UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington, D.C.
20549





FORM
10-Q


(Mark
One)




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





For the
quarterly period ended February 29, 2008




OR




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





For the
transition period from ___________ to _______________




Commission
File Number 0-22182




PATRIOT
SCIENTIFIC CORPORATION


(Exact
name of registrant as specified in its charter)





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





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





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





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




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






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




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




Yes
[_]  No [X]




On April
4, 2008, 391,472,101 shares of common stock, par value $.00001 per share (the
issuer’s only class of voting stock) were outstanding.







INDEX




PagePART
      I. FINANCIAL INFORMATIONITEM
      1. Financial StatementsCondensed
      consolidated Balance Sheets as of February 29, 2008 (unaudited) and May
      31, 2007
            3Condensed
      consolidated Statements of Operations for the three and nine months ended
      February 29, 2008 and February 28, 2007 (unaudited)
            4Condensed
      consolidated Statements of Cash Flows for the nine months ended February
      29, 2008 and February 28, 2007 (unaudited)
            5-6Notes
      to condensed consolidated Financial Statements (unaudited)
            7-23ITEM
      2. Management’s Discussion and Analysis of Financial Condition and Results
      of Operations
            24-34ITEM
      3. Quantitative and Qualitative Disclosures About Market
    Risk
            34ITEM
      4. Controls and Procedures
            34PART
      II. OTHER INFORMATIONITEM
      1. Legal Proceedings
            35ITEM
      1A. Risk Factors
            36ITEM
      2. Unregistered Sales of Equity Securities and Use of
    Proceeds
            37ITEM
      3. Defaults Upon Senior Securities
            37ITEM
      4. Submission of Matters to a Vote of Security Holders
            37ITEM
      5. Other Information
            37ITEM
      6. Exhibits
            37-39SIGNATURES
            40






2





PART I- FINANCIAL INFORMATION





Item 1. Financial
Statements




Patriot
Scientific Corporation


Condensed
Consolidated Balance Sheets





February
      29,
              2008
            
            
            May
      31,
              2007ASSETS
            
            (Unaudited)Current
      assets:Cash
      and cash equivalents
            
            $
            7,561,911
            
            
            $
            21,605,428Restricted
      cash and cash equivalents
            
            
            50,805
            
            
            
            102,346Short
      term investments
            
            
            15,622,108
            
            
            
            4,349,314Accounts
      receivable, net
            
            
            397,974
            
            
            
            352,390Receivable
      from affiliated company
            
            
            3,616
            
            
            
            -Note
      receivable
            
            
            50,000
            
            
            
            -Inventory
            
            
            315,955
            
            
            
            46,361Prepaid
      income taxes
            
            
            -
            
            
            
            2,070,981Deferred
      tax assets
            
            
            1,454,524
            
            
            
            2,439,975Prepaid
      expenses and other current assets
            
            
            184,934
            
            
            
            431,840Total
      current assets
            
            
            25,641,827
            
            
            
            31,398,635Property
      and equipment, net
            
            
            71,626
            
            
            
            85,518Other
      assets, net
            
            
            8,190
            
            
            
            8,190Investment
      in affiliated company
            
            
            2,198,932
            
            
            
            2,883,969Patents and trademarks,
      net of accumulated amortization of $617,436 and $607,657
            
            
            35,882
            
            
            
            38,317Total
      assets
            
            $
            27,956,457
            
            
            $
            34,414,629LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilities:Accounts
      payable
            
            $
            334,967
            
            
            $
            934,298Accrued
      expenses and other
            
            
            260,670
            
            
            
            1,086,496Income
      taxes payable
            
            
            3,982,909
            
            
            
            -Total
      current liabilities
            
            
            4,578,546
            
            
            
            2,020,794Deferred
      tax liabilities
            
            
            1,764,298
            
            
            
            12,222,944Total
      liabilities
            
            
            6,342,844
            
            
            
            14,243,738Commitments and
      contingenciesMinority
      Interest
            
            
            -
            
            
            
            -Stockholders’
      equity:Preferred
      stock, $0.00001 par value; 5,000,000 shares authorized: none
      outstanding
            
            
            -
            
            
            
            -Common
      stock, $0.00001 par value: 500,000,000 shares authorized: 410,638,449
      shares issued and 391,472,101 shares outstanding at February 29, 2008 and
      406,668,661 shares issued and 393,201,134 shares outstanding at May 31,
      2007
            
            
            4,106
            
            
            
            4,066Additional
      paid-in capital
            
            
            69,889,848
            
            
            
            72,150,581Accumulated
      deficit
            
            
            (36,405,342
            )
            
            
            (43,151,678
            )Common
      stock held in treasury, at cost – 19,166,348 shares and 13,467,527 shares
      at February 29, 2008 and May 31,
    2007,  respectively
            
            
            (11,874,999
            )
            
            
            ( 8,832,078
            )Total
      stockholders’ equity
            
            
            21,613,613
            
            
            
            20,170,891$
            27,956,457
            
            
            $
            34,414,629





See
accompanying notes to unaudited condensed consolidated financial
statements.


3


Patriot
Scientific Corporation


Condensed
Consolidated Statements of Operations


(Unaudited)





Three
      Months Ended
            
            
            Nine
      Months EndedFebruary
      29,
              2008
            
            
            February
      28,
              2007
            
            
            February
      29,
              2008
            
            
            February
      28,
              2007Revenues:Product
      sales and other
            
            $
            801,284
            
            
            $
            22,175
            
            
            $
            2,268,484
            
            
            $
            67,050Cost
      of sales
            
            
            345,084
            
            
            
            -
            
            
            
            852,958
            
            
            
            -Gross
      profit
            
            
            456,200
            
            
            
            22,175
            
            
            
            1,415,526
            
            
            
            67,050Operating
      expenses:Selling,
      general and administrative
            
            
            1,364,077
            
            
            
            1,445,857
            
            
            
            5,308,631
            
            
            
            5,914,803Settlement
      and license expense
            
            
            417,740
            
            
            
            304,337
            
            
            
            836,400
            
            
            
            6,604,337Total
      operating expenses
            
            
            1,781,817
            
            
            
            1,750,194
            
            
            
            6,145,031
            
            
            
            12,519,140Operating
      loss
            
            
            (1,325,617
            )
            
            
            (1,728,019
            )
            
            
            (4,729,505
            )
            
            
            (12,452,090
            )Other
      income (expense):Interest
      and other income
            
            
            318,284
            
            
            
            191,437
            
            
            
            1,093,876
            
            
            
            499,335Loss
      on sale of assets
            
            
            (2,242
            )
            
            
            -
            
            
            
            (3,511
            )
            
            
            (543
            )Interest
      expense
            
            
            -
            
            
            
            -
            
            
            
            (237
            )
            
            
            -Gain
      on sale of subsidiary interest
            
            
            -
            
            
            
            -
            
            
            
            150,000
            
            
            
            -Equity
      in earnings of affiliated company
            
            
            11,696,265
            
            
            
            11,656,603
            
            
            
            15,981,763
            
            
            
            30,401,594Impairment
      of note receivable
            
            
            -
            
            
            
            (339,551
            )
            
            
            -
            
            
            
            (339,551
            )Total
      other income, net
            
            
            12,012,307
            
            
            
            11,508,489
            
            
            
            17,221,891
            
            
            
            30,560,835Income
      before income taxes
            
            
            10,686,690
            
            
            
            9,780,470
            
            
            
            12,492,386
            
            
            
            18,108,745Provision
      for income taxes
            
            
            4,394,505
            
            
            
            162,911
            
            
            
            5,746,050
            
            
            
            4,382,911Net
      income
            
            $
            6,292,185
            
            
            $
            9,617,559
            
            
            $
            6,746,336
            
            
            $
            13,725,834Basic
      income per common share
            
            $
            0.02
            
            
            $
            0.03
            
            
            $
            0.02
            
            
            $
            0.04Diluted
      income per common share
            
            $
            0.02
            
            
            $
            0.02
            
            
            $
            0.02
            
            
            $
            0.03Weighted
      average number of common shares outstanding-basic
            
            
            391,472,101
            
            
            
            381,031,577
            
            
            
            391,055,464
            
            
            
            374,711,954Weighted
      average number of common shares outstanding-diluted
            
            
            395,666,621
            
            
            
            410,747,949
            
            
            
            396,382,070
            
            
            
            416,327,140





See
accompanying notes to unaudited condensed consolidated financial
statements.
 4


Patriot
Scientific Corporation


Condensed
Consolidated Statements of Cash Flows


(Unaudited)




Nine
      months endedFebruary
      29, 2008
            
            
            February
      28, 2007Operating
      activities:Net
      income
            
            $
            6,746,336
            
            
            $
            13,725,834Adjustments
      to reconcile net income to net cash used in operating
      activities:Amortization
      and depreciation
            
            
            36,454
            
            
            
            31,927Expense
      related to extension of expiration date of stock options
            
            
            -
            
            
            
            324Non-cash
      compensation relating to issuance of stock options and vesting
      of  warrants
            
            
            407,652
            
            
            
            2,359,035Accrued
      interest income added to investments
            
            
            (959
            )
            
            
            (1,900
            )Equity
      in earnings of affiliated company
            
            
            (15,981,763
            )
            
            
            (30,401,594
            )Impairment
      of note receivable
            
            
            -
            
            
            
            339,551Loss
      on sale of assets
            
            
            3,513
            
            
            
            543Value
      of stock issued in connection with legal settlement
            
            
            100,000
            
            
            
            -Deferred
      income taxes
            
            
            (9,473,195
            )
            
            
            2,447,138Gain
      on VIE sale of portion of subsidiary interest
            
            
            (150,000
            )
            
            
            -Reversal
      of tax effect of exercise of options
            
            
            (25,645
            )
            
            
            -Changes
      in operating assets and liabilities:Accounts
      receivable
            
            
            (45,584
            )
            
            
            (12,673
            )Receivable
      from affiliated company
            
            
            (3,616
            )
            
            
            -Inventory
            
            
            (269,594
            )
            
            
            -Prepaid
      and other assets
            
            
            250,896
            
            
            
            235,640Prepaid
      income taxes
            
            
            2,070,981
            
            
            
            (1,081,627
            )Accounts
      payable and accrued expenses
            
            
            (1,425,157
            )
            
            
            (125,097
            )Accrued
      contested fee payable
            
            
            -
            
            
            
            (394,063
            )Accrued
      settlement fee payable
            
            
            -
            
            
            
            3,000,000Income
      taxes payable
            
            
            3,982,909
            
            
            
            -Net
      cash used in operating activities
            
            
            (13,776,772
            )
            
            
            (9,876,962
            )Investing
      activities:Proceeds
      from sales of short-term investments
            
            
            6,800,159
            
            
            
            7,441,664Purchases
      of short-term investments
            
            
            (18,072,953
            )
            
            
            (7,537,777
            )Proceeds
      from sale of restricted investments
            
            
            52,500
            
            
            
            -Purchases
      of property and equipment
            
            
            (20,411
            )
            
            
            (5,828
            )Proceeds
      from sale of property and equipment
            
            
            125
            
            
            
            -Costs
      incurred for patents and trademarks
            
            
            (7,344
            )
            
            
            -Proceeds
      from VIE sale of portion of subsidiary interest
            
            
            100,000
            
            
            
            -Investment
      in affiliated company
            
            
            -
            
            
            
            (120,000
            )Issuance
      of note receivable
            
            
            -
            
            
            
            (589,551
            )Distributions
      from affiliated company
            
            
            16,666,800
            
            
            
            29,419,880Net
      cash provided by investing activities
            
            
            5,518,876
            
            
            
            28,608,388Financing
      activities:Proceeds
      from exercise of common stock warrants and options
            
            
            18,200
            
            
            
            114,000Repurchase
      of warrants
            
            
            (2,760,900
            )
            
            
            -Repurchase
      of common stock for treasury
            
            
            (3,042,921
            )
            
            
            (7,441,664
            )Net
      cash used in financing activities
            
            
            (5,785,621
            )
            
            
            (7,327,664
            )Net
      increase (decrease) in cash and cash equivalents
            
            
            (14,043,517
            )
            
            
            11,403,762Cash
      and cash equivalents, beginning of period
            
            
            21,605,428
            
            
            
            3,984,240Cash
      and cash equivalents, end of period
            
            $
            7,561,911
            
            
            $
            15,388,002Supplemental
      Disclosure of Cash Flow Information:Cash
      payments for interest
            
            $
            237
            
            
            $
            -Cash
      payments for income taxes
            
            $
            9,191,000
            
            
            $
            3,017,400








5





Patriot
Scientific Corporation


Condensed
Consolidated Statements of Cash Flows


(Unaudited)




Nine
      months endedFebruary
      29, 2008
            
            
            February
      28, 2007Supplemental
      Disclosure of  Non-Cash Investing and Financing
      Activities:Cashless
      exercise of warrants
            
            $
            25
            
            
            $
            225Cashless
      exercise of stock options
            
            $
            10
            
            
            $
            -Note
      receivable issued in connection with VIE sale of portion of subsidiary
      interest
            
            $
            50,000
            
            
            $
            -Fair
      market value of assets received in collection of note receivable and
      subsequently contributed for preferred stock of affiliate
            
            $
            -
            
            
            $
            250,000










See
accompanying notes to unaudited condensed consolidated financial
statements.
 6
 Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements




1.Basis of Presentation and
Summary of Significant Accounting Policies





The
unaudited condensed consolidated financial statements of Patriot Scientific
Corporation (the “Company”, “we”, “us” or “our”) presented herein have been
prepared pursuant to the rules of the Securities and Exchange Commission (“SEC”)
for quarterly reports on Form 10-Q and do not include all of the information and
footnotes required by accounting principles generally accepted in the United
States of America. These financial statements should be read in conjunction with
our audited consolidated financial statements and notes thereto included in our
Report on Form 10-K for our fiscal year ended May 31, 2007.





In the
opinion of management, the interim condensed consolidated financial statements
reflect all adjustments of a normal recurring nature necessary for a fair
presentation of the results for the interim periods
presented.  Operating results for the nine month period ended February
29, 2008 are not necessarily indicative of the results that may be expected for
the year ending May 31, 2008.





Basis
of Consolidation


The
condensed consolidated statement of operations for the three and nine months
ended February 28, 2007 includes our accounts and those of our inactive
subsidiaries, Metacomp, Inc. and Plasma Scientific Corporation. The condensed
consolidated balance sheet at May 31, 2007 and the condensed consolidated
financial statements as of and for the three and nine months ended February 29,
2008 include our accounts, those of our majority owned subsidiaries that are not
considered variable interest entities (“VIE”s) and all VIEs for which we are the
primary beneficiary. All significant intercompany accounts and transactions have
been eliminated.





Consolidation
of Affiliate


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





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





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





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





Investment
in Affiliated Company


We have a
50% interest in Phoenix Digital Solutions, LLC (see Note 6). This investment is
accounted for using the equity method of accounting since the investment
provides us the ability to exercise significant influence, but not control, over
the investee. Significant influence is generally deemed to exist if we have an
ownership interest in the voting stock of the investee of between 20% and 50%,
although other factors, such as
representation on the investee’s board of directors, are considered in
determining whether the equity method of accounting is appropriate. Under the
equity method of accounting, the investment, originally recorded at cost, is
adjusted to recognize our share of net earnings or losses of the investee and is
recognized in the consolidated statements of operations in the caption “Equity
in earnings of affiliated company”.




7


Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements




Investment
in Affiliated Company, continued





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





Revenue
Recognition


We
recognize revenue from the sale of our product upon shipment to the customer, at
which time title transfers and we have no further obligations. Fees for
maintenance or support are recorded on a straight-line basis over the underlying
period of performance. Revenue from technology license agreements is recognized
at the time we enter into a contract and provide the customer with the licensed
technology. At this point, we have performed all of our obligations under
contract, the rights to our technology have been transferred and no significant
performance obligations remain.





SSDI
recognizes revenue upon shipment of its product and recognizes revenue on its
short-term installation contracts as time and materials costs are
incurred.





SSDI
maintains agreements with stocking distributors. These agreements provide for a
limited product warranty for a period of one year from the date of sale to the
end user. The warranty does not cover damage to the product after it has been
delivered to the distributor. SSDI’s stocking distributor agreements also allow
limited rights to periodic stock rotation.  These rotation rights
allow for the exchange of a percentage of distributor inventory for replacement
products of the distributor’s choosing .  At February 29, 2008,
SSDI  has evaluated the potential for rotated product and has provided
for the estimated impact in the accounting records.





Sales
through large distributors account for the majority of SSDI’s product revenues,
with a majority of sales to Anixter, Inc. and Graybar Electric Company,
Inc.





Shipping
and Handling


Emerging
Issues Task Force (“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. SSDI includes shipping and handling fees
billed to customers in net sales. Shipping and handling costs associated with
inbound freight are included in cost of sales.





Net
Income Per Share


We apply
Statement of Financial Accounting Standards (“SFAS”) No. 128, Earnings Per Share, for the
calculation of "Basic" and "Diluted" earnings per share. Basic earnings per
share includes no dilution and is computed by dividing income available to
common stockholders by the weighted average number of common shares outstanding
for the period. Diluted earnings per share reflects the potential dilution of
securities that could share in the earnings of an entity.  For the
three months ended February 29, 2008, 3,320,000 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.  For the nine months ended February 29, 2008, 3,420,000
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.  For the three months ended February 28,
2007, 3,495,000 potentially dilutive common shares related to our outstanding
warrants and options were not included in the calculation of diluted loss per
share as they had an anti-dilutive  effect.
For the nine months ended February 28, 2007, 330,000 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.




8


Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements





Net Income Per Share,
continued






Three
      Months Ended February 29, 2008Numerator
      (Income)
            
            
            Denominator
      (Shares)
            
            
            Per
      Share AmountBasic
      EPS:Net income
            
            $
            6,292,185
            
            
            
            391,472,101
            
            
            $
            0.02Diluted
      EPS:Effect
      of dilutive securities:Options
    andwarrants
            
            
            -
            
            
            
            4,194,520Income
      available to common shareholders
            
            $
            6,292,185
            
            
            
            395,666,621
            
            
            $
            0.02









Three
      Months Ended February 28, 2007Numerator
      (Income)
            
            
            Denominator
      (Shares)
            
            
            Per
      Share AmountBasic
      EPS:Net income
            
            $
            9,617,559
            
            
            
            381,031,577
            
            
            $
            0.03Diluted
      EPS:Effect
      of dilutive securities:Options
    andwarrants
            
            
            -
            
            
            
            29,716,372Income
      available to common shareholders
            
            $
            9,617,559
            
            
            
            410,747,949
            
            
            $
            0.02







Nine
      Months Ended February 29, 2008Numerator
      (Income)
            
            
            Denominator
      (Shares)
            
            
            Per
      Share AmountBasic
      EPS:Net income
            
            $
            6,746,336
            
            
            
            391,055,464
            
            
            $
            0.02Diluted
      EPS:Effect
      of dilutive securities:Options
    andwarrants
            
            
            -
            
            
            
            5,326,606Income
      available to common shareholders
            
            $
            6,746,336
            
            
            
            396,382,070
            
            
            $
            0.02




9


Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial
Statements


Net
Income Per Share, continued







Nine
      Months Ended February 28, 2007Numerator
      (Income)
            
            
            Denominator
      (Shares)
            
            
            Per
      Share AmountBasic
      EPS:Net income
            
            $
            13,725,834
            
            
            
            374,711,954
            
            
            $
            0.04Diluted
      EPS:Effect
      of dilutive securities:Options
    andwarrants
            
            
            -
            
            
            
            41,615,186Income
      available to common shareholders
            
            $
            13,725,834
            
            
            
            416,327,140
            
            
            $
            0.03





Minority
Interest


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





The
noncontrolling interest in SSDI, which we are required to consolidate as we are
the primary beneficiary, has been reduced to zero due to the initial allocation
of losses prior to the period in which we were required to consolidate. If a
noncontrolling interest has been reduced to zero, the primary beneficiary must
absorb any losses that are in excess of the value of the noncontrolling
interest’s equity. For the period in which we are required to consolidate, March
27, 2007 through February 29, 2008 we absorbed $84,532 of SSDI’s losses as we
are the primary beneficiary. The noncontrolling interest in any future profits
will not be presented until all prior losses have been recovered.





Stock-Based
Compensation




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




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




Stock-based
compensation expense recognized during the period is based on the value of the
portion of share-based payment awards that is ultimately expected to vest during
the period. Stock-based compensation expense recognized in our condensed
consolidated statement of operations for the nine months ended February 28, 2007
included compensation expense for share-based payment awards granted prior to,
but not yet
vested as of May 31, 2006 based on the grant date fair value estimated in
accordance with the pro forma provisions of SFAS No. 123 and compensation
expense for the share-based payment awards granted subsequent to May 31,
2006 based on the grant date fair value estimated in accordance with the
provisions of SFAS No. 123(R). Stock-based compensation expense recognized in
our condensed consolidated statement of operations for the nine months ended
February 29, 2008 included compensation expense for share-based payment awards
granted subsequent to May 31, 2007 based on the grant date fair value
estimated in accordance with the provisions of SFAS No. 123(R). 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 and nine months ended February 29, 2008 and February 28,
2007, of approximately 5% was based on historical forfeiture experience and
estimated future employee forfeitures. The estimated pricing term of option
grants for the three and nine months ended February 29, 2008 and February 28,
2007 was five years.




10
 
 Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements
 
 Stock-Based
Compensation, continued





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 and
nine months ended February 29, 2008 and February 28, 2007 is based on the
historical volatilities of our common stock.  These factors could
change in the future, affecting the determination of stock-based compensation
expense in future periods.





Three
      Months Ended
              February
      29,
              2008
              (Unaudited)
            
            Nine
      Months Ended
              February
      29,
              2008
              (Unaudited)
            
            Three
      Months Ended
              February
      28,
              2007
              (Unaudited)
            
            Nine
      Months Ended
              February
      28,
              2007
              (Unaudited)Expected
      term
            
            
            5
            
            years
            
            
            5
            
            years
            
            
            5
            
            years
            
            
            5
            
            yearsExpected
      volatility
            
            
            124
            
            %
            
            
            124-128
            
            %
            
            
            146
            
            %
            
            
            146
      -156
            
            %Risk-free
      interest rate
            
            
            2.5
            
            %
            
            
            2.5
      – 4.96
            
            %
            
            
            4.78
            
            %
            
            
            4.78
      – 5
            
            %Expected
      dividends
            
            
            2.82
            
            %
            
            
            2.82
            
            %
            
            
            -
            
            
            
            
            -




A summary
of option activity as of February 29, 2008 and changes during the nine months
then ended, is presented below:





Shares
            
            
            Weighted
              Average
              Exercise
              Price
            
            
            Weighted
              Average
              Remaining
      Contractual
              Term
              (Years)
            
            
            Aggregate
              Intrinsic
              ValueOptions
      outstanding at June 1, 2007
            
            
            7,245,000
            
            
            $
            0.40Options
      granted
            
            
            5,975,000
            
            
            $
            0.44Options
      exercised
            
            
            (1,107,846
            )
            
            $
            0.16Options
      forfeited
            
            
            (2,792,154
            )
            
            $
            0.39Options
      outstanding at February 29, 2008
            
            
            9,320,000
            
            
            $
            0.45
            
            
            
            3.24
            
            
            $
            461,750Options
      vested and expected to vest at February 29, 2008
            
            
            9,155,000
            
            
            $
            0.46
            
            
            
            3.21
            
            
            $
            461,750Options
      exercisable at February 29, 2008
            
            
            6,020,000
            
            
            $
            0.48
            
            
            
            2.32
            
            
            $
            461,750




11


Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements
 
  Stock-Based
Compensation, continued




The
weighted average grant date fair value of options granted during the nine months
ended February 29, 2008 and February 28, 2007 was $0.32 and $0.82 per option,
respectively. The total intrinsic value of options exercised during the nine
months ended February 29, 2008 and February 28, 2007 was $513,550 and $290,100,
respectively, based on the differences in market prices on the dates of exercise
and the option exercise prices.





The
aggregate intrinsic value represents the differences in market price at the
close of the quarter ($0.40 per share on February 29, 2008) and the exercise
price of outstanding, in the money options (those options with exercise prices
below $0.40) on February 29, 2008.





As of
February 29, 2008, there was approximately $916,394 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 60 months.




The
following table summarizes employee and director stock-based compensation
expense related to stock options under SFAS No. 123(R) for the three and nine
months ended February 29, 2008 and February 28, 2007, which was recorded as
follows:




Three
              Months
              Ended
            
            
            Nine
              Months
              Ended
            
            
            Three
              Months
              Ended
            
            
            Nine
              Months
              EndedFebruary 29,
      2008
            
            
            February
      29, 2008
            
            
            February
      28, 2007
            
            
            February
              28,
      2007Selling,
      general and administrative expense
            
            $
            61,517
            
            
            $
            407,652
            
            
            $
            586,000
            
            
            $
            2,356,000





Recent
Accounting Pronouncements





In July
2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income
Taxes - an interpretation of FASB Statement No. 109 (“FIN 48”). This
interpretation clarifies the application of SFAS No. 109, Accounting for Income Taxes,
by defining criteria that an individual tax position must meet for any part of
the benefit of that position to be recognized in a company’s financial
statements and also provides guidance on measurement, derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure and transition. We adopted FIN 48 on June 1, 2007 and did not record
any cumulative effect adjustment to retained earnings as a result of adopting
FIN 48.  Interest and penalties, if any, related to unrecognized tax
benefits are recorded in income tax expense.  As of June 1, 2007, we
are subject to U.S. Federal income tax examinations for the tax years May 31,
1991 through May 31, 2007, and we are subject to state and local income tax
examinations for the tax years May 31, 1999 through May 31, 2007 due to the
carryover of net operating losses from previous years.





12
 
 Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements
 
 Recent
Accounting Pronouncements, continued
  
 In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements
(“SFAS No. 157”).  SFAS No. 157 defines fair value, establishes a framework
for measuring fair value in generally accepted accounting principals and expands
disclosures about fair value measurements.  The statement does not require
new fair value measurements, but is applied to the extent that other accounting
pronouncements require or permit fair value measurements.  The statement
emphasizes that fair value is a market-based measurement that should be
determined based on the assumptions that market participants would use in
pricing an asset or liability.  Companies that have assets and liabilities
measured at fair value will be required to disclose information that enables the
users of its financial statements to access the inputs used to develop those
measurements.  The reporting entity is encouraged, but not required, to
combine the fair value information disclosed under this statement with the fair
value information disclosed under other accounting pronouncements.  SFAS
No. 157 is effective for fiscal years beginning after November 15, 2007. We
expect to adopt SFAS No. 157 on June 1, 2008.  We are in the process of
evaluating the provisions of the statement, but do not anticipate that the
adoption of SFAS No. 157 will have a material impact on our consolidated
financial statements.





In
February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial
Assets and Financial Liabilities(“SFAS No. 159”). SFAS No. 159 permits
entities to choose to measure at fair value many financial instruments and
certain other items that are not currently required to be measured at fair
value. The objective is to improve financial reporting by providing entities
with the opportunity to mitigate volatility in reported earnings caused by
measuring related assets and liabilities differently without having to apply
complex hedge accounting provisions. SFAS No. 159 also establishes
presentation and disclosure requirements designed to facilitate comparisons
between entities that choose different measurement attributes for
similar types of assets and liabilities. SFAS No. 159 does not affect
any existing accounting literature that requires certain assets and liabilities
to be carried at fair value. SFAS No. 159 does not establish
requirements for recognizing and measuring dividend income, interest income, or
interest expense. This Statement does not eliminate disclosure requirements
included in other accounting standards. SFAS No. 159 is effective in
fiscal years beginning after November 15, 2007. We are in the process of
evaluating the provisions of the statement, but do not anticipate that the
adoption of SFAS No. 159 will have a material impact on our consolidated
financial statements.





In
December 2007, the FASB issued SFAS No. 141(R), Business Combinations (“SFAS
No. 141(R)”). 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 they need to evaluate and
understand the nature and financial effect of the business combination. SFAS
No. 141(R) is effective in fiscal years beginning after December 15, 2008.
We expect to adopt SFAS No. 141(R) on June 1, 2009.  We are currently
assessing the impact the adoption of SFAS No. 141(R) will have on our
consolidated financial statements.





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




13
 
 Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements
  2.Cash, Cash Equivalents
and Short-Term Investments





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





Our
short-term investments consist of auction rate securities and are reported at
cost, which approximate fair market value.





At
February 29, 2008 we had short-term investments in auction rate securities of
approximately $15.6 million.  Auction rate securities generally have
long-stated maturities of 20 to 40 years.  These securities have
certain economic characteristics of short-term investments due to a rate-setting
mechanism and the ability to liquidate them through a Dutch auction process that
occurs on pre-determined intervals of less than 90 days.  Due to the
frequent resetting of interest rates, the carrying value of auction rate
securities approximates fair value.





During
the quarter ended February 29, 2008, investment banks were reporting an
inability to successfully obtain subscribers for high credit quality auction
rate securities.  As of February 29, 2008 we held such auction rate
securities with a par value totaling $10.4 million that failed in February 2008
to sell at auction.  The unsuccessful auctions have resulted in the
interest rate on these securities resetting at a premium interest rate every 35
days or less.  In the event we need to access funds invested in these
auction rate securities we would 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
preferred 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 February 2008.  These instruments are collateralized
in excess of the underlying obligations, are insured by the various state
educational agencies, and are guaranteed by the Department of Education as an
insurer of last resort.  We have the intent and the ability to hold
these investments until the anticipated recovery period which we believe will be
less than twelve months.





3.Accounts
Receivable





Accounts
receivable consist of trade receivables recorded at the original invoice amount,
less an estimated allowance for uncollectible accounts.  At February
29, 2008 the allowance for doubtful accounts was $3,200.  Trade
receivables are periodically evaluated for collectibility based on past credit
histories with customers and their current financial
condition.  Changes in the estimated collectibility of trade
receivables are recorded in the results of operations for the period in which
the estimate is revised.  Trade receivables that are deemed
uncollectible are offset against the allowance for uncollectible
accounts.





4.Inventory





Inventory
at February 29, 2008, consisted of raw materials of $110,629 and finished goods
of $205,326.





14


Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements




5.License
Agreements





In
February 2005, we entered into two separate licensing agreements with one
customer for our patent portfolio and Ignite microprocessor technology. The
aggregate amount of the two licenses was $3,050,000, of which $2,950,000 was for
licensing fees and $100,000 was for maintenance services. Maintenance under the
agreement is expected to be provided over a period not to exceed four years.
Maintenance revenue recognized during the nine months ended February 29, 2008
and February 28, 2007 was $18,750 and $18,750, respectively. The payment terms
of the agreements required aggregate payments of $300,000 at the time of
execution, three quarterly payments of $750,000 each on April 1, August 15, and
November 15, 2005 and one final payment of $500,000 on February 15, 2006. The
$500,000 payment due on February 15, 2006 was paid in March 2006. Total payments
received in fiscal 2005 amounted to $1,050,000, and total payments received in
fiscal 2006 amounted to $2,000,000. The agreements also provide for the future
payment of royalties to us based on sales of product using the Ignite licensed
technology. In connection with this license agreement, we became obligated to
the co-inventor of the patent portfolio technology for $207,600 pursuant to a
July 2004 agreement under which we were obligated to pay a percentage of all
patent portfolio licensing proceeds to the co-inventor. The amount due under
that license was payable in four installments of $51,900. The co-inventor of the
patent portfolio technology filed a lawsuit against us seeking damages and/or
enforcement of the July 2004 agreement. We challenged the enforceability of the
agreement by counterclaim in that action. On February 14, 2007, a settlement of
the litigation was finalized. Terms of the settlement required us to pay
$3,400,000 in cash on February 14, 2007 and $3,000,000 on May 1, 2007, which
amounted to approximately the debt claimed by the co-inventor to be owed to him
under the July 2004 agreement. In addition, the settlement required us to make a
donation of $15,000 on February 14, 2007 on behalf of Russell H. Fish III
(“Fish”) to Maasai Power and Education Project, Inc., and to pay Fish the
equivalent of 4% of 50% of the next $100 million of gross license fees as they
are collected by Phoenix Digital and as distributions are made to us, after
excluding the first $20 million collected by Phoenix Digital after December 1,
2006. Our commitment to make payments to Fish related to such future license
revenues was limited to $2 million. During the nine months ended February 29,
2008, we recorded $836,400 in settlement and license expenses relating to
royalty payments due to the Fish parties.  In January 2008, we made
the final payment under the Fish settlement agreement.





6.Investment in Affiliated
Company/License Agreement





On June
7, 2005, we entered into a Master Agreement (the “Master Agreement”) with
Technology Properties Limited Inc., a California corporation (“TPL”), and
Charles H. Moore (“Moore”), the co-inventor of certain of our technology,
pursuant to which we, TPL and Moore resolved all legal disputes between us.
Pursuant to the Master Agreement, we and TPL entered into the Limited Liability
Company Operating Agreement of Phoenix Digital (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 Phoenix Digital, 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 Phoenix Digital 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 Phoenix Digital 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. Phoenix Digital 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 Phoenix Digital) for supporting efforts to secure licensing
agreements by the other member on behalf of Phoenix Digital. During the nine
months ended February 29, 2008 and February 28, 2007, Phoenix Digital paid
$1,952,362 and $2,934,075, respectively, to TPL pursuant to this
commitment.




15


Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements







Investment
in Affiliated Company/License Agreement, continued





We are
accounting for our investment in Phoenix Digital under the equity method of
accounting, and accordingly have recorded our share of Phoenix Digital’s net
income of $15,981,763 during the nine months ended February 29, 2008 and our
share of Phoenix Digital’s net income of $30,401,594 during the nine months
ended February 28, 2007 as an increase in our investment. Cash distributions of
$16,666,800 received from Phoenix Digital during the nine months ended February
29, 2008 and cash distributions of $29,419,880 received from Phoenix Digital
during the nine months ended February 28, 2007 have been recorded as a reduction
in our investment. Our investment in Phoenix Digital is $2,198,932 at February
29, 2008 and has been recorded as “Investment in Affiliated
Company”.  We have recorded our share of Phoenix Digital’s net income
as “Equity in Earnings of Affiliated Company” in the accompanying consolidated
statements of operations for the nine months ended February 29, 2008 and
February 28, 2007.





During
the nine months ended February 29, 2008, TPL entered into licensing agreements
with third parties, pursuant to which Phoenix Digital received aggregate
proceeds of $48,851,970.  During the nine months ended February 28,
2007, TPL entered into licensing agreements with third parties, pursuant to
which Phoenix Digital received aggregate proceeds of
$64,869,000.  License proceeds of $2,920,000 relating to an additional
license agreement signed in February 2007 were received in March
2007.  Phoenix Digital recorded this amount as a license
receivable.





The
condensed balance sheets and statements of operations of Phoenix Digital at
February 29, 2008 and February 28, 2007 and for the nine months then ended are
as follows:





Condensed
Balance Sheets





ASSETS:




2008
            
            
            2007Cash
            
            $
            8,017,494
            
            
            $
            7,500,220License
      fees receivable
            
            
            -
            
            
            
            2,920,000Prepaid
      expenses
            
            
            55,000
            
            
            
            15,000Total
      assets
            
            $
            8,072,494
            
            
            $
            10,435,220





LIABILITIES
AND MEMBERS’ EQUITY:







2008
            
            
            2007Accounts
      payable and accrued expenses
            
            $
            3,662,840
            
            
            $
            629,934Income
      taxes payable
            
            
            11,790
            
            
            
            11,790Members’
      equity
            
            
            4,397,864
            
            
            
            9,793,496Total
      liabilities and members’ equity
            
            $
            8,072,494
            
            
            $
            10,435,220





Condensed
Statements of Operations





2008
            
            
            2007Revenues
            
            $
            48,851,970
            
            
            $
            67,788,985Operating
      expenses
            
            
            16,334,021
            
            
            
            7,295,104Operating
      income
            
            
            32,517,949
            
            
            
            60,493,881Interest
      income
            
            
            177,281
            
            
            
            309,308Net
      income
            
            $
            32,695,230
            
            
            $
            60,803,189






16


Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements






7.Consolidated Variable
Interest Entity





On
February 2, 2007, we invested an aggregate of $370,000 in SSDI for 2,100,000
shares of convertible preferred stock. This represents all of SSDI’s preferred
stock and a 46% ownership interest in SSDI, a California corporation that
manufactures products that protect information transmitted over secure networks.
The investment consisted of certain assets contributed by us to SSDI valued at
$250,000 and cash of $120,000. The shares are convertible at our option into
shares of SSDI’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 SSDI. The
investment in SSDI’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.





On March
27, 2007, we entered into an 18 month revolving line of credit with SSDI for a
maximum amount of $500,000. The line of credit matures on September 27, 2008. If
we do not provide notice to SSDI at least 90 days prior to the maturity date,
the maturity date automatically extends 12 months. The line of credit is
collateralized by all assets presently owned or hereafter acquired by SSDI. The
carrying value of the collateral is approximately $558,723 at February 29, 2008.
The creditors of SSDI do not have recourse to our other assets. During the three
and nine months ended February 29, 2008 we advanced $50,000 and $150,000,
respectively, under terms of the agreement.  The total amount drawn on
the line of credit at February 29, 2008 is $400,000.





The line
of credit carries a floating interest rate which is defined as the prime rate as
announced by Bank of America. At February 29, 2008, the interest rate on
the note was 6.00%. SSDI is required to make minimum monthly payments on the
line consisting of unpaid and accrued interest on the first day of the month
following the initial advance.





During
the quarter ended February 29, 2008 we subordinated our interest in the
repayment of principal due under the revolving line of credit, up to a maximum
of $100,000, for the benefit of a customer of SSDI.





As a
result of the line of credit, we have a variable interest in SSDI, a variable
interest entity, and we have determined that we are the primary beneficiary as
we absorb more than half of the variable interest entity’s expected losses. FIN
46(R), requires us to consolidate SSDI as long as we are deemed to be the
primary beneficiary. The equity interests of SSDI not owned by us are reported
as a minority interest in our February 29, 2008 condensed consolidated balance
sheet.  As of February 29, 2008, the noncontrolling interest in SSDI,
which we are required to consolidate as we are the primary beneficiary, has been
reduced to zero due to the initial allocation of losses prior to the period in
which we were required to consolidate. If a noncontrolling interest has been
reduced to zero, the primary beneficiary must absorb any losses that are in
excess of the value of the noncontrolling interest’s equity. For the period in
which we are required to consolidate, March 27, 2007 through February 29, 2008
we absorbed $84,532 of SSDI’s losses as we are the primary beneficiary. The
noncontrolling interest in any future profits will not be presented until all
prior losses have been recovered.





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





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





During
the three months ended August 31, 2007, SSDI sold a membership interest in its
subsidiary DataSecurus, LLC to an unrelated third party for $100,000 in cash and
a $50,000 note receivable due June 2008.





17
 
 Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


8.Stockholders’
Equity





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 5,698,821 and 10,779,027
shares of our common stock at an aggregate cost of $3,042,921 and $7,441,664
during the nine months ended February 29, 2008 and February 28, 2007,
respectively.





The
following table summarizes equity transactions during the nine months ended
February 29, 2008:







Common
      StockShares
            
            
            Amounts
            
            
            Additional
      Paid-
              in
      Capital
            
            
            Accumulated
      Deficit
            
            
            Treasury
      StockBalance
      June 1, 2007
            
            
            393,201,134
            
            
            $
            4,066
            
            
            $
            72,150,581
            
            
            $
            (43,151,678
            )
            
            $
            (8,832,078
            )Exercise
      of warrants and options at $0.05 to $0.10 per share
            
            
            250,000
            
            
            
            3
            
            
            
            18,197
            
            
            
            -
            
            
            
            -Cashless
      exercise of options
            
            
            982,846
            
            
            
            10
            
            
            
            (10
            )
            
            
            -
            
            
            
            -Cashless
      exercise of warrants
            
            
            2,536,942
            
            
            
            25
            
            
            
            (25
            )
            
            
            -
            
            
            
            -Issuance
      of stock
            
            
            200,000
            
            
            
            2
            
            
            
            99,998
            
            
            
            -
            
            
            
            -Repurchase
      of warrants
            
            
            -
            
            
            
            -
            
            
            
            (2,760,900
            )
            
            
            -
            
            
            
            -Non-cash
      compensation
            
            
            -
            
            
            
            -
            
            
            
            407,652
            
            
            
            -
            
            
            
            -Tax
      effect of exercise of options
            
            
            -
            
            
            
            -
            
            
            
            (25,645
            )
            
            
            -
            
            
            
            -Repurchase
      of common stock for treasury
            
            
            (5,698,821
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (3,042,921
            )Net
      income
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            6,746,336
            
            
            
            -Balance
      February 29, 2008
            
            
            391,472,101
            
            
            $
            4,106
            
            
            $
            69,889,848
            
            
            $
            (36,405,342
            )
            
            $
            (11,874,999
            )





During
November 2007 we issued 200,000 shares of our common stock to a former officer
in connection with a settlement agreement.





Stock Optionsand Warrant
Activity




As of
February 29, 2008, we had 100,000 options outstanding pursuant to our 1996 Stock
Option Plan exercisable at $0.07 per share expiring in 2009; 875,000 options
outstanding pursuant to our 2001 Stock Option Plan exercisable at a range of
$0.10 to $0.86 per share expiring through 2013; 3,550,000 options outstanding
pursuant to our 2003 Stock Option Plan exercisable at a range of $0.05 to $0.49
per share expiring through 2013; and 4,795,000 options outstanding pursuant to
our 2006 Stock Option Plan exercisable at a range of $0.45 to $0.70 per share
expiring through 2013.  Some of the options outstanding under these
plans are not presently exercisable and are subject to meeting vesting
criteria.





During
the quarter ended November 30, 2007, we issued options to acquire 750,000 shares
of common stock to our newly appointed chief financial officer at an exercise
price of $0.45 per share.





During
the quarter ended February 29, 2008, we issued options to acquire 3,000,000
shares of common stock to our newly appointed chief executive officer at an
exercise price of $0.40 per share.





During
the nine months ended February 29, 2008, directors exercised stock options to
purchase 125,000 shares of common stock for proceeds of $11,950, and a director
exercised stock options utilizing a share certification exchange procedure
within our stock option plans to exercise 1,500,000 shares and receive 982,846
new shares upon exercise.





During
the nine months ended February 29, 2008, we recorded $407,652 of non cash
compensation expense related to stock options issued and vesting of stock
options.





18


Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements





Stockholders’
Equity, continued





As of
February 29, 2008, we had warrants outstanding to purchase 500,000 common shares
at exercise prices ranging from $0.06 to $1.00 per share, expiring at various
dates through 2011.  During the nine months ended February 29, 2008,
we issued no warrants to purchase shares of common stock, an investor exercised
warrants to purchase 125,000 shares of common stock for proceeds of $6,250,
1,898,973 warrants expired, 3,500,000 warrants were exercised utilizing the
cashless method of exercise for 2,536,942 shares, and we repurchased 7,000,000
warrants for $2,760,900 under terms of our warrant repurchase agreement with
Lincoln Ventures, LLC.





In
connection with a previous debt agreement, we entered into an Antidilution
Agreement (the “Antidilution Agreement”) with Swartz Private Equity, LLC
(“Swartz”) wherein we were obligated to issue to Swartz warrants equal to 11% of
the common stock issued between January 28, 2002 and March 11, 2002, 20% of the
common stock issued between March 12, 2002 and April 1, 2003, and after April 1,
2003, 30% of the common stock issued to any parties other than
Swartz.  There were no warrants issued during the three month period
ended August 31, 2006 in connection with the Antidilution agreement, nor were
warrants issued during September 2006 in connection with the Antidilution
agreement. On October 10, 2006, we entered into an Approval Rights Agreement and
Termination of Antidilution Agreement and Addendum to Warrants (the “Termination
Agreement”) with Swartz to terminate the Antidilution Agreement.  In
consideration for entering into the Termination Agreement, we agreed that
through May 31, 2008 we would obtain Swartz’s written approval at least 30 days
prior to entering into (i) any acquisition of any business entity or asset of
any kind where the aggregate number of shares of common stock and derivative
securities (on a fully diluted basis) issued as consideration for the
acquisition equals or exceeds 10% of the number of shares of  our
common stock outstanding at the time of the acquisition (on a fully diluted
basis) or (ii) any acquisition (regardless of size) by us of any business entity
or asset of any kind that is not unanimously approved by our board of
directors.





9.Commitments and
Contingencies





Litigation





Patent
Litigation





Pursuant
to the joint venture that the Company entered into in June 2005 with TPL (in
settlement of inventorship/ownership litigation between the parties, and in
return for a 50-50 sharing of net licensing and enforcement revenues), the
Company granted TPL the complete and exclusive right to enforce and
license  the microprocessor patent portfolio. The Company then
dismissed its patent infringement claims against Fujitsu Computer Systems, Inc.
(“Fujitsu”), Matsushita Electric Corporation of America (“MEI”), NEC Solutions
(America) Inc. (“NEC”), Sony Electronics Inc. (“Sony”), and Toshiba America
Inc., and certain related entities of these defendants which had been pending in
the Federal District Court for the Northern District of California. Thereafter,
TPL filed patent infringement actions against the foregoing defendants (except
Sony) and their related entities in the Federal District Court for the Eastern
District of Texas. Patriot was subsequently joined as a party to the litigation.
Litigation was not reinitiated with regard to Fujitsu or NEC and certain of
NEC’s subsidiaries as listed below.





In
February 2006, a license agreement was entered into with Fujitsu and in
connection with that transaction, the litigation involving Fujitsu, TPL and the
Company in both California and Texas was dismissed.





On August
25, 2006, ARM Ltd. and ARM, Inc. intervened as defendants, seeking a declaration
of non-infringement of the ‘584 patent with respect to ARM processor cores
contained within some alleged infringing chips of other defendants.





19


Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Commitments
and Contingencies, continued





In
February 2007, a license agreement was entered into with NEC Corporation, NEC
Corporation of America, Inc., NEC Display Solutions of America, Inc. and NEC
Unified Solutions, Inc. In connection with that transaction, the above named
defendants, excluding NEC Electronics America, Inc., were dismissed from the
lawsuit.





A Claims
Construction Hearing was held May 3, 2007 in The United States District Court
for the Eastern District of Texas. On June 15, 2007, the court ruled on the
claims construction of the patents-in-suit, the ‘336, ‘148 and ‘584 patents.
Based on the claims construction ruling, TPL/Patriot proceeded with discovery
with respect to the ‘336 and ‘148 patents. However, based on the claims
construction ruling as to the ‘584 patent TPL/Patriot entered into a Stipulation
of non-infringement by the accused ARM products with respect to the ‘584 patent
with ARM, the purpose of which was to expedite an appeal of that claims
construction.  A notice of appeal to the Federal Circuit was filed
with respect to the ARM Stipulation and the District Court’s claims construction
with respect to the ‘584 patent.  The appeal has been briefed and oral
argument before the Federal Circuit concerning claims construction of the ‘584
patent is scheduled for May 6, 2008.





On
December 18, 2007 all remaining parties to the litigation announced that a
resolution was reached in the patent infringement lawsuits.  The terms
of the settlement included the grant by TPL of rights under the Moore
Microprocessor Patent Portfolio to NEC Electronics America, Toshiba, Matsushita
and JVC and their respective subsidiaries in the form of license
agreements.  The parties have agreed that the details of the
settlement are confidential.





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





The Asustekcase seeks
declaratory relief that our '336, '584 and '749 patents are not infringed by
enforceable claims of those patents. The Asustekaction also seeks a
similar declaration with respect to two patents owned by TPL that are not a part
of the MMP Portfolio, and as such the Company is not engaged in this aspect of
the litigation and defense.  The Acercomplaint seeks
invalidity of the '336, '584 and '749 patents. The HTCcomplaint seeks
invalidity of those three and our '148 patent. Our responsive pleadings,
including potential counterclaims for patent infringement are currently
scheduled to be filed by April 25, 2008.





401(k)
Plan





We have a
retirement plan that complies with Section 401(k) of the Internal Revenue Code.
All employees are eligible to participate in the plan. We match 50% of each
participant’s voluntary contributions, subject to a maximum contribution of 6%
of the participant’s compensation. Participants vest 33% per year over a three
year period in our contributions. Our matching contributions during the nine
months ended February 29, 2008 and February 28, 2007 were $6,724 and $8,237,
respectively.





Employment
Contracts





In
connection with Mr. Turley’s appointment as President and Chief Executive
Officer, and commencing on June 5, 2007, we entered into an employment
agreement with Mr. Turley for a one-year term.  Pursuant to the
agreement, if Mr. Turley is terminated without cause, he is entitled to his then
current salary level for the remaining term of his agreement conditional upon
the execution of a general release.




20


Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Commitments
and Contingencies, continued





On
February 28, 2008, Mr. Turley resigned.  As a result, we recorded a
one-time severance charge of $56,250 in full discharge of all remaining
obligations to Mr. Turley.




In
connection with Mr. Flowers’ appointment as the Chief Financial Officer,
and commencing on September 17, 2007, we entered into an employment
agreement with Mr. Flowers for an initial 120-day term if not terminated
pursuant to the agreement, with an extension period of one year and on a
continuing basis thereafter.  Pursuant to the agreement, if
Mr. Flowers is terminated without cause or resigns with good reason within
the first two years of employment, he is entitled to receive an amount equal to
his annual base salary for the greater of (i) 6 months or (ii) the
period remaining in the extended one-year term.  If Mr. Flowers
is terminated without cause or resigns with good reason any time after two years
of continuous employment, he is entitled to receive an amount equal to 12 months
of his annual base salary.  Mr. Flowers is also entitled to
certain payments upon a change of control of the Company if the surviving
corporation does not retain him. All such payments are conditional upon the
execution of a general release.




In
connection with Mr. Goerner’s appointment as Interim President and Chief
Executive Officer, and commencing on February 29, 2008, we agreed to preliminary
compensation terms with Mr. Goerner for an initial 120-day term if not
terminated pursuant to the agreement, with an extension period of one year and
on a continuing basis thereafter.  Pursuant to the agreement, if
Mr. Goerner is terminated without cause within the first year of
employment, after the initial 120-day term, he is entitled to receive an amount
equal to his base salary for the period remaining in the
agreement.  Payments are conditional upon the execution of a general
release.  We are in the process of securing a formal employment
agreement with Mr. Goerner.




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 SSDI. In connection with our facility
leases, we have indemnified our lessors for certain claims arising from the use
of the facilities. The duration of the guarantees and indemnities varies, and in
many cases is indefinite. These guarantees and indemnities do not provide for
any limitation of the maximum potential future payments we could be obligated to
make. Historically, we have not been obligated to make any payments for these
obligations and no liabilities have been recorded for these guarantees and
indemnities in the accompanying consolidated balance sheets.





Operating
Leases


We have a
non-cancelable operating lease agreement for our Carlsbad, California office
facility. Future minimum lease payments required under the operating lease are
$24,570 and $73,710 in fiscal years ended 2008 and 2009,
respectively.





SSDI
subleases their Carlsbad, California office facility which was amended to extend
through June 2008 with a month-to-month option until no later than December
2008. Future minimum lease payments required under the operating lease are
$22,053 and $7,351 in fiscal years ended 2008 and 2009,
respectively.





Earn-Out
Agreement


SSDI
entered into an earn-out agreement with a former debt holder of Holocom
Networks, Inc. (“Holocom Networks”) upon our contribution of the foreclosure
sale collateral of Holocom Networks to SSDI in fiscal 2007. The agreement
required the former debt holder to release all of his rights to any Holocom
Networks collateral in exchange for receiving 3% of the net sales (defined as
cash revenues actually received less credits or
discounts and other claims of customers) of SSDI’s protected distribution system
products for a period of 48 months from the foreclosure sale date of February 2,
2007. The earn-out is to be paid each calendar quarter.  A liability
for payment under this agreement of $11,156 is included in accounts payable in
the accompanying condensed consolidated balance sheet at February 29,
2008.




21
 
 Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial
Statements


10.Segment
Information





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





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





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





Operating
segment net revenue, operating loss and income (loss) before taxes for the three
and nine months ended February 29, 2008 and February 28, 2007 were as
follows:





Three
      Months Ended
            
            
            Nine
      Months EndedFebruary
      29,
              2008
            
            
            February
      28,
              2007
            
            
            February
      29,
              2008
            
            
            February
      28,
              2007Net
      revenue:SSDI
            
            $
            784,447
            
            
            $
            -
            
            
            $
            2,229,592
            
            
            $
            -All
      other
            
            
            16,837
            
            
            
            22,175
            
            
            
            38,892
            
            
            
            67,050Total
      net revenue
            
            $
            801,284
            
            
            $
            22,175
            
            
            $
            2,268,484
            
            
            $
            67,050Operating
      loss:SSDI
            
            $
            (44,376
            )
            
            $
            -
            
            
            $
            (69,418
            )
            
            $
            -All
      other
            
            
            (1,281,241
            )
            
            
            (1,728,019
            )
            
            
            (4,660,087
            )
            
            
            (12,452,090
            )Total
      operating loss
            
            $
            (1,325,617
            )
            
            $
            (1,728,019
            )
            
            $
            (4,729,505
            )
            
            $
            (12,452,090
            )





Income
      (loss) before taxes:SSDI
            
            $
            (38,667
            )
            
            $
            -
            
            
            $
            85,381
            
            
            $
            -All
      other
            
            
            10,725,357
            
            
            
            9,780,470
            
            
            
            12,407,005
            
            
            
            18,108,745Total
      income before taxes
            
            $
            10,686,690
            
            
            $
            9,780,470
            
            
            $
            12,492,386
            
            
            $
            18,108,745





All sales
were to unaffiliated customers within the United States. During the nine months
ended February 29, 2008, one customer accounted for 42% of SSDI’s sales and this
same customer accounted for 17% of SSDI’s accounts receivable at February 29,
2008.  Another customer accounted for 22% of SSDI’s sales and this
same customer accounted for 40% of SSDI’s accounts receivable at February 29,
2008.  Another customer accounted for 13% of SSDI’s sales and this
same customer accounted for 22% of SSDI’s accounts receivable at February 29,
2008.





22


Patriot
Scientific Corporation
 Notes
to Unaudited Condensed Consolidated Financial Statements


Segment Information,
continued





Operating
segment total assets and depreciation and amortization as of and for the nine
months ended February 29, 2008 and February 28, 2007 were as
follows:





2008
            
            
            2007Depreciation
      and amortization:SSDI
            
            $
            14,892
            
            
            $
            -All
      other
            
            
            21,562
            
            
            
            31,927Total
      depreciation and amortization
            
            $
            36,454
            
            
            $
            31,927





2008
            
            
            2007Total
      assets:SSDI
            
            $
            948,155
            
            
            $
            -All
      other
            
            
            27,008,302
            
            
            
            28,138,099Total
      assets
            
            $
            27,956,457
            
            
            $
            28,138,099





11.Subsequent
Events





On March
3 and March 12, 2008 the remainder of our auction rate securities with a par
value of $5,000,000 failed to sell at auction.  The investments
consist of student loan auction rate preferred 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 March
2008.  These instruments are collateralized in excess of the
underlying obligations, are insured by the various state educational agencies,
and are guaranteed by the Department of Education as an insurer of last
resort.  We have the intent and the ability to hold these investments
until the anticipated recovery period which we believe will be less than twelve
months.





On March
11, 2008 we amended our 2006 Stock Option Plan to increase the total number of
shares of our common stock issuable under the plan to 7,000,000 from
5,000,000.  Shareholders will be asked to ratify the amendment to the
plan at our next annual meeting.





On March
17, 2008 we issued options to acquire 400,000 shares of common stock to our
newly appointed Vice President of Business Development at an exercise price of
$0.38 per share.





On March
18, 2008 the interest rate on our line of credit with SSDI decreased to 5.25% in
accordance with the change in the prime interest rate.





On March
20, 2008 we made an advance to SSDI of $100,000, the maximum amount remaining on
the line of credit.





On April
4, 2008 SSDI repaid $50,000 on the line of credit.





On April
7, 2008 SSDI repaid $50,000 on the line of credit.




23


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





THE
FOLLOWING DISCUSSION INCLUDES FORWARD-LOOKING STATEMENTS WITH RESPECT TO OUR
FUTURE FINANCIAL PERFORMANCE. ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE
CURRENTLY ANTICIPATED AND FROM HISTORICAL RESULTS DEPENDING UPON A VARIETY OF
FACTORS, INCLUDING THOSE DESCRIBED BELOW UNDER THE SUB-HEADING, "RISK FACTORS".
SEE ALSO OUR ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED MAY 31,
2007.





Overview





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





Critical
Accounting Policies and Estimates





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




1. Revenue
Recognition





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





Our
consolidated variable interest entity recognizes revenue upon shipment of its
product and recognizes revenue on its short-term installation contracts as time
and materials costs are incurred.





2. Assessment of
Contingent Liabilities





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





24


3. Stock Options
and Warrants




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




In
November 2005, FASB issued FASB Staff Position No. FAS 123R-3, “Transition Election Related to
Accounting for Tax Effects of Share-Based Payment Awards”
(“FAS123R-3”).  We have elected to adopt the alternative transition
method provided in FAS 123R-3.  The alternative transition method
includes a simplified method to establish the beginning balance of the
additional paid-in capital pool (“APIC pool”) related to the tax effects of
employee share-based compensation, which is available to absorb tax deficiencies
recognized subsequent to the adoption of SFAS No. 123(R).




Stock-based
compensation expense recognized during the period is based on the value of the
portion of share-based payment awards that is ultimately expected to vest during
the period. Stock-based compensation expense recognized in our condensed
consolidated statement of operations for the nine months ended February 28, 2007
included compensation expense for share-based payment awards granted prior to,
but not yet vested as of May 31, 2006 based on the grant date fair value
estimated in accordance with the pro forma provisions of SFAS No. 123 and
compensation expense for the share-based payment awards granted subsequent to
May 31, 2006 based on the grant date fair value estimated in accordance
with the provisions of SFAS No. 123(R). Stock-based compensation expense
recognized in our condensed consolidated statement of operations for the nine
months ended February 29, 2008 included compensation expense for share-based
payment awards granted subsequent to May 31, 2007 based on the grant date
fair value estimated in accordance with the provisions of SFAS No. 123(R). 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 nine months ended February 29, 2008 and February
28, 2007, of approximately 5% was based on historical forfeiture experience and
estimated future employee forfeitures.





4. Patents and
Trademarks





We carry
our patents and trademarks at cost less accumulated amortization and we amortize
the patents over their estimated useful lives of four years. We periodically
review the carrying value of the patents and trademarks
for impairment and recognize impairment when the expected future benefit to be
derived from an individual intangible asset is less than its carrying
value.





5. 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.





25


6. Investment
in Affiliated Company




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





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





7. Variable
Interest Entity





We own
100% of the preferred stock of Scripps Secured Data, Inc. (“SSDI”). On March 27,
2007 we entered into an 18 month revolving line of credit with SSDI for a
maximum amount of $500,000. The line of credit caused us to have a variable
interest in SSDI, a variable interest entity, and we have determined that we are
the primary beneficiary as we absorb more than half of the variable interest
entity’s expected losses. FIN46(R), Consolidation of Variable Interest
Entities, requires us to consolidate SSDI as long as we are deemed to be
the primary beneficiary.





We
reevaluate our primary beneficiary position at each of our balance sheet dates
using the guidance in FIN46(R). If we are no longer deemed to be the primary
beneficiary of the variable interest entity, we will discontinue
consolidation.





Results
of Operations





Comparison
of the Nine Months Ended February 29, 2008 and Nine Months Ended February 28,
2007.





Our
revenues increased from approximately $67,000 for the nine months ended February
28, 2007 to approximately $2,268,000 for the nine months ended February 29,
2008. Our revenue amounts do not include income of approximately $30,402,000
from our investment in Phoenix Digital Solutions, LLC for the nine months ended
February 28, 2007, or income of approximately $15,982,000 from our investment in
Phoenix Digital Solutions, LLC for the nine months ended February 29,
2008.  During the nine months ended February 29, 2008 we recorded
sales amounting to approximately $2,230,000 by our consolidated variable
interest entity, SSDI, with cost of sales amounting to approximately $853,000.
During the nine months ended February 28, 2007 and February 29, 2008, we
recognized maintenance fee revenues totaling approximately $18,750 and $18,750
in connection with an agreement with AMD Corporation during the 2005 fiscal
year. The agreement called for maintenance fees totaling $100,000 connected with
a license agreement for our Ignite technology; the license fee revenue is being
recognized as revenue evenly over the four year period of the license. In
addition during the nine months ended February 29, 2008, we recorded sales of
approximately $20,100 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.  During the nine months ended February 28,
2007, we recorded sales of approximately $48,300 relating to the microprocessor
chips.





Selling,
general and administrative expenses decreased from approximately $5,915,000 for
the nine months ended February 28, 2007 to approximately $5,309,000 for the nine
months ended February 29, 2008.  Legal and accounting expenses
decreased by approximately $356,000 for the nine months ended February 29, 2008
compared with the nine months ended February 28, 2007 the decreases were
primarily due to reduction in legal activity due to the settlement of the patent
litigation suit and accounting restatement expenses incurred during the nine
months ended February 28, 2007, not occurring in the nine months ended February
29, 2008. Salary costs and related expenses included non-cash expenses
associated with the fair value of options granted during the period in
accordance with SFAS No. 123R.  During the nine months ended February
29, 2008, options were granted to our newly-appointed officers pursuant to terms
of their employment contracts, those option grants plus the related vesting on
the grants resulted in non-cash compensation expense of approximately
$295,000.  On August 16, 2007 options were granted to certain
employees and a newly-appointed director resulting in non-cash compensation of
approximately $113,000.  During the




26




nine
months ended February 28, 2007, 1,500,000 options were granted to the chief
executive officer of the Company resulting in non-cash compensation expense
amounting to approximately $1,527,000. On October 23, 2006, 230,000 options were
granted to employees resulting in non-cash compensation expense of approximately
$184,000. On February 9, 2007, 1,070,000 options were granted to employees and
directors resulting in non-cash compensation expense of approximately $584,000.
Additional non-cash compensation for the nine months ended February 28, 2007
amounted to $61,000 for vesting of employee stock options in accordance with
SFAS No 123(R).  Board of director fees amounting to approximately
$326,000 were paid during the nine months ended February 29, 2008 as compared to
$240,000 paid for the nine months ended February 28, 2007.  Other
salary expenses increased by approximately $997,000 for the nine months ended
February 29, 2008 as compared with the nine months ended February 28, 2007
including approximately $887,000 in salaries and related expenses for SSDI
during the nine months ended February 29, 2008. Salary expenses for the parent
company including wages, payroll taxes, employee benefits and expenses connected
with 401(k) employer matching increased by approximately $110,000 during the
nine months ended February 29, 2008 as compared with the nine months ended
February 28, 2007.  Travel and related expenses for the nine months
ended February 29, 2008 increased by approximately $130,000 due to expenses for
SSDI being combined with the parent company.  Consulting expenses
increased by approximately $36,000 for the nine months ended February 29, 2008
as compared to the nine months ended February 28, 2007 due to one time fees for
evaluations of our various technologies and expenses associated with our
production of materials for the upcoming litigation.  Expenses for
re-design and maintenance of our website were approximately $21,000 for the nine
months ended February 29, 2008 with no such expenses occurring during the nine
months ended February 28, 2007.  Offsetting the increases in selling,
general and administrative expenses for the nine months ended February 29, 2008
as compared to the nine months ended February 28, 2007, were decreases amounting
to approximately $64,000 for public relations expenses and $15,000 for
insurance.





Settlement
and license expenses amounting to $836,000 were recorded for the nine months
ended February 29, 2008 relating to royalties payable resulting from an
agreement with Fish (see Note 5 to our condensed consolidated financial
statements for more information).  For the nine months ended February
28, 2007, $6,604,000 was recorded related to the Fish agreement.





Our other
income and expenses for the nine months ended February 29, 2008 and February 28,
2007 included equity in the earnings of PDS. The investment is accounted for in
accordance with the equity method of accounting for investments. Our investment
in PDS for the nine months ended February 29, 2008 provided net income after
expenses in the amount of approximately $15,982,000 as compared to net income
after expenses of $30,402,000 for the nine months ended February 28, 2007.Total other income and
expense for the nine months ended February 29, 2008 amounted to net other income
of approximately $17,222,000 compared with total other income and expense for
the nine months ended February 28, 2007 of net other income amounting to
approximately $30,561,000. Interest income and other income increased from
approximately $499,000 for the nine months ended February 28, 2007 to
approximately $1,094,000 for the  nine months ended February 29, 2008
as interest bearing account balances increased from cash received as
distributions from our investment in PDS and we recognized other income of
approximately $227,000 in connection with our reimbursement request billings to
PDS for our prior period legal expenses incurred in connection with the patent
litigation.  During the nine months ended February 29, 2008, SSDI
recognized $150,000 of other income in connection with the sale of a portion of
its interest in Holocom MultiDomain Computers, LLC, now known as DataSecurus,
LLC, on November 7, 2007 DataSecurus, LLC changed its name to Talis Data
Systems, LLC.




27




During
the nine months ended February 28, 2007, we recorded a provision for income
taxes of  approximately $4,383,000 related to federal and California
taxes.  During the nine months ended February 29, 2008, we recorded a
provision for income taxes of approximately $5,746,000 related to federal and
California taxes.  At February 29, 2008 we have utilized all of our
remaining available federal net operating loss
carry-forwards.   At May 31, 2007, we had utilized all of our
state net operating loss carry-forwards of approximately
$17,822,000.





We
recorded net income for the nine months ended February 28, 2007 of $13,725,834
compared with net income of $6,746,336 for the nine months ended February 29,
2008.





Comparison
of the Three Months Ended February 29, 2008 and Three Months Ended February 28,
2007.





Our
revenues increased from approximately $22,000 for the three months ended
February 28, 2007 to approximately $801,000 for the three months ended February
29, 2008. Our revenue amounts do not include income of approximately $11,657,000
from our investment in PDS for the three months ended February 28, 2007, or
income of approximately $11,696,000 from our investment in PDS for the three
months ended February 29, 2008.  During the three months ended
February 29, 2008 we recorded sales amounting to approximately $784,000 by our
consolidated variable interest entity, SSDI, with cost of sales amounting to
approximately $345,000. During the three months ended February 29, 2008 and
February 28, 2007, we recognized maintenance fee revenues totaling approximately
$6,250 and $6,250 in connection with an agreement with AMD Corporation during
the 2005 fiscal year. The agreement called for maintenance fees totaling
$100,000 connected with a license agreement for our Ignite technology; the
license fee revenue is being recognized as revenue evenly over the four year
period of the license. In addition during the three months ended February 29,
2008, we recorded sales of approximately $10,600 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.  During the three
months ended February 28, 2007, we recorded sales of approximately $15,900
relating to the microprocessor chips.





Selling,
general and administrative expenses decreased from approximately $1,446,000 for
the three months ended February 29, 2008 to approximately $1,364,000 for the
three months ended February 28, 2007.  Legal expenses decreased by
approximately $222,000 for the three months ended February 29, 2008 compared
with the three months ended February 28, 2007 and accounting expenses increased
by approximately $31,000 for the three months ended February 29, 2008 compared
with the three months ended February 28, 2007.  Salary costs and
related expenses included non-cash expenses associated with the fair value of
options granted during the period in accordance with SFAS No.
123R.  During the three months ended February 29, 2008, options were
granted to our newly-appointed chief executive officer pursuant to terms of his
employment contract, those option grants plus the related vesting on the grants
and vesting on existing grants,  resulted in non-cash compensation
expense of approximately $62,000.  During the three months ended
February 28, 2007, 1,070,000 options were granted to employees and directors
resulting in non-cash compensation expense of approximately $584,000. Additional
non-cash compensation for the three months ended February 28, 2007 amounted to
approximately $2,000 for vesting of employee stock options in accordance with
SFAS 123(R).Board of
director fees amounting to approximately $114,000 were paid during the three
months ended February 29, 2008 as compared to $90,000 paid for the three months
ended February 28, 2007.  Other salary expenses increased by
approximately $363,000 for the three months ended February 29, 2008 as compared
with the three months ended February 28, 2007 including approximately $290,000
in salaries and related expenses for SSDI during the three months ended February
29, 2008. Salary expenses for the parent company including wages, payroll taxes,
employee benefits and expenses connected with 401(k) employer matching increased
by approximately $73,000 during the three months ended February 29, 2008 as
compared with the three months ended February 28, 2007.  Travel and
related expenses for the three months ended February 29, 2008 increased by
approximately $31,000, a decrease of approximately $13,000 for the parent
company and an increase of $44,000 for SSDI.





Settlement
and license expenses amounting to $418,000 were recorded for the three months
ended February 29, 2008 relating to royalties payable resulting from an
agreement with Fish (see Note 5 to our condensed consolidated financial
statements for more information).  For the three months ended February
28, 2007, $304,000 was recorded related to the Fish agreement.





28


Our other
income and expenses for the three months ended February 29, 2008 and February
28, 2007 included equity in the earnings of PDS. The investment is accounted for
in accordance with the equity method of accounting for investments. Our
investment in PDS for the three months ended February 29, 2008 provided net
income after expenses in the amount of approximately $11,696,000 as compared to
net income after expenses of $11,657,000 for the three months ended February 28,
2007.Total other
income and expense for the three months ended February 29, 2008 amounted to net
other income of approximately $12,012,000 compared with total other income and
expense for the three months ended February 28, 2007 of net other income
amounting to approximately $11,508,000. Interest income and other income
increased from approximately $191,000 for the three months ended February 28,
2007 to approximately $318,000 for the three months ended February 29, 2008 as
interest bearing account balances increased from cash received as distributions
from our investment in PDS.





During
the three months ended February 28, 2007, we recorded a provision for income
taxes of  approximately $163,000 related to federal and California
taxes.  During the three months ended February 29, 2008, we recorded a
provision for income taxes of approximately $4,395,000 related to federal and
California taxes.





We
recorded net income for the three months ended February 28, 2007 of $9,617,559
compared with net income of $6,292,185 for the three months ended February 29,
2008.





Liquidity
and Capital Resources





Liquidity





Our cash
and short-term investment balances decreased from approximately $25,955,000 as
of May 31, 2007 to approximately $23,184,000 as of February 29, 2008. We also
have restricted cash balances amounting to approximately $102,000 as of May 31,
2007 and approximately $51,000 as of February 29, 2008. Total current assets
decreased from approximately $31,399,000 as of May 31, 2007 to approximately
$25,642,000 as of February 29, 2008. Total current liabilities amounted to
approximately $2,021,000 and approximately $4,579,000 as of May 31, 2007 and
February 29, 2008, respectively. The change in our current position as of
February 29, 2008 as compared with May 31, 2007 results in part from our
utilization of cash to repurchase warrants and to purchase treasury stock, which
amounted to $5,804,000.  Additionally, during the
nine  months ended February 29, 2008, we utilized our remaining
federal net operating losses for income tax purposes, resulting in a current tax
liability of approximately $3,983,000 and causing our prepaid income taxes and
deferred tax assets at May 31, 2007 to be reclassified to the current tax
liability.  Total cash paid for income taxes during the nine months
ended February 29, 2008 was $9,191,000.  We also used $500,000 for the
settlement of an arbitration with a former executive officer and director of the
Company.





Cash
Flows From Operating Activities





Cash used
in operating activities for the nine months ended February 29, 2008 was
approximately $13,777,000 as compared with cash used in operating activities for
the nine months ended February 28, 2007 of approximately $9,877,000. The
principal components of the current period amount were: net income of
approximately $6,746,000, change in prepaid income taxes of approximately
$2,071,000 and a change in income taxes payable of approximately
$3,988,000.  These increases were partially offset by: equity in
earnings of PDS of $15,982,000, change in deferred taxes of approximately
$9,473,000, and changes in accounts payable and accrued expenses of
approximately $1,425,000.





Cash
Flows From Investing Activities





Cash
provided by investing activities was approximately $5,519,000 for the nine
months ended February 29, 2008 as compared to cash provided by investing
activities of approximately $28,608,000 for the nine months ended February 28,
2007. The decrease was primarily due to a reduction of distributions received
from our investment in affiliate from $29,420,000 in 2007 to $16,667,000 in
2008.  Cash used during the nine months ended February 29, 2008 also
included $18,073,000 in net purchases of short-term investments and purchases of
fixed assets of approximately $20,000.  The cash used during the nine
months ended February 29, 2008 was partially offset by proceeds of $100,000
received by SSDI for the sale of a membership interest in DataSecurus, LLC, now
known as Talis Data Systems, LLC and proceeds of $52,500 received from
collateral accounts held on former officers’ credit cards that were
cancelled.




29


Cash
Flows From Financing Activities





Cash used
in financing activities for the nine months ended February 29, 2008 was
approximately $5,786,000 as compared to approximately $7,328,000 for the nine
months ended February 28, 2007 primarily due to payments of approximately
$3,043,000 to repurchase shares of our common stock for treasury and warrant
repurchases of approximately $2,761,000 for the nine months ended February 29,
2008. The cash used during the nine months ended February 29, 2008 was partially
offset by cash received of approximately $18,000 from the exercise of common
stock options and warrants.





Capital
Resources





Our
current position as of February 29, 2008 is expected to provide the funds
necessary to support our operations through at least the next twelve
months.





Contractual
Obligations and Commitments





A summary
of our outstanding contractual obligations at February 29, 2008 is as
follows:




Contractual
              Cash
      Obligations
            
            Total
              Amounts
              Committed
            
            
            1-3
              YearsOperating
      leases - facilities
            
            $
            127,684
            
            
            $
            127,684





Recent
Accounting Pronouncements





In July
2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income
Taxes - an interpretation of FASB Statement No. 109 (“FIN 48”). This
interpretation clarifies the application of SFAS No. 109, Accounting for Income Taxes,
by defining criteria that an individual tax position must meet for any part of
the benefit of that position to be recognized in a company’s financial
statements and also provides guidance on measurement, derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure and transition.  We adopted FIN 48 on June 1, 2007 and did
not record any cumulative effect adjustment to retained earnings as a result of
adopting FIN 48.  Interest and penalties, if any, related to
unrecognized tax benefits are recorded in income tax expense.  As of
June 1, 2007, we are subject to U.S. Federal income tax examinations for the tax
years May 31, 1991 through May 31, 2007, and we are subject to state and local
income tax examinations for the tax years May 31, 1999 through May 31, 2007 due
to the carryover of net operating losses from prior years.





In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements
(“SFAS No. 157”).  SFAS No. 157 defines fair value, establishes a framework
for measuring fair value in generally accepted accounting principals and expands
disclosures about fair value measurements.  The statement does not require
new fair value measurements, but is applied to the extent that other accounting
pronouncements require or permit fair value measurements.  The statement
emphasizes that fair value is a market-based measurement that should be
determined based on the assumptions that market participants would use in
pricing an asset or liability.  Companies that have assets and liabilities
measured at fair value will be required to disclose information that enables the
users of its financial statements to access the inputs used to develop those
measurements.  The reporting entity is encouraged, but not required, to
combine the fair value information disclosed under this statement with the fair
value information disclosed under other accounting pronouncements.  SFAS
No. 157 is effective for fiscal years beginning after November 15, 2007. We
expect to adopt SFAS No. 157 on June 1, 2008.  We are in the process of
evaluating the provisions of the statement, but do not anticipate that the
adoption of SFAS No. 157 will have a material impact on our consolidated
financial statements.





30


In
February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial
Assets and Financial Liabilities(“SFAS No. 159”). SFAS No. 159 permits
entities to choose to measure at fair value many financial instruments and
certain other items that are not currently required to be measured at fair
value. The objective is to improve financial reporting by providing entities
with the opportunity to mitigate volatility in reported earnings caused by
measuring related assets and liabilities differently without having to apply
complex hedge accounting provisions. SFAS No. 159 also establishes
presentation and disclosure requirements designed to facilitate comparisons
between entities that choose different measurement attributes for similar types
of assets and liabilities. SFAS No. 159 does not affect any existing
accounting literature that requires certain assets and liabilities to be carried
at fair value. SFAS No. 159 does not establish requirements for
recognizing and measuring dividend income, interest income, or interest expense.
This Statement does not eliminate disclosure requirements included in other
accounting standards. SFAS No. 159 is effective in fiscal years
beginning after November 15, 2007. We are in the process of evaluating the
provisions of the statement, but do not anticipate that the adoption of SFAS No.
159 will have a material impact on our consolidated financial
statements.





In
December 2007, the FASB issued SFAS No. 141(R), Business Combinations (“SFAS
No. 141(R)”). 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 they need to evaluate and
understand the nature and financial effect of the business combination. SFAS
No. 141(R) is effective in fiscal years beginning after December 15, 2008.
We expect to adopt SFAS No. 141(R) on June 1, 2009.  We are currently
assessing the impact the adoption of SFAS No. 141(R) will have on our
consolidated financial statements.





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





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.





We
Have Reported Substantial Income In 2006, 2007 and 2008 Which May Not Be
Indicative Of Our Future Income





During
fiscal 2008, 2007 and 2006, we entered into license agreements, directly and
through our joint venture with Technology Properties Limited. 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, and
the possible effect of new judicial interpretation of patent laws, we cannot
predict the amount of future revenues from such agreements, or whether there
will be future revenues from license agreements at all.





31


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





In June
of 2005, we entered into a joint venture with Technology Properties Limited,
pursuant to which Technology Properties Limited is responsible for the licensing
and enforcement of our microprocessor patent portfolio. This joint venture has
been the source of virtually all of our income since June of 2005. Therefore, in
light of the absence of significant revenue from other sources, we should be
regarded as entirely dependent on the success or failure of the licensing and
prosecution efforts of Technology Properties Limited on behalf of the joint
venture. Sales of our microprocessor products and data security products have
resulted in limited revenues. Our other product lines are no longer being
actively marketed, and also only generate limited and sporadic
sales.





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




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




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




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




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





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





We hold a
minority interest in a company (Scripps Secured Data, Inc.) to which we provide
financing. Under the applicable provisions of accounting principles generally
accepted in the United States of America, including FIN 46(R), we currently
consolidate the financial statements and results of operations of this company
into our consolidated financial statements and results of operations, and record
the equity interest that we do not own as a minority interest. For our other
investment (Phoenix Digital Solutions, LLC), accounted for under the equity
method, we record as part of other income or expense our share of the increase
or decrease in the equity of the company in which we have invested. It is
possible that, in the future, our relationships and/or our interests in or with
this consolidated entity and equity method investee could change. Such potential
future changes could result in deconsolidation or consolidation of such
entities, as the case may be, which could result in changes in our reported
results.




32


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





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





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





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





During
the quarter ended February 29, 2008, we were named as co-defendants in three
separate lawsuits regarding the MMP Portfolio.  See footnote 9 to our
financial statements and Part II, Item 1. Legal Proceedings in this Report on
Form 10-Q.





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





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





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





33


Our
Share Price Could Decline As A Result Of Short Sales





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





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





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





Item
3. Quantitative and Qualitative Disclosures About Market Risk




Interest rate risk





Our
exposure to market risk for changes in interest rates relates primarily to our
short-term investments.  At February 29, 2008 our short-term
investment balance consisted of auction rate securities of which $10.4 million
failed at auction in February 2008.  While we now earn the maximum
interest rate as defined by the contract, the investments are not currently
liquid.  In the event we need to access these funds, we will not be
able to sell these investments at par value until a future auction of these
investments is successful or a buyer is found outside of the auction
process.  Based on our ability to access our cash and cash
equivalents, and our expected operating cash flows, we have the ability and the
intent to hold these investments until the anticipated recovery period which we
believe will be less than twelve months.





Item
4. Controls and Procedures





Evaluation
of Disclosure Controls and Procedures




As
required by Rule 13a-15(e) under the Exchange Act, as of February 29,
2008, the end of the period to which this quarterly report relates, we have
carried out an evaluation of the effectiveness of the design and operation of
our disclosure controls and procedures.  This evaluation was carried
out under the supervision and with the participation of our management,
including our Chief Executive Officer and our Chief Financial
Officer.




Disclosure
controls and procedures are controls and other procedures that are designed to
ensure that information required to be disclosed in our report filed or
submitted under the Exchange Act is recorded, processed, summarized and
reported, within the time periods specified in the Securities and Exchange
Commission’s rules and forms.  Disclosure controls and procedures
include, without limitation, controls and procedures designed to ensure that
information required to be disclosed in our reports filed under the Exchange Act
is accumulated and communicated to management, including the Chief Executive
Officer and Chief Financial Officer as appropriate, to allow timely decisions
regarding required disclosure. Management recognizes that any controls and
procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving their objectives, and management necessarily
applies its judgment in evaluating the cost-benefit relationship of possible
controls and procedures.  Based on the evaluation of our disclosure
controls and procedures as of February 29, 2008, our Chief Executive
Officer and Chief Financial Officer concluded that, as of such date, our
disclosure controls and procedures were effective.




34


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.




PART
II- OTHER INFORMATION





Item
1. Legal Proceedings





Patent
Litigation





Pursuant
to the joint venture that the Company entered into in June 2005 with TPL (in
settlement of inventorship/ownership litigation between the parties, and in
return for a 50-50 sharing of net licensing and enforcement revenues), the
Company granted TPL the complete and exclusive right to enforce and
license  the microprocessor patent portfolio. The Company then
dismissed its patent infringement claims against Fujitsu Computer Systems, Inc.
(“Fujitsu”), Matsushita Electric Corporation of America (“MEI”), NEC Solutions
(America) Inc. (“NEC”), Sony Electronics Inc. (“Sony”), and Toshiba America
Inc., and certain related entities of these defendants which had been pending in
the Federal District Court for the Northern District of California. Thereafter,
TPL filed patent infringement actions against the foregoing defendants (except
Sony) and their related entities in the Federal District Court for the Eastern
District of Texas. Patriot was subsequently joined as a party to the litigation.
Litigation was not reinitiated with regard to Fujitsu or NEC and certain of
NEC’s subsidiaries as listed below.





In
February 2006, a license agreement was entered into with Fujitsu and in
connection with that transaction, the litigation involving Fujitsu, TPL and the
Company in both California and Texas was dismissed.





On August
25, 2006, ARM Ltd. and ARM, Inc. intervened as defendants, seeking a declaration
of non-infringement of the ‘584 patent with respect to ARM processor cores
contained within some alleged infringing chips of other defendants.





In
February 2007, a license agreement was entered into with NEC Corporation, NEC
Corporation of America, Inc., NEC Display Solutions of America, Inc. and NEC
Unified Solutions, Inc. In connection with that transaction, the above named
defendants, excluding NEC Electronics America, Inc., were dismissed from the
lawsuit.





A Claims
Construction Hearing was held May 3, 2007 in The United States District Court
for the Eastern District of Texas. On June 15, 2007, the court ruled on the
claims construction of the patents-in-suit, the ‘336, ‘148 and ‘584 patents.
Based on the claims construction ruling, TPL/Patriot proceeded with discovery
with respect to the ‘336 and ‘148 patents. However, based on the claims
construction ruling as to the ‘584 patent TPL/Patriot entered into a Stipulation
of non-infringement by the accused ARM products with respect to the ‘584 patent
with ARM, the purpose of which was to expedite an appeal of that claims
construction.  A notice of appeal to the Federal Circuit was filed
with respect to the ARM Stipulation and the District Court’s claims construction
with respect to the ‘584 patent.  The appeal has been briefed and oral
argument before the Federal Circuit concerning claims construction of the ‘584
patent is scheduled for May 6, 2008.





35


On
December 18, 2007 all remaining parties to the litigation announced that a
resolution was reached in the patent infringement lawsuits.  The terms
of the settlement included the grant by TPL of rights under the Moore
Microprocessor Patent Portfolio to NEC Electronics America, Toshiba, Matsushita
and JVC and their respective subsidiaries in the form of license
agreements.  The parties have agreed that the details of the
settlement are confidential.





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





The Asustekcase seeks
declaratory relief that our '336, '584 and '749 patents are not infringed by
enforceable claims of those patents. The Asustekaction also seeks a
similar declaration with respect to two patents owned by TPL that are not a part
of the MMP Portfolio, and as such the Company is not engaged in this aspect of
the litigation and defense.  The Acercomplaint seeks
invalidity of the '336, '584 and '749 patents. The HTCcomplaint seeks
invalidity of those three and our '148 patent. Our responsive pleadings,
including potential counterclaims for patent infringement are currently
scheduled to be filed by April 25, 2008.





Item
1A. Risk Factors





Please
see Part I, Item 2, above, for our risk factors.  Following are the
material updates to the risk factors previously disclosed in our Report on Form
10-K.





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




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




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




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




36


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





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





None.





Item
3. Defaults Upon Senior Securities





None.





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





None.





Item
5. Other Information





None.





Item
6. Exhibits





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




Exhibit No.
            
            Document2.1
            
            Agreement
      to Exchange Technology for Stock in the Company, incorporated by reference
      to Exhibit 2.1 to Form 8-K dated August 10, 1989 (Commission
      file No. 33-23143-FW)2.2
            
            Assets
      Purchase Agreement and Plan of Reorganization dated June 22, 1994,
      among the Company, nanoTronics Corporation and Helmut Falk, incorporated
      by reference to Exhibit 10.4 to Form 8-K dated July 6, 1994
      (Commission file No. 000-22182)2.2.1
            
            Amendment
      to Development Agreement dated April 23, 1996 between the Company and
      Sierra Systems, incorporated by reference to Exhibit 2.2.1 to
      Pre-Effective Amendment No. 1 to Registration Statement on Form SB-2
      filed April 29, 1996 (Commission file No.
  333-01765)2.3
            
            Form
      of Exchange Offer dated December 4, 1996 between the Company and
      certain shareholders of Metacomp, Inc., incorporated by reference to
      Exhibit 2.3 to Form8-K
      filed January 9, 1997 (Commission file No.
  000-22182)


2.4
            
            Letter
      of Transmittal to Accompany Shares of Common Stock of Metacomp, Inc.
      Tendered Pursuant to the Exchange Offer Dated December 4, 1996,
      incorporated by reference to Exhibit 2.4 to Form 8-K filed
      January 9, 1997 (Commission file No.
  000-22182)




37




3.1
            
            Original
      Articles of incorporation of the Company’s predecessor, Patriot
      Financial Corporation, incorporated by reference to Exhibit 3.1 to
      registration statement on Form S-18, (Commission file No.
      33-23143-FW)3.2
            
            Articles of
      Amendment of Patriot Financial Corporation, as filed with the Colorado
      Secretary of State on July 21, 1988, incorporated by reference to
      Exhibit 3.2 to registration statement on Form S-18, (Commission file
      No. 33-23143-FW)3.3
            
            Certificate of
      Incorporation of the Company, as filed with the Delaware Secretary of
      State on March 24, 1992, incorporated by reference to
      Exhibit 3.3 to Form 8-K dated May 12, 1992 (Commission file No.
      33-23143-FW)3.3.1
            
            Certificate of
      Amendment to the Certificate of Incorporation of the Company, as filed
      with the Delaware Secretary of State on April 18, 1995, incorporated
      by reference to Exhibit 3.3.1 to Form 10-KSB for the fiscal year
      ended May 31, 1995 (Commission file No.
    000-22182)3.3.2
            
            Certificate of
      Amendment to the Certificate of Incorporation of the Company, as filed
      with the Delaware Secretary of State on June 24, 1997, incorporated
      by reference to Exhibit 3.3.2 to Form 10-KSB for the fiscal year
      ended May 31, 1997, filed July 18, 1997 (Commission file No.
      000-22182)3.3.3
            
            Certificate of
      Amendment to the Certificate of Incorporation of the Company,
      as filed with the Delaware Secretary of State on April 28, 2000,
      incorporated by reference to Exhibit 3.3.3 to Registration Statement
      on Form S-3 filed May 5, 2000 (Commission file No.
      333-36418)3.3.4
            
            Certificate of
      Amendment to the Certificate of Incorporation of the Company, as filed
      with the Delaware Secretary of State on May 6, 2002, incorporated by
      reference to Exhibit 3.3.4 to Registration Statement on Form S-3
      filed June 27, 2002 (Commission file No.
    333-91352)3.3.5
            
            Certificate of
      Amendment to the Certificate of Incorporation of the Company, as filed
      with the Delaware Secretary of State on October 16, 2003,
      incorporated by reference to Exhibit 3.3.5 to Registration Statement
      on Form SB-2 filed May 21, 2004 (Commission file No.
      333-115752)


3.4
            
            Articles and
      Certificate of Merger of Patriot Financial Corporation into the Company
      dated May 1, 1992, with Agreement and Plan of Merger attached thereto
      as Exhibit A, incorporated by reference to Exhibit 3.4 to Form
      8-K dated May 12, 1992 (Commission file No.
    33-23143-FW)3.5
            
            Certificate
      of Merger issued by the Delaware Secretary of State on May 8, 1992,
      incorporated by reference to Exhibit 3.5 to Form 8-K dated
      May 12, 1992 (Commission file No. 33-23143-FW)3.6
            
            Certificate
      of Merger issued by the Colorado Secretary of State on May 12, 1992,
      incorporated by reference to Exhibit 3.6 to Form 8-K dated
      May 12, 1992 (Commission file No. 33-23143-FW)3.7
            
            Bylaws
      of the Company, incorporated by reference to Exhibit 3.7 to Form 8-K
      dated May 12, 1992 (Commission file No.
  33-23143-FW)4.1
            
            Specimen
      common stock certificate, incorporated by reference to Exhibit 4.1
      Form 8-K dated May 12, 1992 (Commission file No.
      33-23143-FW)


4.2
            
            1996
      Stock Option Plan of the Company dated March 25, 1996 and approved by
      the Shareholders on May 17, 1996, incorporated by reference to
      Exhibit 10.13 to Pre-Effective Amendment No. 2 to Registration
      Statement on Form SB-2 filed May 23, 1996 (Commission file No.
      333-01765)4.3
            
            2001
      Stock Option Plan of the Company dated February 21, 2001 incorporated
      by reference to Exhibit 4.19 to Registration Statement on Form S-8
      filed March 26, 2001 (Commission file No.
  333-57602)




38




4.4
            
            2003
      Stock Option Plan of the Company dated July 2, 2003 incorporated by
      reference to Exhibit 4.27 to Registration Statement on Form S-8 filed
      September 4, 2003 (Commission file No. 333-108489)4.5
            
            2006
      Stock Option Plan of the Company dated March 31, 2006 incorporated by
      reference to Exhibit 4.19 to Registration Statement on Form S-8 filed
      June 20, 2006 (Commission file No. 333-135156)4.6
            
            Approval
      Rights Agreement and Termination of Antidilution Agreement and Addendum to
      Warrants dated October 10, 2006, incorporated by reference to
      Exhibit 4.29 to Form 10-KSB for the fiscal year ended May 31,
      2006, filed on October 13, 2006 (Commission file No.
      000-22182)10.1
            
            Employment
      Agreement dated June 5, 2007 by and between the Company and James Turley,
      incorporated by reference to Exhibit 10.1 to Form 8-K filed June 8, 2007
      (Commission file No. 000-22182)10.2
            
            Employment
      Agreement dated September 17, 2007 by and between the Company and Clifford
      Flowers, incorporated by reference to Exhibit 10.1 to Form 8-K filed
      September 19, 2007 (Commission file No. 000-22182)31.1*
            
            Certification
      of Frederick C. Goerner, CEO, pursuant to Rule
      13a–14(a)/15d–14(a)31.2*
            
            Certification
      of Clifford L. Flowers, CFO, pursuant to Rule
      13a–14(a)/15d–14(a)32.1*
            
            Certification
      of Frederick C. Goerner, CEO, pursuant to Section 1350 of Chapter 63 of
      Title 18 of the United States Code32.2*
            
            Certification
      of Clifford L. Flowers, CFO, pursuant to Section 1350 of Chapter 63 of
      Title 18 of the United States Code




39




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:  April 9,
      2008
              PATRIOT
      SCIENTIFIC CORPORATIONBy:
              /S/ FREDERICK
      C. GOERNERFrederick
      C. GoernerChief
      Executive Officer




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




Signature
            Title
            Date/S/
      FREDERICK C.
      GOERNER
            President
      and Chief Executive Officer
            April
      9, 2008Frederick
      C. Goerner/S/
      CLIFFORD L.
      FLOWERS
            Chief
      Financial Officer and Principal Accounting Officer
            April 9,
      2008Clifford
      L. Flowers/S/
      CARLTON M.
      JOHNSON
            Director
            April 9,
      2008Carlton
      M. Johnson/S/
      GLORIA H.
      FELCYN
            Director
            April 9,
      2008Gloria
      H. Felcyn/S/
      HELMUT FALK,
      JR.
            Director
            April 9,
      2008Helmut
      Falk, Jr./S/
      HARRY L.
      TREDENNICK
            Director
            April 9,
      2008Harry
      L. Tredennick






40