IMAGEWARE SYSTEMS INC - 10-K/A - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

[April 13, 2012]

IMAGEWARE SYSTEMS INC - 10-K/A - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with our consolidated financial statements and the related notes and other financial information appearing elsewhere in this Form 10-K. Readers are also urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including (without limitation) the disclosures made under the captions "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Risk Factors," and in the audited consolidated financial statements and related notes included in this Annual Report on Form 10-K.

Recent Developments New Software as a Service Business Model.

With the advent of cloud based computing, the proliferation of mobile devices which allow for mobile transactions across wide geographical areas, the emergence of inexpensive and reliable biometric capture devices and the need to secure access to data, product and services, the Company believes that the market for multi-biometric solutions will expand to encompass significant deployments of biometric systems in the commercial and consumer markets. The Company therefore intends to leverage the strength of its existing government clients who have deployed the Company's products for large populations, as well as its foundational patent portfolio in the field of multi-modal biometrics and the fusion of multiple biometric algorithms, to address the commercial and consumer market. As part of its marketing plan, the Company will offer new versions of its product suite on a Software as a Service ("SaaS") model during 2012. This new business model, which is intended to supplement the Company's existing business model, will allow new commercial and consumer clients to verify identity in order to access data, products or services from mobile and desktop devices.

Additional Intellectual Property.

The Company is a pioneer in inventing the technology of using multi-biometrics on a seamless and integrated platform, in addition to "fusing" multiple biometrics into a common or fused score for greater reliability in authenticating identity. The Company believes it has the foundational patents on the use of multiple biometrics and fusing on such a platform and continues to be an IP leader in the space. It is the Company's belief that this intellectual property leadership will create a sustainable competitive advantage. In addition to its eight issued U.S. and foreign patents, the Company recently filed three new patent applications surrounding new "Anonymous Matching" technologies. These technologies will allow biometric matching for identity verification while protecting the privacy of an individual. It is the Company's belief that such technology will be critical to providing biometric management solutions for the consumer market where privacy protection has been a historical issue and barrier to biometric adoption.

Consummation of Financing.

On December 20, 2011, the Company consummated an equity financing resulting in gross proceeds of $10.0 million ("Qualified Financing"), including the $750,000 of promissory notes converted into the Qualified Financing. In connection with the Qualified Financing, the Company issued 20.0 million shares of its common stock (the "Shares"), and warrants to purchase 12,207,500 shares of its common stock exercisable for $0.50 per share ("Warrants"). The Warrants expire five years from the date of grant. As a result of the Qualified Financing, the Company's Series C 8% Convertible Preferred Stock ("Series C Preferred") and Series D 8% Convertible Preferred Stock ("Series D Preferred") was automatically converted into 11,768,525 shares of common stock. In addition, in connection with the Qualified Financing, (i) the anti-dilution provision contained in certain of the Company's existing warrants were amended resulting in such warrants no longer qualifying as derivative liabilities; and (ii) a significant investor ("Investor") exchanged $4.5 million principal amount of convertible promissory notes of the Company ("Exchanged Notes"), and accrued but unpaid interest on the Exchanged Notes and on an additional $2.25 million in promissory notes, into 9,774,559 shares of the Company's common stock ("Exchange Shares").

The Investor also agreed to convert $750,000 principal amount of additional promissory notes held by the Investor and invest the proceeds into the Qualified Financing. The Company is obligated to file a registration statement with the Securities and Exchange Commission on or before February 20, 2012 to register for resale the Shares and the common stock issuable upon exercise of the Warrants.

-25--------------------------------------------------------------------------------- Table of Contents The net proceeds from the Qualified Financing, approximately $9.2 million, will be used for (i) the customization of identity management products for enterprise and consumer applications; (ii) further development of intellectual property; (iii) development of SaaS capabilities for existing products; (iv) the payment of $1.5 million principal amount of convertible promissory notes; and (v) for working capital and general corporate purposes.

Overview The Company is a pioneer and leader in the emerging market for biometrically enabled software-based identity management solutions. Using those human characteristics that are unique to us all, the Company creates software that provides a highly reliable indication of a person's identity. Our "flagship" product is our patented IWS Biometric Engine®. Scalable for small city business or worldwide deployment, our Biometric Engine is a multi-biometric software platform that is hardware and algorithm independent, enabling the enrollment and management of unlimited population sizes. It allows a user to utilize one or more biometrics on a seamlessly integrated platform. Our products are used to manage and issue secure credentials, including national IDs, passports, driver licenses and access control credentials. Our products also provide law enforcement with integrated mug shot, fingerprint LiveScan and investigative capabilities. We also provide comprehensive authentication security software using biometrics to secure physical and logical access to facilities or computer networks or Internet sites. Biometric technology is now an integral part of all markets we address and all of our products are integrated into the IWS Biometric Engine.

While we have historically marketed our products to the government market at the federal, state and local levels, the emergence of cloud based computing - a mobile market that demands increased security and interoperable systems, and the proven success of our products in the government market, will enable us to enlarge our target market focus to include the emerging consumer and non-government enterprise marketplace.

Our biometric technology is a core software component of an organization's security infrastructure and includes a multi-biometric identity management solution for enrolling, managing, identifying and verifying the identities of people by the physical characteristics of the human body. We develop, sell and support various identity management capabilities within government (federal, state and local), law enforcement, commercial enterprises, and transportation and aviation markets for identification and verification purposes. Our IWS Biometric Engine is a patented biometric identity management software platform for multi-biometric enrollment, management and authentication, managing population databases of virtually unlimited sizes. It is hardware agnostic and can utilize different types of biometric algorithms. It allows different types of biometrics to be operated at the same time on a seamlessly integrated platform. It is also offered as a Software Development Kit (SDK) based search engine, enabling developers and system integrators to implement a biometric solution or integrate biometric capabilities into existing applications without having to derive biometric functionality from pre-existing applications. The IWS Biometric Engine combined with our secure credential platform, IWS EPI Builder, provides a comprehensive, integrated biometric and secure credential solution that can be leveraged for high-end applications such as passports, driver licenses, national IDs, and other secure documents.

Our law enforcement solutions enable agencies to quickly capture, archive, search, retrieve, and share digital images, fingerprints and other biometrics as well as criminal history records on a stand-alone, networked, wireless or Web-based platform. We develop, sell and support a suite of modular software products used by law enforcement and public safety agencies to create and manage criminal history records and to investigate crime. Our IWS Law Enforcement solution consists of five software modules: Capture and Investigative modules, which provide a criminal booking system with related databases as well as the ability to create and print mug photo/SMT image lineups and electronic mugbooks; a Facial Recognition module, which uses biometric facial recognition to identify suspects; a Web module, which provides access to centrally stored records over the Internet in a connected or wireless fashion; and a LiveScan module, which incorporates LiveScan capabilities into IWS Law Enforcement providing integrated fingerprint and palm print biometric management for civil and law enforcement use. The IWS Biometric Engine is also available to our law enforcement clients and allows them to capture and search using other biometrics such as iris or DNA.

-26--------------------------------------------------------------------------------- Table of Contents Our secure credential solutions empower customers to create secure and smart digital identification documents with complete ID systems. We develop, sell and support software and design systems which utilize digital imaging and biometrics in the production of photo identification cards, credentials and identification systems. Our products in this market consist of IWS EPI Suite and IWS EPI Builder (SDK). These products allow for the production of digital identification cards and related databases and records and can be used by, among others, schools, airports, hospitals, corporations or governments. We have added the ability to incorporate multiple biometrics into the ID systems with the integration of IWS Biometric Engine to our secure credential product line.

Our enterprise authentication software includes the IWS Desktop Security product which is a comprehensive authentication management infrastructure solution providing added layers of security to workstations, networks and systems through advanced encryption and authentication technologies. IWS Desktop Security is optimized to enhance network security and usability, and uses multi-factor authentication methods to protect access, verify identity and help secure the computing environment without sacrificing ease-of-use features such as quick login. Additionally, IWS Desktop Security provides an easy integration with various smart card-based credentials including the Common Access Card (CAC), Homeland Security Presidential Directive 12 (HSPD-12), Personal Identity Verification (PIV) credential, and Transportation Worker Identification Credential (TWIC) with an organization's access control process. IWS Desktop Security provides the crucial end-point component of a Logical Access Control System (LACS), and when combined with a Physical Access Control System (PACS), organizations benefit from a complete door to desktop access control and security model.

CRITICAL ACCOUNTING ESTIMATES The discussion and analysis of our consolidated financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America, or U.S. GAAP. The preparation of these consolidated financial statements in accordance with U.S. GAAP requires us to utilize accounting policies and make certain estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingencies as of the date of the consolidated financial statements and the reported amounts of revenue and expenses during a fiscal period. The SEC considers an accounting policy to be critical if it is important to a company's financial condition and results of operations, and if it requires significant judgment and estimates on the part of management in its application.

Significant estimates include the allowance for doubtful accounts receivable, calculation of the Company's tax provision, inventory obsolescence reserve, deferred tax asset valuation allowances, accounting for loss contingencies, recoverability of goodwill and acquired intangible assets and amortization periods, assumptions used in the Black-Scholes model to calculate the fair value of share based payments, assumptions used in the application of fair value methodologies to calculate the fair value of derivative liabilities and revenue and cost of revenues recognized under the percentage of completion method.

The following are our critical accounting policies because we believe they are both important to the portrayal of our financial condition and results of operations and require critical management judgments and estimates about matters that are uncertain. If actual results or events differ materially from those contemplated by us in making these estimates, our reported financial condition and results of operations for future periods could be materially affected. For a detailed discussion on the application of these and other accounting policies, see Note 2 in the Notes to the Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K, beginning on page F-13.

Revenue Recognition. Our revenue recognition policy is significant because our revenue is a key component of our consolidated results of operations. We recognize revenue from the following major revenue sources: ? Long-term fixed-price contracts involving significant customization ? Fixed-price contracts involving minimal customization; ? Software licensing; ? Sales of computer hardware and identification media; and ? Post contract customer support (PCS) -27--------------------------------------------------------------------------------- Table of Contents The Company's revenue recognition policies are consistent with U.S. GAAP including ASC 985-605, "Software Revenue Recognition", ASC 605-35 "Revenue Recognition, Construction-Type and Production-Type Contracts", "Securities and Exchange Commission Staff Accounting Bulletin 104, and ASC 605-25 "Revenue Recognition, Multiple Element Arrangements". Accordingly, the Company recognizes revenue when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the fee is fixed or determinable, and collectability is reasonably assured.

We recognize revenue and profit as work progresses on long-term, fixed-price contracts involving significant amount of hardware and software customization using the percentage of completion method based on costs incurred to date compared to total estimated costs at completion. Revenue from contracts for which we cannot reliably estimate total costs or there are not significant amounts of customization are recognized upon completion. Determining when a contract should be accounted for using the percentage of completion method involves judgment. Critical items that are considered in this process are the degree of customization and related labor hours necessary to complete the required work as well as ongoing estimates of the future labor hours needed to complete the contract. We also generate non-recurring revenue from the licensing of our software. Software license revenue is recognized upon the execution of a license agreement, upon deliverance, fees are fixed and determinable, collectability is probable and when all other significant obligations have been fulfilled. We also generate revenue from the sale of computer hardware and identification media. Revenue for these items is recognized upon delivery of these products to the customer. Our revenue from periodic maintenance agreements is generally recognized ratably over the respective maintenance periods provided no significant obligations remain and collectability of the related receivable is probable.

For a detailed discussion on the application of these and other accounting policies, see Note 2 in the Notes to the Consolidated Financial Statements beginning on page F-9.

Allowance for Doubtful Accounts. We provide an allowance for our accounts receivable for estimated losses that may result from our customers' inability to pay. We determine the amount of allowance by analyzing historical losses, customer concentrations, customer creditworthiness, current economic trends, the age of the accounts receivable balances, and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Our accounts receivable balance was $239,000, net of allowance for doubtful accounts of $5,000 at December 31, 2010. Our accounts receivable balance was $627,000, net of allowance for doubtful accounts of $15,000 at December 31, 2009.

Valuation of Goodwill, Other Intangible and Long-Lived Assets. The Company accounts for its intangible assets under the provisions of ASC 350, "Intangibles - Goodwill and Other". In accordance with ASC 350, intangible assets with a definite life are analyzed for impairment under ASC 360-10-05 and intangible assets with an indefinite life are analyzed for impairment under ASC 360. In accordance with ASC 350, goodwill, or the excess of cost over fair value of net assets acquired, is no longer amortized but is tested for impairment using a fair value approach at the "reporting unit" level. A reporting unit is the operating segment, or a business one level below that operating segment (referred to as a component) if discrete financial information is prepared and regularly reviewed by management at the component level. The Company's reporting unit is at the entity level. The Company recognizes an impairment charge for any amount by which the carrying amount of a reporting unit's goodwill exceeds its fair value. The Company uses fair value methodologies to establish fair values.

We assess impairment of goodwill and identifiable intangible assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following: • Significant underperformance relative to historical or expected future operating results; • Significant changes in the manner of our use of the acquired assets or the strategy of our overall business; and • Significant negative industry or economic trends.

The Company annually, or more frequently if events or circumstances indicate a need, tests the carrying amount of goodwill for impairment. The Company performs its annual impairment test in the fourth quarter of each year. A two-step impairment test is used to first identify potential goodwill impairment and then measure the amount of goodwill impairment loss, if any. These tests were conducted by determining and comparing the fair value, employing the market approach, of the Company's reporting units to the carrying value of the reporting unit. In 2006, the Company determined that its only reporting unit is Identity Management. Based on the results of these impairment tests, the Company determined that its goodwill assets were not impaired as of December 31, 2010 and 2009.

The Company evaluates long-lived assets for impairment whenever events or changes in circumstances indicate their net book value may not be recoverable.

When such factors and circumstances exist, the Company compares the projected undiscounted future cash flows associated with the related asset or group of assets over their estimated useful lives against their respective carrying amount. Impairment, if any, is based on the excess of the carrying amount over the fair value, based on market value when available, or discounted expected cash flows, of those assets and is recorded in the period in which the determination is made. The Company's management currently believes there is no impairment of its long-lived assets. There can be no assurance, however, that market conditions will not change or demand for the Company's products under development will continue. Either of these could result in future impairment of long-lived assets.

There are many management assumptions and estimates underlying the determination of an impairment loss, and estimates using different, but reasonable, assumptions could produce significantly different results. Significant assumptions include estimates of future levels of revenues and operating expenses. Therefore, the timing and recognition of impairment losses by us in the future, if any, may be highly dependent upon our estimates and assumptions.

There can be no assurance that goodwill impairment will not occur in the future.

Goodwill and other net intangible assets amounted to approximately $3,494,000 at December 31, 2010.

-28- -------------------------------------------------------------------------------- Table of Contents Stock-Based Compensation. At December 31, 2010, the Company had two stock-based compensation plans for employees and nonemployee directors, which authorize the granting of various equity-based incentives including stock options and restricted stock.

The Company estimates the fair value of its stock options using a Black-Scholes option-pricing model, consistent with the provisions of ASC No. 718, Compensation - Stock Compensation. The fair value of stock options granted is recognized to expense over the requisite service period. Stock-based compensation expense for all share-based payment awards is recognized using the straight-line single-option method. Stock-based compensation expense is reported in selling, general and expenses based upon the departments to which substantially all of the associated employees report and credited to additional paid-in-capital. Stock-based compensation expense related to equity options was approximately $243,000 and $246,000 for the twelve month ended December 31, 2010 and 2009, respectively.

ASC 718 requires the use of a valuation model to calculate the fair value of stock-based awards. For the years ended December 31, 2010 and 2009, the Company has elected to use the Black-Scholes option-pricing model, which incorporates various assumptions including volatility, expected life, and interest rates. The Company is required to make various assumptions in the application of the Black-Scholes option-pricing model. The Company has determined that the best measure of expected volatility is based on the historical weekly volatility of the Company's common stock. Historical volatility factors utilized in the Company's Black-Scholes computations range from 64% to 119%. The Company has elected to estimate the expected life of an award based upon the SEC approved "simplified method" noted under the provisions of Staff Accounting Bulletin No. 110. The expected term used by the Company as computed by this method range from 5.5 years to 6.1 years. The difference between the actual historical expected life and the simplified method was immaterial. The interest rate used is the risk free interest rate and is based upon U. S. Treasury rates appropriate for the expected term. Interest rates used in the Company's Black-Scholes calculations range from 4.1% to 4.6%. Dividend yield is zero as the Company does not expect to declare any dividends on the Company's common shares in the foreseeable future.

In addition to the key assumptions used in the Black-Scholes model, the estimated forfeiture rate at the time of valuation is a critical assumption. The Company has estimated an annualized forfeiture rate of approximately 10% for corporate officers, 4% for members of the Board of Directors and 6% for all other employees. The Company reviews the expected forfeiture rate annually to determine if that percent is still reasonable based on historical experience.

Income Taxes. The Company accounts for income taxes in accordance with ASC 740, Accounting for Income Taxes, (ASC 740). Deferred income taxes are recognized for the tax consequences related to temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for tax purposes at each year-end, based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. A valuation allowance is established when necessary based on the weight of available evidence, if it is considered more likely than not that all or some portion of the deferred tax assets will not be realized. Income tax expense is the sum of current income tax plus the change in deferred tax assets and liabilities.

-29--------------------------------------------------------------------------------- Table of Contents ASC 740-10 requires a company to first determine whether it is more-likely-than-not (defined as a likelihood of more than fifty percent) that a tax position will be sustained based on its technical merits as of the reporting date, assuming that taxing authorities will examine the position and have full knowledge of all relevant information. A tax position that meets this more-likely-than-not threshold is then measured and recognized at the largest amount of benefit that is greater than fifty percent likely to be realized upon effective settlement with a taxing authority.

We recognize and measure uncertain tax positions in accordance with U.S.GAAP, pursuant to which we only recognize the tax benefit from an uncertain tax position if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. Any tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement. We report a liability for unrecognized tax benefits resulting from uncertain tax positions taken or expected to be taken in a tax return. U.S. GAAP further requires that a change in judgment related to the expected ultimate resolution of uncertain tax positions be recognized in earnings in the quarter of such change. We recognize interest and penalties, if any, related to unrecognized tax benefits in income tax expense.

We file annual income tax returns in multiple taxing jurisdictions around the world. A number of years may elapse before an uncertain tax position is audited and finally resolved. While it is often difficult to predict the final outcome or the timing of resolution of any particular uncertain tax position, we believe that our analysis of income tax reserves reflects the most likely outcome. We adjust these reserves, if any, as well as the related interest, in light of changing facts and circumstances. Settlement of any particular position could require the use of cash.

In June 2010, the Company was notified that the Canada Revenue Agency ("CRA") has proposed certain significant adjustments to the Company's transfer pricing tax position for the years 2001 through 2008. Management evaluated those proposed adjustments and in July 2010 filed a formal notice of appeal. In 2011, the Company was notified that certain significant portions of the Company's appeal had been accepted by the CRA. As a result of appeal, the Company has recorded a tax provision of approximately $126,000 and $0 for the years ended 2010 and 2009, respectively.

Significant judgment is required in evaluating the Company's uncertain tax positions and determining the Company's provision for income taxes. No assurance can be given that the final tax outcome of these matters will not be different from that which is reflected in the Company's historical income tax provisions and accruals. The Company adjusts these items in light of changing facts and circumstances. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made.

Fair-Value Measurements. The Company accounts for fair value measurements in accordance with ASC Topic No. 820, Fair Value Measurements and Disclosures, (ASC 820) which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. The provisions of ASC 820 were adopted on January 1, 2008.

In February 2008, ASC 820-10 delayed the effective date of fair value measurement and disclosure for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). The provisions of ASC 820-10 were effective for the Company's fiscal year beginning January 1, 2009.

-30--------------------------------------------------------------------------------- Table of Contents ASC 820 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under FAS 157 are described below: Level 1 Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2 Level 2 applies to assets or liabilities for which there are inputs other than quoted prices included within Level 1 that areobservable for the asset or liability such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which significant inputs are observable or can be derivedprincipally from, or corroborated by, observable market data.

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

Assessing the significance of a particular input to the fair value measurement requires judgment, considering factors specific to the asset or liability. Determining whether a fair value measurement is based on Level 1, Level 2, or Level 3 inputs is important because certain disclosures are applicable only to those fair value measurements that use Level 3 inputs. The use of Level 3 inputs may include information derived through extrapolation or interpolation which involves management assumptions.

Derivative Financial Instruments The Company does not use derivative instruments to hedge exposures to cash flow, market or foreign currency risks.

The Company reviews the terms of the common and preferred stock, warrants and convertible debt it issues to determine whether there are embedded derivative instruments, including embedded conversion options, which are required to be bifurcated and accounted for separately as derivative financial instruments. In circumstances where the host instrument contains more than one embedded derivative instrument, including the conversion option, that is required to be bifurcated, the bifurcated derivative instruments are accounted for as a single, compound derivative instrument.

Bifurcated embedded derivatives are initially recorded at fair value and are then revalued at each reporting date with changes in the fair value reported as non-operating income or expense. When the equity or convertible debt instruments contain embedded derivative instruments that are to be bifurcated and accounted for as liabilities, the total proceeds received are first allocated to the fair value of all the bifurcated derivative instruments. The remaining proceeds, if any, are then allocated to the host instruments themselves, usually resulting in those instruments being recorded at a discount from their face value.

The discount from the face value of the convertible debt, together with the stated interest on the instrument, is amortized over the life of the instrument through periodic charges to interest expense, using the effective interest method.

RESULTS OF OPERATIONS This management's discussion and analysis of financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes contained elsewhere in this Annual Report.

-31--------------------------------------------------------------------------------- Table of Contents Comparison of Results for Fiscal Years Ended December 31, 2010 and 2009 Product Revenues.

Years Ended December 31, Net Product Revenues 2010 2009 $ Change % Change (dollars in thousands) Software and royalties $ 1,882 $ 2,307 $ (425) (18) % Percentage of total net product % revenue 59 67 % Hardware and consumables $ 381 $ 230 $ 151 66 % Percentage of total net product % revenue 12 7 % Services $ 929 $ 893 $ 36 4 % Percentage of total net product % revenue 29 26 % Total net product revenues $ 3,192 $ 3,430 $ (238) (7) % Software and royalty revenues decreased 18% or $425,000 during the year ended December 31, 2010 as compared to the corresponding period in 2009. The decrease is due primarily to lower sales of our boxed identity management software sold through our distribution channel of approximately $270,000 combined with lower law enforcement project-oriented revenues of approximately $166,000.

Revenues from the sale of hardware and consumables increased 66% or $151,000 during the year ended December 31, 2010 as compared to the corresponding period in 2009. The increase reflects higher levels of hardware and consumables generated from project solutions.

Services revenues are comprised primarily of software integration services, system installation services and customer training. Such revenues increased approximately $36,000 during the year ended December 31, 2010 as compared to the corresponding period in 2009 due to higher service revenues being generated from software integration of our Biometric Engine and PIV products into project solutions. We expect service revenues to continue to be a significant component of our revenues through our implementation of large-scale high-end installations.

We believe that the period-to-period fluctuations of identity management software revenue in project-oriented solutions are largely due to the timing of government procurement with respect to the various programs we are pursuing. Based on management's current visibility into the timing of potential government procurements, and while no assurances can be given, we believe that we will see a significant increase in government procurement and implementations with respect to identity management initiatives; however, we cannot predict the timing of such initiatives.

Maintenance Revenues.

Years Ended December 31, Net Maintenance Revenues 2010 2009 $ Change % Change (dollars in thousands) Maintenance Revenues $ 2,619 $ 2,599 $ 20 1 % The increase in maintenance revenues reflects higher maintenance revenues from of our Identification Products of approximately $58,000 during the year ended December 31, 2010 as compared to the comparable period of 2009, offset by a decrease in law enforcement maintenance revenues of approximately $38,000. The increase in maintenance revenues from our Identification products is due to our expanding installed base of this product suite. The decrease in maintenance revenues from our law enforcement products reflects the expiration of certain maintenance contracts. While no assurances can be given, we expect maintenance revenues to increase in 2011 due to the expansion of our installed base resulting from the completion of significant project-oriented work during the 2011 fiscal year.

-32--------------------------------------------------------------------------------- Table of Contents We anticipate the growth of our maintenance revenues through the retention of existing customers combined with the expansion of installed base combined resulting from the completion of project-oriented work, however, we cannot predict the timing of this anticipated growth.

Cost of Product Revenues.

Years Ended December 31, Cost of Product Revenues 2010 2009 $ Change % Change (dollars in thousands) Software and royalties $ 266 $ 310 $ (44) (14) % Percentage of software and royalty product revenue 14 % 13 % Hardware and consumables $ 289 $ 228 $ 61 27 % Percentage of hardware and consumables product revenue 76 % 99 % Services $ 504 $ 627 $ (123) (20) % Percentage of services product revenue 54 % 70 % Total cost of product revenues $ 1,059 $ 1,165 $ (106) (9) % Percentage of total product revenues 33 % 34 % The cost of software and royalty product revenue decreased 14% or $44,000 during the year ended December 31, 2010 as compared to the corresponding period in 2009. This decrease is reflective of lower software and royalty product revenues of approximately $425,000 during the year ended December 31, 2010 as compared to the corresponding period in 2009. Costs of products can vary as a percentage of product revenue from period to period depending upon the level of software customization and third party software license content included in product sales during a given period.

The increase in the cost of product revenues for our hardware and consumable sales of $61,000 for the year ended December 31, 2010 as compared to the corresponding period in 2009 reflects the increase in hardware and consumable revenues of approximately $151,000 for the year ended December 31, 2010 as compared to the comparable period in 2009.

Costs of service revenues decreased $123,000 for the year ended December 31, 2010 as compared to the corresponding period in 2009. This decrease is due primarily to the year ended December 31, 2009 containing integration costs of our identity management products into project solutions in excess of revenues generated on certain contracts.

Cost of Maintenance Revenues.

Years Ended December 31, Cost of Maintenance Revenues 2010 2009 $ Change % Change (dollars in thousands) Total maintenance cost of revenues $ 938 $ 814 $ 124 15 % Percentage of total maintenance revenues 36 % 31 % Costs of maintenance revenues as a percentage of maintenance revenues increased to 36% during the year ended December 31, 2010 from 31% for the corresponding period in 2009. This increase is due primarily to higher identification labor costs incurred to perform maintenance requirements on completed large-scale identity management projects.

-33--------------------------------------------------------------------------------- Table of Contents Product Gross Profit.

Years Ended December 31, Product Gross Profit 2010 2009 $ Change % Change (dollars in thousands) Software and royalties $ 1,616 $ 1,997 $ (381) (19) % Percentage of software and 86 % 87 % royalty product revenue Hardware and consumables $ 92 $ 2 $ 90 4,500 % Percentage of hardware and 24 % 1 % consumables product revenue Services $ 425 $ 266 $ 159 60 % Percentage of services product 46 % 30 % revenue Total product gross profit $ 2,133 $ 2,265 $ (132) (6) % Percentage of total product 67 % 66 % revenues Software and royalty gross profit decreased by 19% or approximately $381,000 for the year ended December 31, 2010 from the corresponding period in 2009. The decrease is principally due to lower software and royalty product revenues of approximately $425,000 in the 2010 period. Costs of software products can vary as a percentage of product revenue from quarter to quarter depending upon product mix and third party software licenses included in software solutions.

Hardware and consumable gross profit increased approximately $90,000 due primarily to higher hardware and consumable revenues of $151,000 during the year ended December 31, 2010 as compared to the corresponding period in 2009.

The increase in services gross profit is comprised of higher service revenues of approximately $36,000 during the year ended December 31, 2010 as compared to the corresponding period in 2009, combined with lower cost of service revenues of approximately $123,000 during the year ended December 31, 2010 as compared to the corresponding period in 2009. The decrease in the cost of service revenues of $123,000 is due primarily to the 2009-year containing integration costs of our identity management products into project solutions in excess of revenues generated on certain contracts.

Maintenance Gross Profit.

Years Ended December 31, Maintenance Gross Profit 2010 2009 $ Change % Change (dollars in thousands) Total maintenance gross profit $ 1,681 $ 1,785 $ (104) (6) % Percentage of total maintenance revenues 64 % 69 % Gross margins related to maintenance revenues decreased despite higher maintenance revenues of approximately $20,000 due to higher maintenance cost of revenues of approximately $124,000. This increase in costs is due primarily to higher labor costs incurred to perform maintenance requirements on completed large-scale identity management projects.

-34--------------------------------------------------------------------------------- Table of Contents Operating Expenses.

Years Ended December 31, Operating Expenses 2010 2009 $ Change % Change (dollars in thousands) General and administrative $ 2,546 $ 2,433 $ 113 5 % Percentage of total net revenue 44 % 40 % Sales and marketing $ 1,528 $ 1,705 $ (177) (10) % Percentage of total net revenue 26 % 28 % Research and development $ 2,531 $ 2,367 $ 164 7 % Percentage of total net revenue 44 % 39 % Depreciation and amortization $ 50 $ 98 $ (48) (49) % Percentage of total net revenue 1 % 2 % General and Administrative Expenses. General and administrative expenses are comprised primarily of salaries and other employee-related costs for executive, financial, and other infrastructure personnel. General legal, accounting and consulting services, insurance, occupancy and communication costs are also included with general and administrative expenses. The increase of $113,000 is comprised of the following major components: · Increase in stock-based compensation expense of approximately $14,000 due to an increase in the issuance of stock options and restricted stock grants in 2010.

· Increase in professional services of approximately $317,000.

· Decrease in occupancy and insurance related expenses of approximately $61,000.

· Decrease in compensation and related fringe benefits of approximately $197,000 due to lower headcounts and the implementation of mandatory furlough days to reduce costs.

· Increase in licenses, dues, miscellaneous financing charges and travel of approximately $40,000.

We are continuing to focus our efforts on achieving additional future operating efficiencies by reviewing and improving upon existing business processes and evaluating our cost structure. We believe these efforts will allow us to gradually decrease our level of general and administrative expenses expressed as a percentage of total revenues.

Sales and Marketing Expenses. Sales and marketing expenses consist primarily of the salaries, commissions, other incentive compensation, employee benefits and travel expenses of our sales force. Selling and marketing expenses decreased in 2010 by approximately $177,000. Major components of this change are: · Decrease in salaries and personnel costs of approximately $48,000 due to reductions in headcount and the implementation of mandatory furlough days to reduce costs.

· Decrease in stock-based compensation expense of approximately $20,000.

· Increase in costs of $48,000 related to our Mexico City sales office.

· Decrease in professional services of approximately $157,000.

We anticipate that the level of expenses incurred for sales and marketing during the year ended December 31, 2011 will increase as we pursue large project solution opportunities.

-35--------------------------------------------------------------------------------- Table of Contents Research and Development Expenses. Research and development costs consist primarily of salaries, employee benefits and outside contractors for new product development, product enhancements and custom integration work.

Research and development expenses were approximately $2,531,000 and $2,367,000 during the years ended December 31, 2010 and 2009, respectively. Such expenses increased 7% or approximately $164,000 for the year ended December 31, 2010 as compared to the corresponding period in 2009. The increase reflects personnel increases in the United States partially offset by personnel decreases in Canada resulting in a net increase in salaries and employee benefit expense of approximately $235,000. Stock compensation expense increased by approximately $3,000. These increases were offset by decreases in facilities related expenses of $47,000. Travel expenditures decreased by $16,000 and contractor expenses decreased by $11,000.

Our level of expenditures in research and development reflects our belief that to maintain our competitive position in markets characterized by rapid rates of technological advancement, we must continue to invest significant resources in new systems and software as well as continue to enhance existing products.

Depreciation and Amortization. During the year ended December 31, 2010, depreciation and amortization expense decreased 49% or $48,000 as compared to the corresponding period in 2009. This decrease reflects the limitations placed on acquiring new equipment in 2010 and 2009.

Interest Expense, Net. For the year ended December 31, 2010, we recognized interest income of $0 and interest expense of $1,123,000. For the year ended December 31, 2009, we recognized interest income of $0 and interest expense of $743,000.

Interest expense for the year ended December 31, 2010 is comprised of the following components: · Coupon interest on secured notes payable and convertible notes payable of approximately $370,000.

· Accretion of note discount and debt issuance costs to interest expense of approximately $674,000.

· Other interest expense of approximately $79,000.

Interest expense for the year ended December 31, 2009 is comprised of the following components: · Coupon interest on secured notes payable and convertible notes payable of approximately $115,000.

· Accretion of note discount and debt issuance costs to interest expense of approximately $363,000.

· Amortization of deferred financing fees to interest expense of approximately $26,000.

· Interest expense of approximately $175,000 related to liquidated damages accrued pursuant to a registration payment arrangement.

· Fair value of warrants issued to related party convertible note holders in consideration for wavier of default of approximately $51,000.

· Other interest expense of approximately $12,000 -36--------------------------------------------------------------------------------- Table of Contents Financing Expense. For the year ended December 31, 2010, we recognized financing expenses of $0 as compared to $1,373,000 for the corresponding period in 2009.

In July 2009 and ending in early August 2009, we undertook a series warrant financing whereby we received cash proceeds of approximately $1,370,000 from the exercise of 2,401,075 warrants. The warrants were originally issued in various previous private placement financings. In conjunction with this financing, we issued to such warrant holders a total of 2,401,075 additional warrants: 2,135,795 five year warrants with an exercise price of $0.50 and 265,280 five year warrants with an exercise price of $1.00 to incentivize the warrants holders to exercise their warrants. Additionally, we agreed to reprice 200,000 warrants from an existing exercise price of $1.67 to $0.50 to incentivize this warrant holder to exercise. We recorded the issuance of the additional warrants as a financing expense equal to the fair value of the warrants issued using the Black-Scholes option-pricing model. We recorded the repricing of the warrants as a modification equal to the difference in fair value immediately before and after the modification using the Black Scholes option-pricing model. The issuance of the additional warrants and the repricing of the warrants resulted in financing expense of approximately $1,373,000 during the year ended December 31, 2009.

Change in Fair Value of Derivative Liabilities. For the year ended December 31, 2010, we recognized a non-cash expense of $738,000 compared to $6,327,000 for the corresponding period in 2009 due to implementation of ASC 815 effective January 1, 2009. Such expense is related to the change in fair value of the Company's Derivative Liabilities. The Derivative Liabilities were revalued using available market information and commonly accepted fair value methodologies.

Change in Fair Value of Financing Obligation. For the year ended 2010, we recognized non-cash income of $551,000 compared to non-cash expense of $1,335,000 for the corresponding period of 2009 related to the change in fair value of the Company's financing obligation. For the year ended 2010, such income is related to the change in fair value of the Company's variable component of the financing obligation of approximately $695,000 offset by the accretion of the fixed component of the financing obligation of approximately $144,000. For the year December 31, 2009, such expense is related to the change in fair value of the Company's variable component of the financing obligation of approximately $1,079,000 and the accretion of the fixed component of the financing obligation of approximately $256,000. The variable component of the financing obligation was revalued using available market information and commonly accepted valuation methodologies.

Other Expense (Income), Net. For the year ended December 31, 2010, we recognized other income of $330,000 and other expense of $2,000. For the year ended December 31, 2009, we recognized other income of $473,000 and other expense of $28,000. Other income for the year ended December 31, 2010 is comprised of approximately $280,000 from the reduction of previously accrued liquidated damages due to the expiration of the statue of limitations; $10,000 for the application of forfeiture account balances of the Company's 401(k) plan against the accrued employer match; $5,000 from the reduction of the allowance for doubtful accounts; $10,000 from the write-off of certain long-outstanding trade accounts payable; and $25,000 in income on previously derecognized accounts receivables offset by $2,000 in losses on the disposal of certain fixed assets.

Other income for the year ended December 31, 2009 is comprised of approximately $454,000 from the negotiated settlement of certain trade accounts payable at amounts less than their carrying value, $13,000 in reductions to the allowance for doubtful accounts, $6,000 in insurance reimbursements offset by other expense of $28,000 related to adjustments to previously established exit activity reserved related to the closure of our German sales office.

Income Tax Expense. During the year ended December 31, 2010, we recorded a provision for income taxes of $126,000 as compared to $0 during the year ended December 31, 2009.

During the year ended December 31, 2010, our provision for income taxes of $126,000 related to taxes on income generated in certain foreign jurisdictions.

We have incurred consolidated pre-tax losses during the years ended December 31, 2010 and 2009, and have incurred operating losses in all periods prior to 2009. Management has determined that it is more likely than not that a tax benefit from such losses will not be realized. Accordingly, we did not record a benefit for income taxes for these periods.

Liquidity and Capital Resources As of December 31, 2010, we had total current assets of $411,000 and total current liabilities of $4,407,000, or negative working capital of $3,996,000. At December 31, 2010 and 2009, we had available cash of $103,000 and $342,000, respectively.

-37--------------------------------------------------------------------------------- Table of Contents Operating Activities Net cash used in operating activities was $2,070,000 during the year ended December 31, 2010 as compared to $2,874,000 for the corresponding period in 2009. We used cash to fund net losses of $2,720,000, excluding non-cash expenses (depreciation, amortization, change in fair value of additional financing obligation and derivative liabilities, amortization of debt discount, stock-based compensation, loss on debt modification and financing expense incurred from the issuance of derivative instruments) of $2,329,000 for the year ended December 31, 2010. We used cash to fund net losses of $1,830,000, excluding non-cash expenses (depreciation, amortization, change in fair value of additional financing obligation and derivative liabilities, amortization of debt discount, stock-based compensation, loss on debt modification and financing expense incurred from the issuance of derivative instruments) of $10,806,000 for the year ended December 31, 2009. For the year ended December 31, 2010 we generated cash of $617,000 through reductions in current assets and generated cash of $34,000 through increases in current liabilities (excluding debt). For the year ended December 31, 2009, we used cash of $222,000 from increases in current assets and used cash of $822,000 through decreases in current liabilities (excluding debt).

Investing Activities For the years ended December 31, 2010 and 2009, we used cash of $13,000 and $16,000, respectively, to fund capital expenditures of computer equipment and software and furniture and fixtures. The level of equipment purchases resulted primarily from continued growth of the business and replacement of older equipment.

Financing Activities Net cash provided by financing activities was $1,820,000 for the year ended December 31, 2010. We generated cash of $5,750,000 from our issuance of convertible notes payable with warrants. We also generated cash of $500,000 from our issuance of common stock pursuant to warrant exercises. In 2010, we used cash of $4,430,000 for the repayment of our secured notes payable. Net cash provided by financing activities was $3,191,000 for the year ended December 31, 2009. We generated cash of $2,325,000 from our issuance of secured notes payable. We also generated cash of $1,370,000 from our issuance of common stock pursuant to warrant exercises. In 2009, we used cash of $350,000 to repay notes a portion of our secured notes payable and incurred financing related expenses of $154,000.

Factors That May Affect Future Financial Condition and Liquidity Currently our cash commitments include normal recurring trade payables, expense accruals, minimum royalty obligations, debt and operating and capital leases, all of which are currently expected to be funded through existing working capital. Aside from these recurring operating expenses, we expect to incur approximately $100,000 in capital expenditures in fiscal 2011.

During the first three quarters of fiscal 2011, we were faced with limited funds for operations. As a result, we took measures to reduce our operating costs. As a result of the consummation of the Qualified Financing in December 2011 we believe that our current cash and cash equivalents will be sufficient to meet our working capital and capital expenditure requirements for at least the next 12 months from the date of the filing of this Annual Report and that we will have sufficient liquidity to fund our business and meet our contractual obligations over a period beyond the next 12 months. However, we may be required to obtain additional financing in order to fund our continued operations. Due to the tightening of the credit markets, general economic conditions, our SEC filing delinquencies and other economic and business factors, this financing may not be available to us on acceptable terms or at all. Although we cannot accurately anticipate the effect of inflation or foreign exchange markets on our operations, we do not believe these external economic forces have had, or are likely in the foreseeable future to have, a material impact on our results of operations.

-38--------------------------------------------------------------------------------- Table of Contents Off-Balance Sheet Arrangements At December 31, 2010, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance, special purpose or variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we did not engage in trading activities involving non-exchange traded contracts. As a result, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships. We do not have relationships and transactions with persons or entities that derive benefits from their non-independent relationship with us or our related parties except as disclosed elsewhere in this Annual Report.

Quarter-Over-Quarter Comparisons The following tables set forth condensed unaudited statement of operations for each of the six quarters beginning January 1, 2009 and ended September 30, 2010.

The following quarterly information is intended to supplement our discussion and analysis of the results of operations provided above and should be read in conjunction with such discussion and our audited financial statements and the notes included elsewhere in this Annual Report.

-39--------------------------------------------------------------------------------- Table of Contents IMAGEWARE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) (UNAUDITED) Quarter Ended March June Sept. March June Sept.

31 30 30 31 30 30 2009 2009 2009 2010 2010 2010 Revenues: Product $ 675 $ 999 $ 241 $ 1,360 $ 511 $ 769 Maintenance 638 646 659 668 640 653 1,313 1,645 900 2,028 1,151 1,422Cost of revenues: Product 284 317 167 528 144 249 Maintenance 209 199 201 247 254 198 Gross profit 820 1,129 532 1,253 753 975 Operating expenses: General and administrative 609 595 555 697 680 512 Sales and marketing 429 451 376 392 381 385 Research and development 587 553 582 697 666 576 Depreciation and amortization 33 30 19 14 12 13 1,658 1,629 1,532 1,800 1,739 1,486 Loss from operations (838 ) (500 ) (1,000 ) (547 ) (986 ) (511 ) Interest expense, net 102 180 212 242 334 60 Change in fair value of financing obligation 152 450 438 229 (744 ) (38 ) Change in fair value of derivative liabilities (748 ) 5,179 756 477 (4,154 ) (506 ) Loss on debt modification - 750 - - - 1,100Financing expense - - 1,371 - - - Other income, net (11 ) (11 ) (124 ) (17 ) (284 ) (12 ) Income (loss) from operations before income taxes (333 ) (7,048 ) (3,653 ) (1,478) 3,862 (1,115 ) Income tax expense - - - - 197 2 Income (loss) from operations (333 ) (7,048 ) (3,653 ) (1,478 ) 3,665 (1,117 ) Net income (loss) $ (333 ) $ (7,048 ) $ (3,653 ) $ (1,478 ) $ 3,665 $ (1,117 ) Preferred dividends (99 ) (100 ) (101 ) (99 (98 ) (99 ) Net income (loss) available to common shareholders $ (432 ) $ (7,148 ) $ (3,754 ) $ (1,577 ) $ 3,567 $ (1,216 ) Basic and diluted income (loss) per common share - see note 2 Income (loss) from operations $ (0.02 ) $ (0.39 ) $ (0.18 ) $ (0.07 ) $ 0.16 $ (0.05 ) Preferred dividends - (0.01 ) (0.01 ) - - - Basic and diluted income (loss) per common shareavailable to common shareholders $ (0.02 ) $ (0.40 ) $ (0.19 ) $ (0.07 ) $ 0.16 (1) $ (0.05 ) (1) For the quarter ended June 30, 2010, amount presented is only basic loss per share.

-40- -------------------------------------------------------------------------------- Table of Contents Restatement of Financial Statements for the Three Months Ended March 31, 2009 The Company has restated its previously issued consolidated financial statements as of and for the three months ended March 31, 2009 to reflect the Company's adoption of ASC 815 which significantly changes how the Company accounts for derivative liabilities and related gains and losses from the change in fair value of these derivative liabilities.

Beginning January 1, 2009, the Company is required to account for the embedded derivative related to the conversion feature in its Series C Preferred and Series D Preferred and certain warrants as derivative liabilities (collectively the "Derivative Liabilities"). The Company is required to mark to market at the end of each reporting period the value of the Derivative Liabilities. The Company revalues these Derivative Liabilities at the end of each reporting period by using available market information and commonly accepted valuation methodologies. The periodic change in value of the Derivative Liabilities is recorded as either non-cash derivative income (if the value of the embedded derivative and warrants decrease) or as non-cash derivative expense (if the value of the embedded derivative and warrants increase). Although the values of the embedded derivative and warrants are affected by interest rates, the remaining contractual conversion period and the Company's stock volatility, the primary cause of the change in the values of will be the value of the Company's common stock. If the stock price goes up, the value of these derivatives will generally increase and if the stock price goes down the value of these derivatives will generally decrease.

The Company's Series C Preferred and Series D Preferred and certain warrants contain anti-dilution provisions which results in these instruments no longer being deemed to be indexed to the Company's own stock. As a result of the restatement, amounts previously classified in equity were reclassified to liabilities as of January 1, 2009. For each subsequent reporting quarter, the value of the Derivative Liabilities was revalued using available market information and commonly accepted valuation methodologies. The cumulative effect of the adoption of ASC 815 as of January 1, 2009 was a decrease in additional paid in capital of $5,836,000, a decrease in accumulated deficit of $1,709,000 and an increase in Derivative Liabilities of $4,127,000. The resulting impact of this accounting change as of and for the three months ended March 31, 2009 is an increase in note discount of $288,000, a decrease in the Company's net loss available to common shareholders of $715,000, a decrease in additional paid-in capital of $241,000, a decrease in accumulated deficit of $715,000 and a decrease in Derivative Liabilities of $186,000.

The revisions relate to non-operating and non-cash items as of and for the three months ended March 31, 2009. ASC 815 did not impact the Company's consolidated financial statements for periods ended December 31, 2008 or earlier.

-41- -------------------------------------------------------------------------------- Table of Contents The following table summarizes the effect of the restated adjustments on amounts previously reported as of, and for the quarter ended March 31 2009 (in thousands, except share and per share amounts): As Previously As ($ in thousands) Reported Adjustments Restated Total assets $ 5,340 $ - $ 5,340 Total current liabilities $ 5,111 $ - $ 5,111 Secured note payable, net of discount 485 (321 ) (2) 316 119 (5) 33 (4) Additional financing obligation, net of discount 440 (119 ) (5) 321 Derivative liabilities - 4,127 (1) 3,941 562 (2) (748 ) (3) Pension obligation 1,073 - 1,073 Total liabilities 7,109 3,653 10,762 Stockholders' equity Preferred stock, authorized 4,000,000 shares: Series B convertible redeemable preferred stock 2 - 2 Series C convertible non-redeemable preferred stock - - - Series D convertible non-redeemable preferred stock - - - Common stock 180 - 180 Additional paid in capital 86,316 (5,836 ) (1) 80,239 (241 ) (2) Treasury Stock (64 ) (64 ) Accumulated other comprehensive income 46 46 Accumulated deficit (88,249 ) 748 (3) (85,824 ) (33 ) (4) 1,709 (1) Total Shareholders' deficit (1,769 ) (3,653 ) (5,422 ) Total Liabilities and Shareholders' Deficit $ 5,340 $ - $ 5,340 The effect of the restatement adjustments on the consolidated statement of operations for the three months ended March 31, 2009 is set forth in the following table: As Previously As ($ in thousands) Reported Adjustments Restated Loss from operations $ (838 ) $ - $ (838 ) Interest expense, net 131 29 (4)(6) 102 Change in fair value of financing obligation 90 62 (6) 152 Other income, net (11 ) - (11 ) Change in fair value of derivative liabilities - (748 ) (3) (748 ) Net loss (1,048 ) 715 (333 ) Preferred dividends (99 ) - (99 ) Beneficial conversion feature on preferred stocks - - - Net loss available to common shareholders $ (1,147 ) $ 715 $ (432 ) Basic and diluted loss per common share Continuing operations $ (0.06 ) $ 0.04 $ (0.02 ) Preferred dividends - - - Basic and diluted loss per common share $ (0.06 ) $ 0.04 $ (0.02 ) (1) to record the cumulative-effect adjustment to the opening balance of retained earnings to reclassify the fair value of the derivatives as a liability (2) to record the fair value of warrants issued February 12, 2009 as a derivative liability (3) to record the change in fair value of derivative liabilities (4) to record the change in interest expense resulting from changes to note discount and related amortization caused by revaluation of warrants issued with debt (5) to record change in discount on additional financing obligation (6) to record reclassification of accretion of minimum portion of additional financing obligation -43--------------------------------------------------------------------------------- Table of Contents Restatement of Financial Statements for the Three Months Ended June 30, 2009 The Company has restated its previously issued consolidated financial statements as of and for the three months ended June 30, 2009 to reflect the Company's adoption of ASC 815 which significantly changes how the Company accounts for Derivative Liabilities and related gains and losses from the change in fair value of these Derivative Liabilities.

Beginning January 1, 2009, the Company is required to account for the embedded derivative related to the conversion feature in its Series C Preferred and Series D Preferred and certain warrants as Derivative Liabilities. The Company is required to mark to market at the end of each reporting period the value of the Derivative Liabilities. The Company revalues these Derivative Liabilities at the end of each reporting period by using available market information and commonly accepted valuation methodologies. The periodic change in value of the Derivative Liabilities is recorded as either non-cash derivative income (if the value of the embedded derivative and warrants decrease) or as non-cash derivative expense (if the value of the embedded derivative and warrants increase). Although the values of the embedded derivative and warrants are affected by interest rates, the remaining contractual conversion period and the Company's stock volatility, the primary cause of the change in the values of will be the value of the Company's common stock. If the stock price goes up, the value of these derivatives will generally increase and if the stock price goes down the value of these derivatives will generally decrease.

The Company's Series C Preferred and Series D Preferred and certain warrants contain anti-dilution provisions which results in these instruments no longer being deemed to be indexed to the Company's own stock. As a result of the restatement, amounts previously classified in equity were reclassified to liabilities as of January 1, 2009. For each subsequent reporting quarter, the value of the Derivative Liabilities was revalued using available market information and commonly accepted valuation methodologies. The cumulative effect of the adoption of ASC 815 as of January 1, 2009 was a decrease in additional paid in capital of $5,836,000, a decrease in accumulated deficit of $1,709,000 and an increase in Derivative Liabilities of $4,127,000. The resulting impact of this accounting change as of and for the three months ended June 30, 2009 is a decrease in discount on secured notes payable and additional financing obligation of $9,000, an increase in the Company's net loss available to common shareholders of $5,589,000, a decrease in additional paid-in capital of $554,000, an increase in accumulated deficit of $4,874,000 and an increase in Derivative Liabilities of 5,419,000.

The revisions relate to non-operating and non-cash items as of and for the three months ended June 30, 2009. ASC 815 did not impact the Company's consolidated financial statements for periods ending December 31, 2008 or earlier.

-44--------------------------------------------------------------------------------- Table of Contents The following table summarizes the effect of the restated adjustments on amounts previously reported as of, and for the quarter ended June 30, 2009 (in thousands, except share and per share amounts): As Previously As ($ in thousands) Reported Adjustments Restated Total assets $ 5,400 $ - $ 5,400 Secured note payable, net of discount 818 (437 ) (2) 933 106 (4) 36 (6) 410 (5) Additional financing obligation, net of discount 877 (106 ) (4) 771 Other current liabilities 5,337 - 5337 Total current liabilities $ 7,032 $ 9 $ 7,041 Derivative liabilities - 4,127 (1) 9,547 989 (2) 4,430 (3) Pension obligation 1,117 - 1,117 Total liabilities 8,149 9,556 17,705 Stockholders' equity Preferred stock, authorized 4,000,000 shares: Series B convertible redeemable preferred stock 2 - 2 Series C convertible non-redeemable preferred stock - - - Series D convertible non-redeemable preferred stock - - - Common stock 180 - 180 Additional paid in capital 86,833 (5,836 ) (1) 80,441 (554 ) (2) Treasury Stock (64 ) (64 ) Accumulated other comprehensive income 9 9 Accumulated deficit (89,709 ) (4,430 ) (3) (92,873 ) (410 ) (5) (34 ) (6) 1,709 (1) Total Shareholders' deficit (2,749 ) (9,556 ) (12,303 ) Total Liabilities and Shareholders' Equity (Deficit) $ 5,400 $ - $ 5,400 -45--------------------------------------------------------------------------------- Table of Contents The effect of the restatement adjustments on the consolidated statement of operations for the three months ended June 30, 2009 is set forth in the following table: As Previously As ($ in thousands) Reported Adjustments Restated Loss from operations $ (500 ) $ - $ (500 ) Interest expense, net 233 (53 ) 180 Change in fair value of financing obligation 397 53 450 Loss on debt modification 340 410 (5) 750 Other income, net (11 ) - (11 ) Change in fair value of derivative liabilities - 5,179 (3) 5,179 Net loss (1,459 ) (5,589 ) (7,048 ) Preferred dividends (100 ) - (100 ) Net loss available to common shareholders $ (1,559 ) $ (5,589 ) $ (7,148 ) Basic and diluted loss per common share Continuing operations $ (0.08 ) $ (0.31 ) $ (0.39 ) Preferred dividends (0.01 ) - (0.01 ) Basic and diluted loss per common share $ (0.09 ) $ (0.31 ) $ (0.40 ) (1) to record the cumulative-effect adjustment to the opening balance of retained earnings to reclassify the fair value of the Derivatives as a liability (2) to record the fair value of 2009 warrant issuances as a derivative liability (3) to record the change in fair value of derivative liabilities (4) to record change in discount on additional financing obligation (5) to record the change in the loss on loan modification (6) to record the change in interest expense resulting from changes to note discount and related amortization caused by revaluation of warrants issued with debt (7) to record reclassification of accretion of minimum portion of additional financing obligation -46--------------------------------------------------------------------------------- Table of Contents Comparison of Results for the Periods Ended March 31, 2010 and March 31, 2009 Product Revenues.

Three Months Ended March 31, Net Product Revenues 2010 2009 $ Change % Change (dollars in thousands) Software and royalties $ 827 $ 390 $ 437 112 % Percentage of total net product revenue 61 % 58 % Hardware and consumables $ 224 $ 60 $ 164 273 % Percentage of total net product revenue 16 % 9 % Services $ 309 $ 225 $ 84 37 % Percentage of total net product revenue 23 % 33 % Total net product revenues $ 1,360 $ 6755 $ 685 101 % Software and royalty revenues increased 112% or $437,000 during the three months ended March 31, 2010 as compared to the corresponding period in 2009. The increase is due to higher sales of our Biometric Engine software solutions of approximately $462,000, higher royalties and license revenues of approximately $4,000 and higher project-oriented revenues of our law enforcement software solutions of approximately $24,000, offset by lower sales of our boxed identity management software sold through our distribution channel of approximately $53,000.

Revenues from the sale of hardware and consumables increased 273% or approximately $164,000 during the three months ended March 31, 2010 as compared to the corresponding period in 2009. The increase reflects higher revenues from project solutions containing hardware and consumable components.

Services revenues are comprised primarily of software integration services, system installation services and customer training. Such revenues increased approximately $84,000 during the three months ended March 31, 2010 as compared to the corresponding period in 2009 due primarily to higher revenues being generated from our identity management and law enforcement project solutions.

Maintenance Revenues.

Three Months Ended March 31, Maintenance Revenues 2010 2009 $ Change % Change (dollars in thousands) Maintenance revenues $ 668 $ 638 $ 30 5 % The increase in maintenance revenues reflects higher maintenance revenues of approximately $9,000 generated from our law enforcement products combined with higher maintenance revenues of approximately $21,000 generated from our identity management product suite.

-47--------------------------------------------------------------------------------- Table of Contents Cost of Product Revenues.

Three Months Ended March 31, Cost of Product Revenues 2010 2009 $ Change % Change (dollars in thousands) Software and royalties $ 182 $ 45 $ 137 304 % Percentage of software and royalty product revenue 22 % 12 % Hardware and consumables $ 193 $ 40 $ 153 383 % Percentage of hardware and consumables product revenue 86 % 67 % Services $ 153 $ 199 $ (46) (23) % Percentage of services product revenue 50 % 88 % Total cost of product revenues $ 528 $ 284 $ 244 86 % Percentage of total product revenues 39 % 42 % The cost of software and royalty product revenue increased 304% or $137,000 during the three months ended March 31, 2010 as compared to the corresponding period in 2009 due to higher third-party software content in solutions provided during the three months ended March 31, 2010 as compared to the corresponding period in 2009.

The increase in the cost of hardware and consumables product revenue of $153,000 for the three months ended March 31, 2010 as compared to the corresponding period in 2009 reflects the increase in hardware and consumable revenues of approximately $164,000 for the three months ended March 31, 2010 as compared to the comparable period in 2009.

Costs of service revenues decreased $46,000 for the three-month period ended March 31, 2010 as compared to the corresponding period in 2009 despite an increase of approximately $84,000 in service revenues. This inverse relationship is due to the three-month period ended March 31, 2009 containing software integration costs of our identity management products into project solutions in excess of revenues generated on certain contracts.

Cost of Maintenance Revenues.

Three Months Ended March 31, Cost of Maintenance Revenues 2010 2009 $ Change % Change (dollars in thousands) Total maintenance cost of revenues $ 247 $ 209 $ 38 18 % Percentage of total maintenance revenues 37 % 33 % Cost of maintenance revenues as a percentage of maintenance revenues increased to 37% during the three months ended March 31, 2010 from 33% for the corresponding period in 2009 due to higher identification labor costs incurred to support completed identity management project solutions.

-48--------------------------------------------------------------------------------- Table of Contents Product Gross Profit.

Three Months Ended March 31, Product Gross Profit 2010 2009 $ Change % Change (dollars in thousands) Software and royalties $ 645 $ 345 $ 300 87 % Percentage of software and 78 % 88 % royalty product revenue Hardware and consumables $ 31 $ 20 $ 11 55 % Percentage of hardware and 14 % 33 % consumables product revenue Services $ 156 $ 26 $ 130 500 % Percentage of services product 50 % 12 % revenue Total product gross profit $ 832 $ 391 $ 441 113 % Percentage of total product 61 % 58 % revenues Software and royalty gross profit increased by 87% or approximately $300,000 for the three months ended March 31, 2010 from the corresponding period in 2009 due to higher software and royalty product revenues of approximately $437,000 in the 2010 period, offset by increases in software and royalty cost of revenues of approximately $137,000. Costs of software products can also vary as a percentage of product revenue from quarter to quarter depending upon product mix and third party software licenses included in software solutions.

Hardware and consumables gross profit increased by 55% or approximately $11,000 for the three months ended March 31, 20010 from the corresponding period in 2009 due to higher hardware and consumables product revenues of approximately $164,000 in the 2010 period, offset by increases in hardware and consumables cost of revenues of approximately $153,000.

Services gross profit increased approximately $130,000 for the three months ended March 31, 2010 as compared to the corresponding period in 2009. The increase is due primarily to a increase of $84,000 in service revenues generated during the three month period ended March 31, 2010 as compared to the comparable period in 2009 combined with the three month period ending March 31, 2009 containing direct labor costs in excess of revenues generated on certain contracts.

Maintenance Gross Profit.

Three Months Ended March 31, Maintenance Gross Profit 2010 2009 $ Change % Change (dollars in thousands) Total maintenance gross profit $ 421 $ 429 $ (8 ) (2) % Percentage of total maintenance revenues 63 % 67 % Gross margins related to maintenance revenues decreased despite higher maintenance revenues of approximately $30,000 due to higher maintenance cost of revenues of approximately $38,000. The increase in maintenance revenues is due to higher maintenance revenues generated from our identity management product suite. The increase in maintenance cost of revenues is reflective of higher identification labor costs incurred to support completed identity management project solutions.

-49--------------------------------------------------------------------------------- Table of Contents Operating Expenses.

Three Months Ended March 31, Operating Expenses 2010 2009 $ Change % Change (dollars in thousands) General and administrative $ 697 $ 609 $ 88 14 % Percentage of total net revenue 34 % 46 % Sales and marketing $ 392 $ 429 $ (37 ) (9) % Percentage of total net revenue 19 % 33 % Research and development $ 697 $ 587 $ 110 19 % Percentage of total net revenue 34 % 45 % Depreciation and amortization $ 14 $ 33 $ (19 ) (58) % Percentage of total net revenue 1 % 3 % General and Administrative Expenses. General and administrative expenses are comprised primarily of salaries and other employee-related costs for executive, financial, and other infrastructure personnel. General legal, accounting and consulting services, insurance, occupancy and communication costs are also included with general and administrative expenses. The dollar increase of $88,000 is comprised of the following major components: † Increase in stock-based compensation expense of approximately $8,000 due to the issuance of restricted stock grants in the quarter ended March 31, 2010.

· Increase in professional services of approximately $180,000.

† † Decrease in occupancy related expenses of approximately $11,000.

· Decrease in compensation and related fringe benefits of approximately $85,000 due to reductions in headcount.

· Increase in travel related expenses of approximately $7,000.

· Decrease in expenses related to our closed sales office in Germany and other expenses of approximately $11,000.

Sales and Marketing. Sales and marketing expenses consist primarily of the salaries, commissions, other incentive compensation, employee benefits and travel expenses of our sales, marketing and business development functions. The dollar decrease of $37,000 is comprised of the following major components: †† Decrease in compensation and related fringe benefits of approximately $38,000.

†† Decrease of $40,000 in expenses incurred for sales contractors and consultants.

· Increase in occupancy related expenses of approximately $1,000.

· Decrease in travel related expenses of approximately $4,000.

· Increase of $44,000 from costs related to our Mexico City sales office opened in June 2009.

-50--------------------------------------------------------------------------------- Table of Contents Research and Development. Research and development expenses consist primarily of salaries, employee benefits and outside contractors for new product development, product enhancements and custom integration work. Such expenses increased 19% or $110,000 for the three months ended March 31, 2010 as compared to 2009. The increase is comprised of the following major components: † † Increase of $109,000 in compensation and related fringe benefits combined with increases in contract programming expenditures of approximately $27,000.

††† Decrease in travel related expenses of approximately $6,000.

· Decrease in occupancy related expenses of approximately $20,000.

Depreciation and Amortization. During the three months ended March 31, 2010, depreciation and amortization expense decreased 58% or $19,000 as compared to the corresponding period in 2009. The decrease in depreciation and amortization expense is due largely to limitations placed on acquiring new equipment in 2010.

Interest Expense (Income), Net. For the three months ended March 31, 2010, we recognized interest income of $0 and interest expense of $242,000. For the three months ended March 31, 2009, we recognized interest income of $0 and interest expense of $102,000.

Interest expense for the three months ended March 31, 2010 is comprised of the following components: · Coupon interest on secured notes payable and convertible notes payable of approximately $64,000.

· Accretion of note discount to interest expense of approximately $162,000.

· Other interest expense of approximately $16,000.

Interest expense for the three months ended March 31, 2009 is comprised of the following components: · Coupon interest on secured notes payable and convertible notes payable of approximately $7,000.

· Accretion of note discount to interest expense of approximately $59,000.

· Amortization of deferred financing fees to interest expense of approximately $16,000.

· Interest expense of approximately $20,000 related to liquidated damages accrued pursuant to a registration payment arrangement.

Change in Fair Value of Derivative Liabilities. For the three months ended March 31, 2010, we recognized a non-cash expense of $477,000 compared to non-cash income of $748,000 for the corresponding period of 2009 due to implementation of ASC 815 effective January 1, 2009. Such expense is related to the change in fair value of the Company's Derivative Liabilities. The Derivative Liabilities were revalued using available market information and commonly accepted valuation methodologies.

Change in Fair Value of Financing Obligation. For the three months ended March 31, 2010, we recognized non-cash expense of $229,000 compared to non-cash expense of $152,000 for the corresponding period of 2009 related to the change in fair value of the Company's financing obligation. For the three months ended March 31, 2010, such expense is related to the change in fair value of the Company's variable component of the financing obligation of approximately $158,000 and the accretion of the fixed component of the financing obligation of approximately $71,000. For the three months ended March 31, 2009, such expense is related to the change in fair value of the Company's variable component of the financing obligation of approximately $90,000 and the accretion of the fixed component of the financing obligation of approximately $62,000. The variable component of the financing obligation was revalued using available market information and commonly accepted valuation methodologies.

-51--------------------------------------------------------------------------------- Table of Contents Other Expense (Income), Net. For the three months ended March 31, 2010, we recognized other income of $17,000 and other expense of $0. For the three months ended March 31, 2009, we recognized other income of $11,000 and other expense of $0. Other income for the three months ended March 31, 2010 contains approximately $2,000 from the negotiated settlement of certain trade accounts payable at amounts less than their carrying value, $10,000 from the forfeiture by certain participants of certain 401(k) plan employer match contributions and $5,000 from collections on previously derecognized receivables. Other income for the three months ended March 31, 2009 is comprised primarily of $6,000 in insurance reimbursement and $5,000 from collection on previously derecognized receivables.

Comparison of Results for the Periods Ended June 30, 2010 and June 30, 2009 Product Revenues.

Three Months Ended June 30, Net Product Revenues 2010 2009 $ Change % Change (dollars in thousands) Software and royalties $ 319 $ 785 $ (466) (59) % Percentage of total net product revenue 62 % 79 % Hardware and consumables $ 98 $ 25 $ 73 292 % Percentage of total net product revenue 19 % 3 % Services $ 94 $ 189 $ (95) (50) % Percentage of total net product revenue 18 % 19 % Total net product revenues $ 511 $ 999 $ (488) (49) % Software and royalty revenues decreased 59% or $466,000 during the three months ended June 30, 2010 as compared to the corresponding period in 2009. The decrease is due primarily to lower identity management software sold into project solutions of approximately $147,000, lower sales of our boxed identity management software sold through our distribution channel of approximately $122,000 and lower project-oriented revenues of our law enforcement software solutions of approximately $237,000. These decreases were partially offset by higher identification software royalties and license revenues of approximately $40,000.

Revenues from the sale of hardware and consumables increased 292% or $73,000 during the three months ended June 30, 2010 as compared to the corresponding period in 2009. The increase reflects higher revenues from consumables sold to our law enforcement customers.

Services revenues are comprised primarily of software integration services, system installation services and customer training. Such revenues decreased approximately $95,000 during the three months ended June 30, 2010 as compared to the corresponding period in 2009 due to lower revenues being generated from our identity management and law enforcement project solutions.

-52--------------------------------------------------------------------------------- Table of Contents Maintenance Revenues.

Three Months Ended June 30, Maintenance Revenues 2010 2009 $ Change % Change (dollars in thousands) Maintenance revenues $ 640 $ 646 $ (6) ) (1) % The decrease in maintenance revenues reflects lower maintenance revenues of approximately $10,000 generated from our law enforcement products offset by higher maintenance revenues of approximately $4,000 generated from our identity management product suite.

Cost of Product Revenues.

Three Months Ended June 30, Cost of Product Revenues 2010 2009 $ Change % Change (dollars in thousands) Software and royalties $ 39 $ 120 $ (81) (68) % Percentage of software and royalty product revenue 12 % 15 % Hardware and consumables $ 48 $ 26 $ 22 85 % Percentage of hardware and consumables product revenue 49 % 104 % Services $ 57 $ 171 $ (114) (67) % Percentage of services product revenue 61 % 90 % Total cost of product revenues $ 144 $ 317 $ (173) (55) % Percentage of total product revenues 28 % 32 % The cost of software and royalty product revenue decreased 68% or $81,000 during the three months ended June 30, 2010 as compared to the corresponding period in 2009 due to lower third-party software content in solutions provided during the three month period ended June 30, 2010 as compared to the corresponding period in 2009. The decrease also reflects the reduction in our project-oriented revenues from our law enforcement and identity management product suites during the three months ended June 30, 2010 as compared to the corresponding period in 2009.

The increase in the cost of hardware and consumables product revenue of $22,000 for the three months ended June 30, 2010 as compared to the corresponding period in 2009 reflects the increase in hardware and consumable revenues of approximately $73,000 for the three months ended June 30, 2010 as compared to the comparable period in 2009.

Costs of service revenues decreased $114,000 for the three-month period ended June 30, 2010 as compared to the corresponding period in 2009. The decrease is due primarily to a decrease of 50% or $95,000 in service revenues generated during the three month period ended June 30, 2010 as compared to the comparable period in 2009 combined with the three month period ended June 30, 2009 containing integration costs of our identity management products into project solutions in excess of revenues generated on certain contracts.

-53--------------------------------------------------------------------------------- Table of Contents Cost of Maintenance Revenues.

Three Months Ended June 30, Cost of Maintenance Revenues 2010 2009 $ Change % Change (dollars in thousands) Total maintenance cost of revenues $ 254 $ 199 $ 55 28 % Percentage of total maintenance revenues 40 % 31 % Costs of maintenance revenues as a percentage of maintenance revenues increased to 40% during the three months ended June 30, 2010 from 31% for the corresponding period in 2009. This increase is due primarily to higher identification labor costs incurred to perform maintenance requirements on completed large-scale identity management projects.

Product Gross Profit.

Three Months Ended June 30, Product Gross Profit 2010 2009 $ Change % Change (dollars in thousands) Software and royalties $ 280 $ 665 $ (385 ) (58 ) % Percentage of software and royalty product revenue 88 % 85 % Hardware and consumables $ 50 $ (1 ) $ 51 5100 % Percentage of hardware and consumables product revenue 51 % -4 % Services $ 37 $ 18 $ 19 106 % Percentage of services product revenue 39 % 10 % Total product gross profit $ 367 $ 682 $ (315 ) (46 ) % Percentage of total product revenues 72 % 68 % Software and royalty gross profit decreased by 58% or approximately $385,000 for the three months ended June 30, 2010 from the corresponding period in 2009 due to lower software and royalty product revenues of approximately $466,000 in 2010. Costs of software products can also vary as a percentage of product revenue from quarter to quarter depending upon product mix and third party software licenses included in software solutions.

Hardware and consumables gross profit increased by approximately $51,000 for the three months ended June 30, 2010 from the corresponding period in 2009 due to higher hardware and consumables product revenues of approximately $73,000 in the 2010 period, offset by increases in hardware and consumables cost of revenues of approximately $22,000.

Services gross profit increased approximately $19,000 for the three months ended June 30, 2010 from the corresponding period in 2009 due to the three months ended June 30, 2009 containing direct labor costs in excess of revenues generated on certain contracts.

-54--------------------------------------------------------------------------------- Table of Contents Maintenance Gross Profit.

Three Months Ended June 30, Maintenance Gross Profit 2010 2009 $ Change % Change (dollars in thousands) Total maintenance gross profit $ 386 $ 447 $ (61) (14) % Percentage of total maintenance revenues 60 % 69 % Gross margins related to maintenance revenues decreased due to lower maintenance revenues of approximately $6,000 combined with higher maintenance cost of revenues of approximately $55,000. This increase in costs is due primarily to higher labor costs incurred to perform maintenance requirements on completed large-scale identity management projects.

Operating Expenses.

Three Months Ended June 30, Operating expenses 2010 2009 $ Change % Change (dollars in thousands) General and administrative $ 680 $ 595 $ 85 14 % Percentage of total net revenue 59 % 36 % Sales and marketing $ 381 $ 451 $ (70) (16) % Percentage of total net revenue 33 % 27 % Research and development $ 666 $ 553 $ 113 20 % Percentage of total net revenue 58 % 34 % Depreciation and amortization $ 12 $ 30 $ (18) (60) % Percentage of total net revenue 1 % 2 % General and Administrative Expenses. General and administrative expenses are comprised primarily of salaries and other employee-related costs for executive, financial, and other infrastructure personnel. General legal, accounting and consulting services, insurance, occupancy and communication costs are also included with general and administrative expenses. The dollar increase of $85,000 is comprised of the following major components: · Increase in professional services of approximately $174,000.

· Decrease in finance related expenses of approximately $59,000.

· Decrease in occupancy and insurance related expenses of approximately $7,000.

· Decrease in compensation and related fringe benefits of approximately $31,000 due to reductions in headcount.

· Decrease in expenses related to our closed sales office in Germany of approximately $3,000.

· Increase in stock based compensation expense of approximately $6,000 due to the issuance of restricted stock grants in the quarter ended March 31, 2010.

· Increase in travel related expenses of approximately $5,000.

-55--------------------------------------------------------------------------------- Table of Contents Sales and Marketing. Sales and marketing expenses consist primarily of the salaries, commissions, other incentive compensation, employee benefits and travel expenses of our sales, marketing and business development functions. The decrease of $70,000 is comprised of the following major components: ††† Decrease in compensation, including stock based compensation and related fringe benefits of approximately $42,000.

††† Decrease of $40,000 in expenses incurred for sales contractors and consultants.

· Decrease in occupancy related expenses of approximately $4,000.

· Increase in travel related expenses of approximately $4,000.

· Increase of $12,000 from costs related to our Mexico City sales office opened in June 2009.

Research and Development. Research and development expenses consist primarily of salaries, employee benefits and outside contractors for new product development, product enhancements and custom integration work. Such expenses increased 20% or $113,000 for the three months ended June 30, 2010 as compared to 2009. The increase is comprised of the following major components: · Increase of $107,000 in compensation and related fringe benefits combined with increases in contract programming expenditures of approximately $9,000.

· Decrease in occupancy and other related expenses of approximately $3,000.

Depreciation and Amortization. During the three months ended June 30, 2010, depreciation and amortization expense decreased 60% or $18,000 as compared to the corresponding period in 2009. The decrease in depreciation and amortization expense reflects the limitations placed on acquiring new equipment in 2010.

Interest Expense (Income), Net. For the three months ended June 30, 2010, we recognized interest income of $0 and interest expense of $334,000. For the three months ended June 30, 2009, we recognized interest income of $0 and interest expense of $180,000.

Interest expense for the three months ended June 30, 2010 is comprised of the following components: · Coupon interest on secured notes payable and convertible notes payable of approximately $58,000.

· Accretion of note discount to interest expense of approximately $271,000.

· Other interest expense of approximately $5,000.

Interest expense for the three months ended June 30, 2009 is comprised of the following components: · Coupon interest on secured notes payable and convertible notes payable of approximately $33,000.

· Accretion of note discount to interest expense of approximately $74,000.

· Amortization of deferred financing fees to interest expense of approximately $8,000.

· Interest expense of approximately $65,000 primarily related to liquidated damages accrued pursuant to a registration payment arrangement.

-56--------------------------------------------------------------------------------- Table of Contents Change in Fair Value of Derivative Liabilities. For the three months ended June 30, 2010, we recognized non-cash income of $4,154,000 compared to non-cash expense of $5,179,000 for the corresponding period of 2009 due to implementation of ASC 815 effective January 1, 2009. Such expense is related to the change in fair value of the Company's Derivative Liabilities. The Derivative Liabilities were revalued using available market information and commonly accepted valuation methodologies.

Change in Fair Value of Financing Obligation. For the three months ended June 30, 2010, we recognized non-cash income of $744,000 compared to non-cash expense of $450,000 for the corresponding period of 2009 related to the change in fair value of the Company's financing obligation. For the three months ended June 30, 2010, such income is related to the change in fair value of the Company's variable component of the financing obligation of approximately $816,000 offset by the accretion of the fixed component of the financing obligation of approximately $72,000. For the three months ended June 30, 2009, such expense is related to the change in fair value of the Company's variable component of the financing obligation of approximately $412,000 and the accretion of the fixed component of the financing obligation of approximately $38,000. The variable component of the financing obligation was revalued using available market information and commonly accepted valuation methodologies.

Other Expense (Income), Net. For the three months ended June 30, 2010, we recognized other income of $284,000 and other expense of $0. For the three months ended June 30, 2009, we recognized other income of $11,000 and other expense of $0. Other income for the three months ended June 30, 2010 contains approximately $280,000 from the reduction of previously accrued liquidated damages due to the expiration of the statue of limitations and $4,000 from collections on previously derecognized receivables. Other income for the three months ended June 30, 2009 is comprised primarily of $6,000 from the negotiated settlement of certain trade accounts payable at amounts less than their carrying value and $5,000 from collection on previously derecognized receivables.

Comparison of Results for the Periods Ended September 30, 2010 and September 30, 2009 Product Revenues.

Three Months Ended September 30, Net Product Revenues 2010 2009 $ Change % Change (dollars in thousands) Software and royalties $ 370 $ 216 $ 154 71 % Percentage of total net product revenue 48 % 90 % Hardware and consumables $ 21 $ 37 $ (16) (43) % Percentage of total net product revenue 3 % 15 % Services $ 378 $ (12 ) $ 390 3,250 % Percentage of total net product revenue 49 % (5 )% Total net product revenues $ 769 $ 241 $ 528 219 % Software and royalty revenues increased 71% or $154,000 during the three months ended September 30, 2010 as compared to the corresponding period in 2009. The increase is due primarily to higher identity management software sold into project solutions of approximately $129,000, higher sales of our boxed identity management software sold through our distribution channel of approximately $17,000 and higher project-oriented revenues of our law enforcement software solutions of approximately $12,000. This was partially offset by lower royalties and license revenues of approximately $4,000.

Revenues from the sale of hardware and consumables decreased 43% or $16,000 during the three months ended September 30, 2010 as compared to the corresponding period in 2009. The decrease reflects the lower levels of hardware and consumables generated from project solutions.

Services revenues are comprised primarily of software integration services, system installation services and customer training. Such revenues increased approximately $390,000 during the three months ended September 30, 2010 as compared to the corresponding period in 2009 due to higher service revenues being generated from our identity management project solutions.

-57--------------------------------------------------------------------------------- Table of Contents Maintenance Revenues.

Three Months Ended September 30, Maintenance Revenues 2010 2009 $ Change % Change (dollars in thousands) Maintenance revenues $ 653 $ 659 $ (6) (1) % The decrease in maintenance revenues reflects lower maintenance revenues of approximately $23,000 generated from our law enforcement products offset by higher maintenance revenues of approximately $17,000 generated from our identity management product suite.

Cost of Product Revenues.

Three Months Ended September 30, Cost of Product Revenues 2010 2009 $ Change % Change (dollars in thousands) Software and royalties $ 36 $ 32 $ 4 13 % Percentage of software and royalty product revenue 10 % 15 % Hardware and consumables $ 26 $ 42 $ (16) (38) % Percentage of hardware and consumables product revenue 124 % 114 % Services $ 187 $ 93 $ 94 101 % Percentage of services product revenue 49 % -775 % Total cost of product revenues $ 249 $ 167 $ 82 49 % Percentage of total product revenues 32 % 69 % The cost of software and royalty product revenue increased 13% or $4,000 during the three months ended September 30, 2010 as compared to the corresponding period in 2009 due to higher third-party software content in solutions provided during the three month period ended September 30, 2010 as compared to the corresponding period in 2009.

The decrease in cost of hardware and consumables product revenue of $16,000 for the three months ended September 30, 2010 as compared to the corresponding period in 2009 reflects the decrease in hardware and consumable revenues of approximately $16,000 for the three months ended September 30, 2010 as compared to the comparable period in 2009.

Costs of service revenues increased $94,000 for the three-month period ended September 30, 2010 as compared to the corresponding period in 2009. The increase is due primarily to an increase of $390,000 in service revenues generated during the three month period ended September 30, 2010 as compared to the comparable period in 2009.

-58--------------------------------------------------------------------------------- Table of Contents Cost of Maintenance Revenues.

Three Months Ended September 30, Cost of Maintenance Revenues 2010 2009 $ Change % Change (dollars in thousands) Total maintenance cost of revenues $ 198 $ 201 $ (3) (1) % Percentage of total maintenance revenues 30 % 31 % Costs of maintenance revenues as a percentage of maintenance revenues decreased to 30% during the three months ended September 30, 2010 from 31% for the corresponding period in 2009. This decrease is due primarily to reductions in costs incurred to perform maintenance requirements on completed law enforcement project solutions.

Product Gross Profit.

Three Months Ended September 30, Product Gross Profit 2010 2009 $ Change % Change (dollars in thousands) Software and royalties $ 334 $ 184 $ 150 ) 82 % Percentage of software and 90 % 85 % royalty product revenue Hardware and consumables $ (5) $ (5) $ 0 0 % Percentage of hardware and -24 % (14) % consumables product revenue Services $ 191 $ (105) $ 296 282 % Percentage of services product 51 % (875) % revenue Total product gross profit $ 520 $ 74 $ 446 ) 603 % Percentage of total product 68 % 31 % revenues Software and royalty gross profit increased by 82% or approximately $150,000 for the three months ended September 30, 2010 from the corresponding period in 2009 due to higher software and royalty product revenues of approximately $154,000 in the 2010 period, offset partially by higher software and royalty cost of revenues of approximately $4,000. Costs of software products can also vary as a percentage of product revenue from quarter to quarter depending upon product mix and third party software licenses included in software solutions.

Services gross profit increased approximately $296,000 for the three months ended September 30, 2010 from the corresponding period in 2009 due to higher service revenues being generated from our identity management project solutions.

Maintenance Gross Profit.

Three Months Ended September 30, Maintenance Gross Profit 2010 2009 $ Change % Change (dollars in thousands) Total maintenance gross profit $ 455 $ 458 $ (3 ) (1) % Percentage of total maintenance revenues 70 % 69 % Gross profit related to maintenance revenues decreased approximately $3,000 due to lower maintenance revenues.

-59--------------------------------------------------------------------------------- Table of Contents Operating Expenses.

Three Months Ended September 30, Operating Expenses 2010 2009 $ Change % Change (dollars in thousands) General and administrative $ 512 $ 555 $ (43 ) (8) % Percentage of total net revenue 36 % 62 % Sales and marketing $ 385 $ 376 $ 9 2 % Percentage of total net revenue 27 % 42 % Research and development $ 576 $ 582 $ (6 ) (1) % Percentage of total net revenue 41 % 65 % Depreciation and amortization $ 13 $ 19 $ (6 ) (32) % Percentage of total net revenue 1 % 2 % General and Administrative Expenses. General and administrative expenses are comprised primarily of salaries and other employee-related costs for executive, financial, and other infrastructure personnel. General legal, accounting and consulting services, insurance, occupancy and communication costs are also included with general and administrative expenses. The decrease of $43,000 is comprised of the following major components: · Decrease in expenses related to our closed sales office in Germany of approximately $9,000.

· Increase in professional services of approximately $6,000.

· Decrease in insurance related expenses of approximately $3,000.

· Decrease in occupancy related expenses of approximately $18,000.

††† Decrease in compensation and related fringe benefits of approximately $14,000 due to reductions in headcount.

· Decrease in travel related expenses of approximately $5,000.

Sales and Marketing. Sales and marketing expenses consist primarily of the salaries, commissions, other incentive compensation, employee benefits and travel expenses of our sales, marketing and business development functions. The increase of $9,000 is comprised of the following major components: ††† Increase in compensation and related fringe benefits of approximately $44,000 due to increases in headcount.

· Decrease of $39,000 in expenses incurred for sales contractors and consultants.

· Decrease in occupancy related expenses of approximately $1,000.

· Decrease in travel related expenses of approximately $4,000.

††† Decrease in stock-based compensation expense of approximately $13,000.

· Increase of $22,000 from costs related to our Mexico City sales office opened in June 2009.

-60--------------------------------------------------------------------------------- Table of Contents Research and Development. Research and development expenses consist primarily of salaries, employee benefits and outside contractors for new product development, product enhancements and custom integration work. Such expenses decreased 1% or $6,000 for the three months ended September 30, 2010 as compared to 2009.

Depreciation and Amortization. During the three months ended September 30, 2010, depreciation and amortization expense decreased 32% or $6,000 as compared to the corresponding period in 2009. The decrease in depreciation and amortization expense reflects the limitations placed on acquiring new equipment in 2010.

Interest Expense (Income), Net. For the three months ended September 30, 2010, we recognized interest income of $0 and interest expense of $60,000. For the three months ended September 30, 2009, we recognized interest income of $0 and interest expense of $212,000.

Interest expense for the three months ended September 30, 2010 is comprised of the following components: · Coupon interest on secured notes payable and convertible notes payable of approximately $54,000.

· Other interest expense of approximately $6,000.

Interest expense for the three months ended September 30, 2009 is comprised of the following components: · Coupon interest on secured notes payable and convertible notes payable of approximately $32,000.

· Accretion of note discount to interest expense of approximately $82,000.

· Fair value of warrants issued to related party convertible note holders in consideration for wavier of default of approximately $52,000.

· Amortization of deferred financing fees to interest expense of approximately $1,000.

· Interest expense of approximately $45,000 primarily related to liquidated damages accrued pursuant to a registration payment arrangement.

Change in Fair Value of Derivative Liabilities. For the three months ended September 30, 2010, we recognized non-cash income of $506,000 compared to non-cash expense of $756,000 for the corresponding period of 2009 due to implementation of ASC 815 effective January 1, 2009. Such expense is related to the change in fair value of the Company's Derivative Liabilities. The Derivative Liabilities were revalued using available market information and commonly accepted valuation methodologies.

Change in Fair Value of Financing Obligation. For the three months ended September 30, 2010, we recognized non-cash income of $38,000 compared to non-cash expense of $438,000 for the corresponding period of 2009 related to the change in fair value of the Company's financing obligation. For the three months ended September 30, 2010, such income is related to the change in fair value of the Company's variable component of the financing obligation. For the three months ended September 30, 2009, such expense is related to the change in fair value of the Company's variable component of the financing obligation of approximately $355,000 and the accretion of the fixed component of the financing obligation of approximately $83,000. The variable component of the financing obligation was revalued using available market information and commonly accepted valuation methodologies.

Other Expense (Income), Net. For the three months ended September 30, 2010, we recognized other income of $12,000 and other expense of $0. For the three months ended September 30, 2009, we recognized other income of $132,000 and other expense of $8,000. Other income for the three months ended September 30, 2010 contains approximately $12,000 from collections on previously derecognized receivables. Other income for the three months ended September 30, 2009 is comprised primarily of $128,000 from the negotiated settlement of certain trade accounts payable at amounts less than their carrying value and $4,000 from collection on previously derecognized receivables. Other expense for the three months ended September 30, 2009 is comprised of approximately $8,000 of foreign currency transaction losses.

Recently Issued Accounting Pronouncements From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board, or FASB, or other standard setting bodies, which are adopted by us as of the specified effective date. Unless otherwise discussed, the Company's management believes that the impact of recently issued standards that are not yet effective will not have a material impact on the Company's consolidated financial statements upon adoption.

-61--------------------------------------------------------------------------------- Table of Contents FASB ASU 2010-06. In January 2010, the FASB issued FASB Accounting Standards Update, or ASU 2010-06, which amends the disclosure requirements relating to recurring and nonrecurring fair value measurements. New disclosures are required about transfers into and out of the levels 1 and 2 fair value hierarchy and separate disclosures about purchases, sales, issuances and settlements relating to Level 3 measurements. This ASU also requires an entity to present information about purchases, sales, issuances and settlements for significant unobservable inputs on a gross basis rather than as a net number. This ASU was effective for us with the reporting period beginning January 1, 2010, except for the disclosures on the roll forward activities for Level 3 fair value measurements, which will become effective for us with the reporting period beginning October 1, 2011. The adoption of this ASU had no impact on the Company's financial position and results of operations, as it only requires additional disclosures.

FASB ASU 2010-29. In December 2010, the FASB issued FASB ASU 2010-29, which requires an entity to disclose revenue and earnings of a combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual period only. It also requires pro forma disclosures to include a description of the nature and amount of the material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The Company does not expect the adoption of ASU 2010-29 to have a material impact on the Company's consolidated financial statements.

FASB ASU 2011-05. In June 2011 the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, ("ASU 2011-05"). This new accounting standard: (1) eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders' equity; (2) requires the consecutive presentation of the statement of net income and other comprehensive income; and (3) requires an entity to present reclassification adjustments on the face of the financial statements from other comprehensive income to net income. This new standard does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income, nor does it affect how earnings per share is calculated or presented. ASU 2011-05 is required to be applied retrospectively and is effective for fiscal years and interim periods within those years beginning after December 15, 2011, with early adoption permitted. As this new standard only requires enhanced disclosure, the adoption of ASU 2011-05 will not impact the Company's financial position or results of operations.

FASB ASU 2011-08. In September 2011 the FASB issued ASU No. 2011-08, Goodwill and Other (Topic 350): Testing Goodwill for Impairment, ("ASU 2011-08"). This new accounting standard simplifies goodwill impairment tests and states that a qualitative assessment may be performed to determine whether further impairment testing is necessary. ASU 2011-08 is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011.

The Company does not expect the adoption of ASU 2011-08 to have a material impact on the Company's consolidated financial statements.

FASB ASU 2011-09. The FASB has issued Accounting Standards Update (ASU) No.

2011-09, Compensation-Retirement Benefits-Multiemployer Plans (Subtopic 715-80): Disclosures about an Employer's Participation in a Multiemployer Plan. ASU 2011-09 is intended to address concerns from various users of financial statements on the lack of transparency about an employer's participation in a multiemployer pension plan. Users of financial statements have requested additional disclosure to increase awareness of the commitments and risks involved with participating in multiemployer pension plans. The amendments in this ASU will require additional disclosures about an employer's participation in a multiemployer pension plan. Previously, disclosures were limited primarily to the historical contributions made to the plans. ASU 2011-09 applies to nongovernmental entities that participate in multiemployer plans. For public entities, ASU 2011-09 is effective for annual periods for fiscal years ending after December 15, 2011. For nonpublic entities, ASU 2011-09 is effective for annual periods for fiscal years ending after December 15, 2012. Early adoption is permissible for both public and nonpublic entities. ASU 2011-09 should be applied retrospectively for all prior periods presented. The Company does not expect the adoption of ASU 2011-09 to have a material impact on the Company's consolidated financial statements.

-62--------------------------------------------------------------------------------- Table of Contents Impact of Inflation The primary inflationary factor affecting our operations is labor costs and we do not believe that inflation has materially affected earnings during the past four years. Substantial increases in costs and expenses, particularly labor and operating expenses, could have a significant impact on our operating results to the extent that such increases cannot be passed along to customers and end users.

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