Alliacense, Ltd. were named as defendants in a
lawsuit filed in the United States District Court for the Northern District of
California by Barco, N.V.  The Barco case seeks declaratory
relief that its products do not infringe enforceable claims of the '584, '749
and '890 patents.  We allege counterclaims for patent infringement of
our '749, '890 and '336 patents.  On June 22, 2009, Judge Fogel also
stayed the Barco case
until September 18, 2009, and that stay has been extended through November 6,
2009.





On April
29, 2009, we, TPL, and Alliacense Ltd., were named as defendants in a lawsuit
filed in the United States District Court for the Southern District of New York
by Sirius XM Radio, Inc.  The Sirius case seeks declaratory
relief that its products do not infringe enforceable claims of our '749, '584,
'890, '360 and '148 patents, and additionally two patents of TPL's "fast logic"
portfolio which do not involve us.  Our Motion to Transfer the Sirius action to the United
States District Court for the Northern District of California has been briefed
to the court and is pending.





Deutsche
Bank Arbitration





On
October 16, 2008, we initiated binding arbitration claims before FINRA against
Deutsche Bank Securities, Inc., and affiliates ("DBSI") based on advisory
services provided to us resulting in our purchases of auction rate securities
("ARS") and the failure of the ARS market in February 2008.  We
experienced a loss of liquidity and other damages as a result and allege DBSI
engaged in negligence and nondisclosure in providing us
services.  DBSI has answered our claims, and an arbitration panel has
been selected.  Document discovery has been initiated.  Some
instruments have been repurchased by the issuers since the claim was filed
(see  Note 17).  The Arbitration is scheduled to commence on
January 11, 2010.





DBSI's
parent, Deutsche Bank AG, denied being required to arbitrate the dispute with
DBSI before FINRA, and so we filed an action against Deutsche Bank AG in the
United States District Court for the Southern District of California based on
its liability with respect to our investments in ARS.  Deutsche Bank
AG has filed motions to stay the proceedings and to dismiss all claims which are
set for hearing on October 26, 2009 and December 21, 2009,
respectively.  Our application to commence discovery is
pending.





Crossflo
Systems, Inc. Litigation





Under the
terms of our Agreement and Plan of Merger (the "Merger Agreement") with
Crossflo, and certain of its principal officers, an escrow account was
established to hold back approximately 10% of the merger consideration payable
to the shareholders of Crossflo (the "Escrow Merger
Consideration").  We contend that certain representations and
warranties made by Crossflo and certain of its principal officers in the Merger
Agreement were false when made, and were false as of the closing of the
merger.  We submitted a demand to the escrow agent on August 31, 2009
not to release the Escrow Merger Consideration to the Crossflo shareholders
and to instead return it to us.  Enough Crossflo shareholders have
opposed our demand that the escrow consideration has not been released to either
side.





32


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Commitments
and Contingencies (continued)





On August
31, 2009, we initiated an arbitration proceeding before the American Arbitration
Association against the three Crossflo principal officers who were signatories
to the Merger Agreement for having provided false representations and warranties
in the Merger Agreement and for nondisclosure of information about Crossflo
during the due diligence process leading up to the Merger.  Those
three principal officers have not responded to the arbitration claim as of the
date of this filing which is deemed to be a denial of such claim.





401(k)
Plan





Patriot
and PDSG have retirement plans that comply with Section 401(k) of the Internal
Revenue Code. All employees are eligible to participate in the plans. Patriot
matches 50% of each participant’s voluntary contributions, subject to a maximum
contribution of 6% of the participant’s compensation. Patriot’s participants
vest 33% per year over a three year period in their contributions. Patriot’s
matching contributions during the three months ended August 31, 2009 and 2008
were $6,020 and $2,038, respectively.  PDSG does not match participant
voluntary contributions.





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 PDSG. 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 condensed consolidated balance
sheets.





Pursuant
to the acquisition of Crossflo, we have indemnified the former owners of
Crossflo for any claims or losses resulting from any untrue, allegedly untrue or
misleading statement made in a registration statement, prospectus or similar
document. Additionally, we have agreed to indemnify the former owners of
Crossflo against losses up to a maximum of the merger consideration for damages
resulting from breach of representations or warranties in connection with the
acquisition.





Retention
Bonuses





In
connection with the acquisition of Crossflo, retention bonuses are to be paid to
individuals who were Crossflo employees pre-merger who remain with PDSG until
March 1, 2010.  In connection with the acquisition of Vigilys, a
retention bonus is to be paid to a key employee who remains with PDSG until
March 27, 2010.  The projected liability for such bonuses is
$245,000.  These liabilities are being accrued ratably over the
retention periods.





33


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Commitments
and Contingencies (continued)





Escrow
Shares





On August
31, 2009 we gave notice to the former shareholders of Crossflo and Union Bank of
California (the “Escrow Agent”) under Section 2.5 of the Agreement and Plan of
Merger between us and Crossflo (the “Agreement”), outlining damages incurred by
us in conjunction with the acquisition of Crossflo, and seeking the return of
2,844,630 shares of our common stock held by the Escrow Agent. 
Subsequently, former shareholders of Crossflo representing a majority of the
escrowed shares responded in protest to our claim, delaying the release of the
escrowed shares until a formal resolution is reached.  In the event we fail
to prevail in our claim against the escrowed shares, we may be obligated to
deposit into escrow approximately $256,000 of cash consideration due to the
decline in our average stock price over the one year escrow period, calculated
in accordance with the Section 2.5 of the Agreement.  We have evaluated the
potential for loss regarding our claim and believe that we will prevail. 
Accordingly, we have not recorded a contingent liability for this
matter.





16.
Segment Information





Holocom
began operations in February 2007 and we consolidated Holocom in our
consolidated financial statements commencing in March 2007.  Due to a
re-consideration event we deconsolidated Holocom May 1, 2009 (see Note 12).
Holocom was an operating segment under SFAS No. 131, Disclosures About Segments of an
Enterprise, as revenue was 10% or more of the total revenue of all
operating segments.





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





We
acquired PDSG in a series of transactions in the second, third and fourth
quarters of fiscal 2009 and consolidate our wholly-owned subsidiary PDSG in our
consolidated financial statements.  PDSG provides data sharing
services and products to the public sector.  There is no inter-segment
revenue and the accounting policies for segment reporting are the same as for us
as a whole.





These
reportable segments are strategic business units that offer different products
and services.  They are managed separately because each business
requires different technology and marketing strategies.





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, 2009 and 2008 were as follows:





Three
      Months EndedAugust
      31, 2009
            
            
            August
      31, 2008Net
      revenue:Holocom
            
            $
            -
            
            
            $
            1,319,366PDSG
            
            
            97,035
            
            
            
            -All
      other
            
            
            -
            
            
            
            39,280Total
      net revenue
            
            $
            97,035
            
            
            $
            1,358,646





34


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





Segment
Information (continued)





Three
      Months EndedAugust
      31, 2009
            
            
            August
      31, 2008Operating
      income (loss):Holocom
            
            $
            -
            
            
            $
            117,453PDSG
            
            
            (1,466,181
            )
            
            
            -All
      other
            
            
            (917,447
            )
            
            
            (1,273,865
            )Total
      operating loss
            
            $
            (2,383,628
            )
            
            $
            (1,156,412
            )Income
      (loss) before taxes and minority interest:Holocom
            
            $
            -
            
            
            $
            114,558PDSG
            
            
            (1,456,845
            )
            
            
            -All
      other
            
            
            (1,849,345
            )
            
            
            5,396,024Total
      income (loss) before taxes and minority interest
            
            $
            (3,306,190
            )
            
            $
            5,510,582





Operating
segment total assets at August 31, 2009 and May 31, 2009 were as
follows:





August
      31, 2009
            
            
            May
      31, 2009Total
      assets:PDSG
            
            $
            9,922,821
            
            
            $
            10,067,007All
      other
            
            
            22,641,835
            
            
            
            23,659,945Total
      assets
            
            $
            32,564,656
            
            
            $
            33,726,952





All
Holocom sales were to unaffiliated customers within the United
States.  All PDSG sales were to unaffiliated customers within the
United States, with the exception of a hosting arrangement with a customer in
Japan.





Sales
concentration information for Holocom for the three months ended August 31, 2008
was as follows:





Three
      months ended
              August
      31, 2008Sales
            
            
            %
      of salesCustomer
      A
            
            $
            793,953
            
            
            
            60
            %Customer
      B
            
            $
            361,313
            
            
            
            27
            %





Accounts
receivable concentration information for PDSG as of August 31, 2009 and May 31,
2009  and sales concentration information for the three months ended
August 31, 2009 and 2008 were as follows:





Three
      months ended
              August
      31, 2009
            
            
            August
      31, 2009
            
            
            Three
      months ended
              August
      31, 2008
            
            
            May
      31, 2009Sales
            
            
            %
      of sales
            
            
            %
      of A/R
            
            
            Sales
            
            
            %
      of sales
            
            
            %
      of A/RCustomer
      A
            
            
            ----
            
            
            
            ----
            
            
            
            80%
            
            
            
            ----
            
            
            
            ----
            
            
            
            60%Customer
      B
            
            $
            28,880
            
            
            
            30%
            
            
            
            ----
            
            
            
            ----
            
            
            
            ----
            
            
            
            ----Customer
      C
            
            $
            33,050
            
            
            
            34%
            
            
            
            ----
            
            
            
            ----
            
            
            
            ----
            
            
            
            14%Customer
      D
            
            $
            11,337
            
            
            
            12%
            
            
            
            3%
            
            
            
            ----
            
            
            
            ----
            
            
            
            5%





35


Patriot
Scientific Corporation


Notes
to Unaudited Condensed Consolidated Financial Statements





17.  Subsequent
Events





On
September 1, 2009, we paid Verras $100,000 pursuant to the asset purchase
agreement.





In
September 2009, we entered into an agreement with Avot in which Avot will
develop a software package for PDSG’s Vigilys product.  Terms of the
agreement require PDSG to pay Avot four milestone payments of $50,000 each on
approximately September 1, approximately October 1, approximately November 1 and
approximately December 1, 2009.  In connection with the agreement,
Avot will provide us 1,000,000 warrants with an exercise price of $0.05 per
share and a 36 month exercise period.  The warrants are to be issued
in four 250,000 installments consistent with the milestone
payments.  On September 11, 2009, PDSG paid Avot $50,000 pursuant to
terms of the agreement.





On
September 16, 2009, $2,500,000 of our ARS was redeemed by the issuers at
par.





On
October 5, 2009, we terminated our CEO and our V.P. of Business
Development.  The 2,000,000 performance options granted to our CEO
that had not yet vested were cancelled.  As of the date of this
filing, a separation agreement for our former CEO has not been
executed.





On
October 5, 2009, our CFO was named as Interim President and CEO of the
company.





36


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





THE
FOLLOWING DISCUSSION AND THE REST OF  THIS REPORT ON FORM 10-Q
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, 2009.





Overview





In June
2005, we entered into a series of agreements with Technology Properties Limited
(“TPL”) and others to facilitate the pursuit of unlicensed users of our
intellectual property. We intend to continue our joint venture with TPL to
pursue license agreements with unlicensed users of our technology. We believe
that utilizing the option of working through TPL, as compared to creating and
using our own 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 which may include i) selective expansion of
our intellectual property 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) acquiring entire
companies.





Critical
Accounting Policies and Estimates





Our
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 consolidated financial statements.





1.           Revenue
Recognition





Historically
we recognized revenue from the sale of our microprocessor chips upon shipment to
the customer, at which time title transferred and we had no further
obligations.  We discontinued the sale of our microprocessor chips
during the first fiscal quarter of 2009. Revenue from technology license
agreements is recognized at the time a contract is entered into, the license
method is determined (paid-in-advance or on-going royalty), and the customer is
provided with the licensed technology, if applicable.  Fees for
maintenance or support are recorded on a straight-line basis over the underlying
period of performance.





Our
wholly-owned subsidiary Partiot Data Solutions Group, Inc. (“PDSG”) sells
software and services to end users primarily through relationships with systems
integrators and prime contractors.  PDSG recognizes revenue in
accordance with American Institute of Certified Public Accountants (“AICPA”)
Statement of Position (“SOP”) No. 97-2,Software Revenue
Recognition, and all related amendments and
interpretations.  PDSG’s revenue is derived primarily from the
following sources: (i) software licensing, (ii) related professional
services, and (iii) post contract customer support (“PCS”)
agreements.  PCS agreements typically include software updates, on a
when and if available basis, and telephone and Internet access to technical
support personnel. Software updates provide customers with rights to unspecified
software product upgrades and to maintenance releases and patches released
during the term of the support period. Revenue for support services is
recognized on a straight-line basis over the support period.





37


When a
sale involves multiple elements, PDSG allocates the entire fee from the
arrangement to each respective element based on its Vendor Specific Objective
Evidence (“VSOE”) of fair value and recognizes revenue when each element’s
revenue recognition criteria are met. VSOE of fair value for each element is
established based on the price charged when the same element is sold
separately.  PDSG has not yet demonstrated VSOE for the professional
services that are rendered in conjunction with its software license sales. 
Accordingly, we have combined their presentation on our consolidated statements
of operations under the caption “License and service revenue.”





The
majority of PDSG’s contracts with customers, including systems integrators and
prime contractors, are multiple element arrangements which contain professional
services that are considered essential to the functionality of the other
elements of the arrangement.  PDSG accounts for revenue on these
arrangements according to the provisions of SOP 81-1,Accounting for Performance of
Construction-Type and Certain Production-Type Contracts. Under SOP 81-1,
PDSG recognizes revenue based on progress towards contract completion measured
by actual hours incurred in relation to the estimate of total expected hours.
PDSG measures SOP 81-1 revenues by applying the contract-specific estimated
percentage of completion to the total contract amount for software and
professional services.  PDSG routinely updates the estimates of future
hours for agreements in process and reports any cumulative effects of such
adjustments in current operations. PDSG immediately recognizes any loss expected
on these contracts when it is projected that a loss is probable.





In
certain situations where PDSG’s customer contracts contain acceptance criteria
or other conditions that are deemed adverse to the probability of collection,
revenues recognized are limited to the amount of cash already
collected.





Prior to
its deconsolidation, Holocom, Inc. (“Holocom”) recognized revenue upon shipment
of its product or upon receipt of its product by the customer when shipped FOB
destination and recognized revenue on its short-term installation contracts as
time and materials costs were 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 any 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
compensation expense recognized during the period is based on the grant date
fair value of the portion of share-based payment awards ultimately expected to
vest during the period in accordance with the provisions of SFAS No. 123(R).As stock-based compensation
expense recognized in the 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, 2009 and 2008 of approximately 5% was
based on historical forfeiture experience and estimated future employee
forfeitures. The estimated term of option grants for the three  months
ended August 31, 2009 and 2008 was five years.





38


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.





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 Phoenix Digital Solutions, LLC (“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 statements of
operations in the caption “Equity in earnings (loss) of affiliated
companies.”





We have a
39.4% interest in Talis Data Systems, LLC (“Talis”).  Prior to the
write down of our investment in Talis we were accounting for our investment
using the equity method of accounting pursuant to paragraph 8 of SOP 78-9, Accounting for Investments in Real
Estate Ventures(which has applicability to non-real estate accounting
matters as well).  Under the equity method of accounting, the
investment, originally recorded at cost, was adjusted to recognize our share of
net earnings or losses of the investee and was recognized in the consolidated
statements 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”).  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 own
100% of the preferred stock of Holocom.  This investment has
historically been accounted for at cost since we do not have the ability to
exercise significant influence over the operating and financial policies of
Holocom. Due to a re-consideration event on May 1, 2009, this investment is
carried at cost plus the effects of deconsolidation of this variable interest
entity on our August 31, 2009 condensed consolidated balance sheet.





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.


The
inability of Talis to meet its business plan and to raise capital and the
general economic environment were indicators of impairment on our investment;
accordingly at August 31, 2009, management obtained a third party valuation of
Talis from Vantage Point Advisors, Inc.  Based on the results of the
valuation, it was determined that our investment in Talis was impaired by
approximately $680,000.  We have recorded this as an impairment of
investment in affiliated company on our condensed consolidated statement of
operations for the three months ended August 31, 2009.


39


6.  Business
Combinations and Intangible Assets Including Goodwill





We
account for business combinations using the purchase method of accounting and
accordingly, the assets and liabilities of the acquired entities are recorded at
their estimated fair values at the acquisition date. Goodwill represents the
excess of the purchase price over the fair value of net assets, including the
amount assigned to identifiable intangible assets. Due to the time it takes to
obtain pertinent information to finalize the acquired company’s balance sheet,
it may be several quarters before we are able to finalize the initial fair value
estimates. Accordingly, it is not uncommon for the initial estimates to be
subsequently revised. The results of operations of acquired businesses are
included in our consolidated financial statements from the acquisition
date.





Identifiable
intangible assets with finite lives are amortized over their estimated useful
lives on a straight line basis. Goodwill and intangible assets are tested for
impairment on an annual basis, or sooner if an indicator of impairment
occurs.





Results
of Operations





Comparison
of the Three Months Ended August 31, 2009 and Three Months Ended August 31,
2008.





Consolidated:





Three
      Months EndedAugust
      31, 2009
            
            
            August
      31, 2008Revenues:Product
      sales and other
            
            $
            -
            
            
            $
            1,358,646License
      and service revenue
            
            
            97,035
            
            
            
            -Total
      revenues
            
            
            97,035
            
            
            
            1,358,646Cost
      of sales:Product
      sales and other
            
            
            -
            
            
            
            584,253License
      and service revenue
            
            
            31,983
            
            
            
            -Amortization
      of purchased intangibles
            
            
            206,688
            
            
            
            -Total
      cost of sales
            
            
            238,671
            
            
            
            584,253Gross
      profit (loss)
            
            $
            (141,636
            )
            
            $
            774,393





Segment
Results:





Three
      months endedAugust
      31, 2009
            
            
            August
      31, 2008Holocom:
            
            Dollars
            
            
            %
      of Revenue
            
            
            Dollars
            
            
            %
      of RevenueRevenues
      - Product sales and other
            
            $
            -
            
            
            
            -
            
            
            $
            1,319,366
            
            
            
            100.0%Cost
      of sales
            
            
            -
            
            
            
            -
            
            
            
            584,253
            
            
            
            44.3%Gross
      profit
            
            $
            -
            
            
            
            -
            
            
            $
            735,113
            
            
            
            55.7%PDSG:License
      and service revenue
            
            $
            97,035
            
            
            
            100.0%
            
            
            $
            -
            
            
            
            -Cost
      of sales
            
            
            31,983
            
            
            
            33.0%
            
            
            
            -
            
            
            
            -Amortization
      of purchased intangibles
            
            
            206,688
            
            
            
            -
            
            
            
            -
            
            
            
            -Gross
      loss
            
            $
            (141,636
            )
            
            
            -
            
            
            $
            -
            
            
            
            -PTSC:Revenues
      - Product sales and other
            
            $
            -
            
            
            
            -
            
            
            $
            39,280
            
            
            
            100.0%Cost
      of sales
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Gross
      profit
            
            $
            -
            
            
            
            -
            
            
            $
            39,280
            
            
            
            100.0%





40


Holocom





During
the three months ended August 31, 2008, we recorded sales amounting to
approximately $1,319,000 by our then consolidated variable interest entity,
Holocom, with cost of sales amounting to approximately $584,000.  Due
to a re-consideration event we deconsolidated Holocom in May 2009.





PDSG





We
acquired PDSG in a series of transactions in the second, third and fourth
quarters of fiscal 2009.  Revenue consists of software licenses and
associated services relating to PDSG’s CDX data agent product and the SherlockTM
software  tool for medical facilities.  Cost of sales
includes the direct time of PDSG employees on each project as well as outside
contractors. Included in cost of sales is approximately $206,700 of amortization
expense on purchased intangible assets.





PTSC





During
the three months ended August 31, 2008, we recognized maintenance fee revenues
totaling $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 was being recognized as revenue evenly over the four year period of the
license, which ended in February 2009.





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.  Our final sales of microprocessor chips
occurred during the quarter ended August 31, 2008.





Consolidated





Our
revenues decreased from approximately $1,359,000 for the three months ended
August 31, 2008 to approximately $97,000 for the three months ended August 31,
2009, primarily due to the deconsolidation of Holocom. Our revenue amounts do
not include income of approximately $6,622,000 for the three months ended August
31, 2008 and loss of approximately $243,000 for the three months ended August
31, 2009 from our investment in PDS and losses of approximately $63,100 and
$21,700, respectively, for the three months ended August 31, 2008 and 2009,
respectively, from our investment in Talis.





Consolidated:





Three
      months endedAugust
      31, 2009
            
            
            August
      31, 2008Research
      and development
            
            $
            314,197
            
            
            $
            -





PDSG





Research
and development costs consist of PDSG’s payroll and related expenses for
software engineers as well as outside contractors retained to assist in the
development of PDSG’s software product.  For the three months ended
August 31, 2009, approximately $1,200 of non-cash compensation was recorded in
connection with vesting of employee stock options in accordance with SFAS
123(R).





Consolidated:





Three
      months endedAugust
      31, 2009
            
            
            August
      31, 2008Selling,
      general and administrative
            
            $
            1,927,795
            
            
            $
            1,930,805





41


Segment
Results:


Three
      months endedAugust
      31, 2009
            
            
            August
      31, 2008Holocom:Selling,
      general and administrative
            
            $
            -
            
            
            $
            617,660PDSG:Selling,
      general and administrative
            
            $
            1,010,348
            
            
            $
            -PTSC:Selling,
      general and administrative
            
            $
            917,447
            
            
            $
            1,313,145





Holocom





During
the three months ended August 31, 2008, we recorded selling, general and
administrative expenses amounting to approximately $618,000 by our then
consolidated variable interest entity, Holocom.  Due to a
re-consideration event we deconsolidated Holocom in May 2009 (see Note
12).





PDSG





Selling,
general and administrative expenses for the three months ended August 31, 2009
consist of approximately $670,000 of payroll and related expenses for the sales
and administrative employees, approximately $43,000 of travel and related
expenses for the sales employees, approximately $120,000 for consultants, and
approximately $50,000 for rent expense.  For the three months ended
August 31, 2009, approximately $15,000 of non-cash compensation was recorded in
connection with vesting of employee stock options in accordance with SFAS
123(R).





PTSC





Selling,
general and administrative expenses decreased from approximately $1,313,000 for
the three months ended August 31, 2008 to approximately $917,000 for the three
months ended August 31, 2009, primarily  due to the preparations for
acquisition of PDSG in the prior year.  The decrease consisted of
approximately $190,000 in legal and accounting expense, approximately $90,000 in
consulting expense and approximately $17,000 in public and investor relations
expenses.  These decreases were offset by increases in payroll and
related expenses of approximately $27,000, and approximately $9,000 in travel
and related expenses.  For the three months ended August 31, 2009,
approximately $22,000 of non-cash compensation was recorded in connection with
vesting of employee stock options in accordance with SFAS 123(R) as compared to
approximately $108,000 for the three months ended August 31, 2008.





Consolidated





Selling,
general and administrative expenses decreased from approximately $1,931,000 for
the three months ended August 31, 2008 to approximately $1,928,000 for the three
months ended August 31, 2009.





Consolidated:


Three
      months endedAugust
      31, 2009
            
            
            August
      31, 2008Other
      income (expense):Interest
      and other income
            
            $
            42,928
            
            
            $
            112,846Impairment
      of investment in affiliated company
            
            
            (680,292
            )
            
            
            -Interest
      expense
            
            
            (20,640
            )
            
            
            (4,622
            )Equity
      in earnings (loss) of affiliated companies
            
            
            (264,558
            )
            
            
            6,558,770Total
      other income (expense), net
            
            $
            (922,562
            )
            
            $
            6,666,994





42


Segment
Results:


Three
      months endedAugust
      31, 2009
            
            
            August
      31, 2008Holocom:Interest
      and other income
            
            $
            -
            
            
            $
            381Interest
      expense
            
            
            -
            
            
            
            (9
            )Total
      other income (expense), net
            
            $
            -
            
            
            $
            372PDSG:Interest
      and other income
            
            $
            9,336
            
            
            $
            -Interest
      expense
            
            
            -
            
            
            
            -Total
      other income (expense), net
            
            $
            9,336
            
            
            $
            -PTSC:Interest
      and other income
            
            $
            33,592
            
            
            $
            112,465Impairment
      of investment in affiliated company
            
            
            (680,292
            )
            
            
            -Interest
      expense
            
            
            (20,640
            )
            
            
            (4,613
            )Equity
      in earnings (loss) of affiliated companies
            
            
            (264,558
            )
            
            
            6,558,770Total
      other income (expense), net
            
            $
            (931,898
            )
            
            $
            6,666,622





Consolidated





Our other
income and expenses for the three months ended August 31, 2009 included equity
in the loss of PDS consisting of net loss after expenses in the amount of
approximately $243,000 and our share of loss in Talis consisting of
approximately $22,000 after expenses.  For the three months ended
August 31, 2008, our other income and expenses included our share of income in
PDS of approximately $6,622,000 and our share of loss in Talis of approximately
$63,000. 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, 2009 amounted to net other expenses of
approximately $932,000 compared with net other income of approximately
$6,667,000 for the three months ended August 31, 2008. Interest income and other
income decreased from approximately $112,000 for the three months ended August
31, 2008 to approximately $34,000 for the three months ended August 31, 2009 due
to declines in interest rates for our cash, cash equivalents and long term
investment accounts.  For the three months ended August 31, 2009, we
recorded an impairment of our investment in Talis of approximately
$681,000.





During
the three months ended August 31, 2009 we recorded a benefit for income taxes of
approximately $1,321,000 and 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, 2009 of $1,985,079
compared with net income of $3,209,513 for the three months ended August 31,
2008.





Liquidity
and Capital Resources





Liquidity





Our cash
and short-term investment balances increased from approximately $6,265,000 as of
May 31, 2009  to approximately $8,224,000 as of August 31, 2009. We
also have restricted cash balances amounting to approximately $52,000 as of May
31, 2009 and August 31, 2009. Total current assets increased from approximately
$8,065,000 as of May 31, 2009 to approximately $9,835,000  as of
August 31, 2009. Total current liabilities amounted to approximately $1,034,000
and approximately $797,000 as of May 31, 2009 and August 31, 2009, respectively.
The change in our current position as of August 31, 2009 as compared with May
31, 2009 results in part from our receipt of approximately $3,667,000 in
distributions from PDS.





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 when drawn upon will
bear interest at the federal funds rate plus 3%.  On October 14, 2008,
we borrowed $3,000,000 on the credit facility.  The amount we can
borrow against our collateral, currently $4,200,000, is limited by FINRA (see
Note 13).


43


Current
global economic conditions have resulted in increased volatility in the
financial markets.  The cost of accessing the credit markets has
increased as many lenders and institutional investors have increased interest
rates, enacted tighter lending standards, and reduced or ceased to provide
funding to borrowers.  Adverse changes in the economy could limit our
ability to obtain financing from debt or equity sources or could adversely
affect the terms on which we may be able to obtain any such
financing.  Currently, we have sufficient resources to fund our
operations through at least the next twelve months.





Cash
Flows From Operating Activities





Cash used
in operating activities for the three months ended August 31, 2009 was
approximately $2,298,000 as compared with cash used in operating activities for
the three months ended August 31, 2008 of approximately $985,000. The principal
components of the current period amount were: impairment
of  investment in affiliated company of approximately $680,000, loss
in earnings of affiliated companies of approximately $265,000 and amortization
and depreciation of approximately $222,000.  These increases were
offset by: net loss of approximately $1,985,000, changes in deferred income
taxes of approximately $1,400,000 and changes in accounts payable and accrued
expenses of approximately $214,000.  The change in results over the
prior period is mainly attributable to the current period loss in PDS as
compared to income provided by PDS during the three months ended August 31,
2008.





Cash
Flows From Investing Activities





Cash
provided by investing activities was approximately $4,300,000 and $3,894,000 for
the three months ended August 31, 2009 and 2008, respectively. While we
experienced a decrease in distributions received from PDS for the three months
ended August 31, 2009 as compared to the three months ended August 31, 2008, the
increase in cash provided by investing activities was mainly attributable to a
decrease in investments in affiliated companies.  Cash used during the
three months ended August 31, 2009 included approximately $67,000 in purchases
of fixed assets, approximately $33,000 in purchases of Talis membership units
and approximately $55,000 in note receivable advances to Avot.





Cash
Flows From Financing Activities





Cash used
in financing activities for the three months ended August 31, 2009 and 2008 was
approximately $6,000 and $575,000, respectively.  For the three months
ended August 31, 2009, cash of approximately $5,500 was used to purchase common
stock for treasury.





Capital
Resources





Our
current resources as of August 31, 2009 are expected to provide the funds
necessary to support our operations through at least the next twelve
months.





Contractual
Obligations and Commitments





In
September 2009, we entered into an agreement with Avot in which Avot will
develop a software package for PDSG’s Vigilys product.  Terms of the
agreement require PDSG to pay Avot four milestone payments of $50,000 each on
approximately September 1, approximately October 1, approximately November 1 and
approximately December 1, 2009.  In connection with the agreement,
Avot will provide us 1,000,000 warrants with an exercise price of $0.05 per
share and a 36 month exercise period.  The warrants are to be issued
in four 250,000 installments consistent with the milestone
payments.  On September 11, 2009 PDSG paid Avot $50,000 pursuant to
terms of the agreement.





44


Recent
Accounting Pronouncements





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.  The adoption of this standard did
not have a material impact 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.  The adoption of this
standard did not have a material impact 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 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. The adoption of this
standard did not have a material impact on our consolidated financial
statements.





In
April 2008, the FASB issued FSP No. 142-3, Determination of the Useful Life of
Intangible Assets.The FSP 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 adoption of this FSP did not have a
material 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.  The adoption of this FSP did not have a material impact on our
consolidated financial statements.





In April
2009, the FASB issued FSP No. FAS 115-2 and FAS 124-2,Recognition and Presentation of
Other-Than-Temporary Impairments. This FSP provides additional guidance
designed to create greater clarity and consistency in accounting and presenting
impairment losses on securities. The FSP is intended to bring greater
consistency to the timing of impairment recognition, and provide greater clarity
to investors about the credit and noncredit components of impaired debt
securities that are not expected to be sold. The measure of impairment in
comprehensive income remains fair value. The FSP also requires increased and
more timely disclosures regarding expected cash flows, credit losses, and an
aging of securities with unrealized losses. The FSP is effective for interim and
annual reporting periods ending after June 15, 2009.  The adoption of
this FSP did not have a material impact on our consolidated financial
statements.





45


In June
2009, the FASB issued SFAS No. 167, Amendments to FASB Interpretation
No. 46(R).  The objective of this statement is to improve
financial reporting by enterprises involved with variable interest
entities.  The statement is effective as of the beginning of each
reporting entity’s first annual reporting period that begins after November 15,
2009.  We expect to adopt this standard on June 1, 2010 and do not
expect the standard to have a material impact on our consolidated financial
statements.





In June
2009, the FASB issued SFAS No. 168, The FASB Accounting Standards
CodificationTM and the Hierarchy of Generally Accepted Accounting Principles – a
Replacement of FASB Statement No. 162.The Codification will
become the source of authoritative U.S. GAAP.  The statement is
effective for financial statements issued for interim and annual periods ending
after September 15, 2009.  We expect to adopt this standard with the
filing of our Quarterly Report on Form 10-Q for the period ended November 30,
2009 and do not expect the standard to have a material impact on our
consolidated financial statements.





In
July 2009, the FASB issued EITF 09-3, Applicability of AICPA Statement of
Position 97-2 to Certain Arrangements That Contain Software Elements,
which amends the scope of AICPA Statement of Position (SOP) 97-2, Software Revenue Recognitionand EITF 03-5, Applicability of AICPA Statement of
Position  97-2 to Non-Software Deliverables in an Arrangement
Containing More-Than-Incidental Softwareto exclude  all
tangible products containing both software and non-software components that
function together to deliver the product’s essential functionality. EITF 09-3 is
effective for revenue arrangements entered into or materially modified in fiscal
years beginning on or after June 15, 2010 and shall be applied on a
prospective basis. Earlier application is permitted as of the beginning of an
entity’s fiscal year provided it has not previously issued financial statements
for any period within that year. We expect to adopt EITF 09-3 on June 1, 2011
and do not expect EITF 09-3 to have a material impact on our consolidated
financial statements.





In
September 2009, the FASB ratified EITF 08-1,Revenue Arrangements with Multiple
Deliverables, which requires companies to allocate revenue in
arrangements involving multiple deliverables based on the estimated selling
price of each deliverable, even though such deliverables are not sold separately
either by  the company itself or other vendors. EITF 08-1 eliminates
the requirement that all undelivered elements must have objective and reliable
evidence of fair value before a company can recognize the portion of the overall
arrangement fee that is attributable to items that already have been delivered.
As a result, the new guidance may allow some companies to recognize revenue on
transactions that involve multiple deliverables earlier than under current
requirements. EITF 08-1 is effective for revenue arrangements entered into or
materially modified in fiscal years beginning on or after December 15, 2009.
Early adoption is permitted at the beginning of a company’s fiscal year. We
expect to adopt EITF 08-1 on June 1, 2010 and do not expect EITF 08-1 to have a
material 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.  Please refer to our risk factors contained in our Form 10-K for
the year ended May 31, 2009 for additional factors.





We Have Reported Income For The Fiscal Years
2009, 2008 and 2007 Which May Not Be Indicative Of Our Future
Income





We have
entered into license agreements through our joint venture with TPL and have
reported income as a result of this activity for the fiscal years 2009, 2008 and
2007. 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, potential adverse outcomes associated with USPTO re-examinations, and
the possible effect of new judicial interpretations of patent laws, we may not
receive revenues from such agreements in the future consistent with amounts
received in the past, and we may not receive future revenues from license
agreements at all.





46


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





In June
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  substantially
all of our income since June 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.





A
Successful Challenge To Our Intellectual Property Rights Could 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 could 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.  From time to time 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 could have a very significant and
adverse effect on our business.





We have
been named as co-defendants in multiple lawsuits regarding the MMP
Portfolio.  See footnote 15 to our consolidated financial statements
and Part II, Item 1. “Legal Proceedings” in this Report on Form 10-Q for more
information.





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 has been 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.





47


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 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 to the
carrying value of minority investments, 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.  Further, the inability of our minority investees to obtain
funding as a result of disruptions in the debt and equity markets may impair
their ability to operate as going concerns and may result in additional
write-downs to the carrying value of these assets.





Disruptions
In The Debt And Equity Markets Will Have An Adverse Affect On Our Ability To
Obtain Funding





The debt
and equity markets have been experiencing extreme volatility and disruption for
more than twelve months.  These issues, along with significant
write-offs in the financial services sector, the re-pricing of credit risk, and
the current weak economic conditions have made, and will likely continue to
make, it difficult to obtain funding.  The cost of accessing the
credit markets has increased as many lenders and institutional investors have
increased interest rates, enacted tighter lending standards, and reduced or
ceased to provide funding to borrowers.  Adverse changes in the
economy could limit our ability to obtain financing from debt or equity sources
or could adversely affect the terms on which we may be able to obtain any such
financing for our operating activities and acquisitions.  See Part I –
Item 2. “Management’s Discussion and Analysis of Financial Condition and Results
of Operations-Liquidity and Capital Resources-Liquidity.” in this report on Form
10-Q for more information.





Unstable Market And Economic Conditions May Have Serious
Adverse Consequences On Our Business





Our general business strategy may be adversely affected
by the recent economic downturn and volatile business environment and continued
unpredictable and unstable market conditions. A prolonged or profound economic
downturn may result in adverse changes to our sales and pricing, which would
harm our operating results. Failure to secure any necessary financing in a
timely manner and on favorable terms could have a material adverse effect on our
growth strategy, financial performance and stock price and could require us to
delay or abandon development plans. There is also a possibility that our stock
price may decline further, due in part to the volatility of the stock market and
the general economic downturn.





48


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





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 investments in Avot and
Holocom are recorded at cost basis.  It is possible that, in the
future, our relationships and/or our interests in or with these equity method
investees and our cost basis investees 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.





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





Most of
our shareholders 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 our
Common Stock is trading may cause the market price of our Common Stock 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 approximately $8.4 million as of the date of this
filing, 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; however the amount we can borrow against our
collateral is limited by the Financial Industry Regulatory Authority (“FINRA”).
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 FINRA Over-The-Counter
Bulletin (“OTC”) Board Market and is subject to the “penny stock rules” adopted
pursuant to Section 15(g) of the Securities Exchange Act of 1934, as amended
(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.








49





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.





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 fiscal year ended May 31, 2009,
investment banks were reporting an inability to successfully obtain subscribers
for high credit quality auction rate securities.  As of the date of
this filing, we held such auction rate securities with a par value totaling $8.4
million that failed to sell at auction. During June 2009 and September 2009,
auction rate securities with a par value of $750,000 and $2,500,000,
respectively, were redeemed by the issuers at par value.  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 2009.  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, 2009, the fair value of our auction rate securities was estimated at $10
million based on a valuation by Houlihan Smith & Company, Inc.  We
recorded the net temporary valuation adjustment of $530,147 in other
comprehensive income, which represents the gross valuation adjustment of
$886,788, net of the related tax benefit of $356,641.  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 do not intend to sell our auction rate securities before we are
able to recover our cost basis and it is more likely than not that we will not
have to sell our auction rate securities before recovery of our cost
basis.  Since this valuation adjustment is deemed to be temporary, it
did not affect our earnings for the three months ended August 31, 2009 and
2008.


50





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 sheets at August 31, 2009
and May 31, 2009.





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.





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 when drawn upon will bear interest
at the federal funds rate plus 3%.  On October 14, 2008 we drew
$3,000,000 on the credit facility.





Item
4. Controls and Procedures





Quarterly
Evaluation of Disclosure Controls and Procedures




As
required by Rule 13a-15(b) under the Exchange Act, as of August 31,
2009, 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 reports 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, 2009, our management, with the
participation of 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




There
were no changes to our internal control over financial reporting (as defined in
Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during our most
recently completed fiscal quarter that materially affected, or are reasonably
likely to materially affect, our internal control over financial
reporting.




51


PART
II- OTHER INFORMATION





Item
1. Legal Proceedings





Patent
Litigation





Our
patent litigation with TPL and Alliacense Ltd. in the United States District
Court for the Northern District of California against Acer, Inc., HTC
Corporation and affiliated entities, as described in Item 3 - Legal Proceedings
in our Annual Report on Form 10-K for the year ended May 31, 2009 ("Annual
Report"), is still ongoing, but there have been no material developments in such
litigation since our Annual Report.





Our
patent litigation with TPL and Alliacense Ltd. in the United States District
Court for the Northern District of California against Barco, N.V., as described
in Item 3 - Legal Proceedings in our Annual Report, is still ongoing, but there
have been no material developments in such litigation since our Annual
Report.





Deutsche
Bank Arbitration





Our
arbitration claims before FINRA against Deutsche Bank Securities, Inc. and
affiliates, as described in Item 3 - Legal Proceedings in our Annual Report, is
still ongoing, but there have been no material developments in such arbitration
since our Annual Report.





Crossflo
Systems, Inc. Litigation





Under the
terms of our Agreement and Plan of Merger (the "Merger Agreement") with
Crossflo, and certain of its principal officers, an escrow account was
established to hold back approximately 10% of the merger consideration payable
to the shareholders of Crossflo (the "Escrow Merger
Consideration").  We contend that certain representations and
warranties made by Crossflo and certain of its principal officers in the Merger
Agreement were false when made, and were false as of the closing of the
merger.  We submitted a demand to the escrow agent on August 31, 2009
not to release the Escrow Merger Consideration to the Crossflo shareholders and
to instead return it to us.  Enough Crossflo shareholders have opposed
our demand that the escrow consideration has not been released to either
side.





On August
31, 2009, we initiated an arbitration proceeding before the American Arbitration
Association against the three Crossflo principal officers who were signatories
to the Merger Agreement for having provided false representations and warranties
in the Merger Agreement and for nondisclosure of information about Crossflo
during the due diligence process leading up to the Merger.  Those
three principal officers have not responded to the arbitration claim as of the
date of this filing which is deemed to be a denial of such claim.





Item
1A. Risk Factors





Please
see Part I, Item 2, above, for our risk factors.





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





On April
28, 2006, our Board of Directors authorized a stock repurchase
program.  We commenced the program in July 2006 and plan to repurchase
outstanding shares of our common stock on the open market from time to
time.  As part of the program, we purchased 50,000 shares of our
common stock at an aggregate cost of $5,513 during the three months ended August
31, 2009.





52


Following
is a summary of all repurchases by us of our common stock during the three month
period ended August 31, 2009:





Period
            
            Total
      Number of
              Shares
      Purchased
            
            Average
      Price Paid
              per
      Share
            
            Total
      Number of Shares Purchased as Part of Publicly Announced Plans or
      ProgramsJune
      1 – 30, 2009
            
            
            --
            
            
            $
            --
            
            
            
            --July
      1 – 31, 2009
            
            
            50,000
            
            
            $
            0.11
            
            
            
            50,000August
      1 – 31, 2009
            
            
            --
            
            
            $
            --  -
            
            
            
            --Total
            
            
            50,000
            
            
            $
            0.11
            
            
            
            50,000





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
      and Plan of Merger dated August 4, 2008, among Patriot Scientific
      Corporation, PTSC Acquisition 1 Corp, Crossflo Systems, Inc. and the
      Crossflo principal officers, incorporated by reference to Exhibit 99.1 to
      our Current Report on Form 8-K filed August 11, 2008 (Commission file No.
      000-22182)3.1
            Original
      Articles of incorporation of Patriot Scientific Corporation’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 Patriot Scientific Corporation, as filed with the
      Delaware Secretary of State on March 24, 1992, incorporated by
      reference to Exhibit 3.3 to our Current Report on Form 8-K dated
      May 12, 1992 (Commission file No. 33-23143-FW)   53
  3.3.1
            Certificate
      of Amendment to the Certificate of Incorporation of Patriot Scientific
      Corporation, as filed with the Delaware Secretary of State on
      April 18, 1995, incorporated by reference to Exhibit 3.3.1 to
      our Annual Report on 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 Patriot Scientific
      Corporation, as filed with the Delaware Secretary of State on
      June 24, 1997, incorporated by reference to Exhibit 3.3.2 to our
      Annual Report on 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 Patriot Scientific
      Corporation, 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 Patriot Scientific
      Corporation, as filed with the Delaware Secretary of State on May 6,
      2002, incorporated by reference to Exhibit 3.3.4 to our Quarterly Report
      on Form 10-Q for the quarterly period ended February 28, 2009, filed April
      9, 2009 (Commission file No. 000-22182)3.3.5
            Certificate
      of Amendment to the Certificate of Incorporation of Patriot Scientific
      Corporation,  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)3.3.6
            Certificate
      of Amendment to the Certificate of Incorporation of Patriot Scientific
      Corporation, as filed with the Delaware Secretary of State on
      April 29, 2005, incorporated by reference to Exhibit 3.3.6 to our
      Quarterly Report on Form 10-Q for the quarterly period ended February 28,
      2009, filed April 9, 2009 (Commission file No. 000-22182)3.3.7
            Certificate
      of Amendment to the Certificate of Incorporation of Patriot Scientific
      Corporation, as filed with the Delaware Secretary of State on
      November 14, 2005, incorporated by reference to Exhibit
      3.3.7  to our Quarterly Report on Form 10-Q for the quarterly
      period ended February 28, 2009, filed April 9, 2009 (Commission file No.
      000-22182)3.3.8
            Certificate
      of Amendment to the Certificate of Incorporation of Patriot Scientific
      Corporation, as filed with the Delaware Secretary of State on March 18,
      2009, incorporated by reference to Exhibit 3.3.8 to our Annual Report on
      Form 10-K for the year ended May 31, 2009, filed August 14, 2009
      (Commission file No. 000-22182)3.4
            Articles and
      Certificate of Merger of Patriot Financial Corporation into Patriot
      Scientific Corporation dated May 1, 1992, with Agreement and Plan of
      Merger attached thereto as Exhibit A, incorporated by reference to
      Exhibit 3.4 to our Current Report on 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 our Current Report on
      Form 8-K dated May 12, 1992 (Commission file No.
      33-23143-FW)3.6
            Certificate
      of Merger issued by the Colorado Secretary of State on May 12, 1992,
      incorporated by reference to Exhibit 3.6 to our Current Report on
      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 our
      Current Report on Form 8-K dated May 12, 1992 (Commission file No.
      33-23143-FW)23.1*
            Consent
      of Independent Valuation Firm23.2*
            Consent
      of Independent Valuation Firm31.1*
            Certification
      of Clifford L. Flowers, Interim 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 Clifford L. Flowers, CFO and Interim CEO, pursuant to Section 1350 of
      Chapter 63 Title 18 of the United States Code


54


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 9,
      2009
              PATRIOT
      SCIENTIFIC CORPORATIONBy:
              /s/ CLIFFORD
      L. FLOWERSClifford
      L. FlowersChief
      Financial Officer(Duly
      Authorized and Principal Financial Officer)