[May 13, 2013] APPLIED VISUAL SCIENCES, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Tweet (Edgar Glimpses Via Acquire Media NewsEdge) GENERAL You should read the following summary together with the more detailed information and consolidated financial statements and notes thereto and schedules appearing elsewhere in this report. Throughout this report when we refer to the "Company," "Applied Visual Sciences," "we," "our" or "us," we mean Applied Visual Sciences, Inc., and its subsidiaries. This discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our critical accounting policies and estimates, including those related to revenue recognition, intangible assets, and contingencies. We base our estimates on historical 43 experience, where available, and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions and conditions. Except for historical information, the statements and other information contained in this Management's Discussion and Analysis is forward-looking. Our actual results could differ materially from the results discussed in the forward-looking statements, which include certain risks and uncertainties. These risks and uncertainties include the rate of market development and acceptance of our "intelligent imaging informatics" ("3i™") technology (particularly for our PinPoint™ and Signature Mapping™ products), the unpredictability of our sales cycle, the limited revenues and significant operating losses generated to date, and the possibility of significant ongoing capital requirements. Our independent registered public accounting firm's report on the consolidated financial statements included herein for the years ended December 31, 2012 and 2011 contains an explanatory paragraph wherein they expressed an opinion that there is substantial doubt about our ability to continue as a going concern. Accordingly, careful consideration of such opinions should be given in determining whether to continue or become our stockholder. OVERVIEW Applied Visual Sciences, Inc. was incorporated under the name Guardian Technologies International, Inc., in the Commonwealth of Virginia in 1989 and reincorporated in State of Delaware in February 1996. We changed our name to Applied Visual Sciences, Inc., on July 9, 2010. The Company, previously an operating stage company, became a development stage company on April 1, 2012, the date of inception as a development stage company for financial reporting. Applied Visual Sciences, Inc. and its subsidiaries are collectively referred to herein as the "Company," "Applied Visual Sciences, Inc.," "Applied Visual," "us," "we," or "our." Applied Visual Sciences is a software technology company that designs and develops imaging informatics solutions for delivery to its target markets, aviation/homeland security and healthcare. Our two product lines are offered through our two operating subsidiaries as follows: Guardian Technologies International, Inc. for aviation/homeland security products and Signature Mapping Medical Sciences, Inc., for healthcare. On March 23, 2012, the Company established a new entity; Instasis Imaging, Inc., for the development, marketing, and sales of a suite of imaging analytic applications for the automated detection of breast cancer. We may engage in one or more acquisitions of businesses that are complementary, and may form wholly-owned subsidiaries to operate within defined vertical markets products. The Company utilizes imaging technologies and analytics to create integrated information management technology products and services that address critical problems experienced by corporations and governmental agencies in healthcare and homeland security. Each product and service can improve the quality and response time of decision-making, organizational productivity, and efficiency within the enterprise. Our product suite integrates, streamlines, and distributes business and clinical information and images across the enterprise. Please refer to Item 1A - Risk Factors, above for certain risks related to us and our business. Our Business Strategy Our strategic vision is to position our core technology as the de facto standard for digital image analysis, knowledge extraction, and detection. Our strategy is based upon the following principal objectives: · Maintain product development and sales/marketing focus on large, underserved, and rapidly growing markets with a demonstrated need for intelligent imaging informatics. · Leverage Applied Visual Sciences, Inc.'s technology, experienced management team, research and development infrastructure. · Focus our talents on solving highly challenging information problems associated with digital imaging analysis. · Establish an international market presence through the development of a significant OEM/Reseller network. · Build and maintain a strong balance sheet to ensure the availability of capital for product development, acquisitions, and growth. · Seek to broaden our investment appeal to large institutions. To achieve our strategic vision, we are aware of the need to exercise the financial and operational discipline necessary to achieve the proper blend of resources, products and strategic partnerships. These efforts can accelerate our ability to develop, deploy and service a broad range of intelligent imaging informatics solutions directly to our target markets and indirectly through OEM/value added reseller 44 ("VAR") partners. During 2012, we continued implementing changes across the spectrum of our business. We refined our marketing strategy for PinPoint™ and Signature Mapping™, and enhanced our Signature Mapping™ product offerings. We may engage in one or more acquisitions of businesses that are complementary, and may form wholly-owned subsidiaries to operate within defined vertical markets. Our Core Technology Our core technology is an "intelligent imaging informatics" ("3i™") engine that is capable of extracting embedded knowledge from digital images, and has the capacity to analyze and detect image anomalies. The technology is not limited by type of digital format. It can be deployed across divergent digital sources such as still images, x-ray images, video and hyper-spectral imagery. To date, the technology has been tested in the area of threat detection for baggage scanning at airports, for bomb squad applications and the detection of tuberculosis by analyzing digital images of stained sputum slides captured through a photo microscopy system. Varying degrees of research and development have been conducted in the areas of detection for cargo scanning, people scanning, military target acquisition in a hyper-spectral environment, satellite remote sensing ground surveys and mammography CAD products and radiologists' diagnostic imaging tools, and while product development in these areas is ongoing, there can be no assurance that we will successfully develop product offerings in these areas. We are currently focused on providing software technology solutions and services in two primary markets - aviation/homeland security with PinPoint™ and healthcare technology with Signature Mapping™ solutions. However, as new or enhanced solutions are developed, we expect to expand into other markets such as military and defense utilizing hyper-spectral technology, and imaging diagnostics for the medical industry. Patents and Proprietary Rights We rely on a combination of common law trademark, service mark, copyright and trade secret law and contractual restrictions to establish and protect our proprietary rights and promote our reputation and the growth of our business. We do not own any patents that would prevent or inhibit our competitors from using our technology or entering our market, although we intend to seek such protection as appropriate. It is our practice to require all of our employees, consultants and independent contractors to enter into agreements containing non-disclosure, non-competition and non-solicitation restrictions and covenants, and while our agreements with some of our customers and suppliers include provisions prohibiting or restricting the disclosure of proprietary information, we can not assure you that these contractual arrangements or the other steps taken by us to protect our proprietary rights will prove sufficient protection to prevent misappropriation of our proprietary rights or to deter independent, third-party development of similar proprietary assets. The United States Patent & Trademark Office ("USPTO") has granted the Company six patents, all of which are related to our underlying 3i™ technology. We also have nine pending patents applications (U.S. and foreign) that further cover the implementation of our core 3i™ technology. We cannot provide assurance that any or all of the remaining patent applications or the provisional application will be issued patents, or that they will not be challenged, or that rights granted to us would actually provide us with an advantage over our competitors. Prior art searches have been conducted and, based on the results of these searches; we believe that we do not infringe any third party patents identified in the searches. Date Granted Patent No. Patent Description February 17, 2009 7,492,937 System and Method for Identifying Objects of Interest in Image Data February 24, 2009 7,496,218 System and Method for Identifying Objects of Interest in Image Data October 19, 2010 7,817,833 System and Method for Identifying Feature of Interest in Hyperspectral Data November 23, 2010 7,840,048 System and Method for Determining Whether There is an Anomaly in Data March 15, 2011 7,907,762 Method of Creating a Divergence Transform for Identifying a Feature of Interest in Hyperspectral Data October 25, 2011 8,045,805 Method for Determining Whether a Feature of Interest Anomaly is Present in an Image Due to the rapid pace of technological change in the software industry, we believe patent, trade secret and copyright protection are less significant to our competitive edge than factors such as the knowledge, ability and experience of our personnel, new product development, frequent product enhancements, name recognition and the ongoing reliability of our products. Aviation/Homeland Security Technology Solution - PinPoint™ Market Initially, management has focused its principal development and marketing efforts for its PinPoint™ product on the market for airport baggage screening technology solutions. However, as discussed further below, and although there can be no assurance, 45 management believes that its PinPoint™ solution is also capable of being adapted for use in the people portal and cargo screening markets. The following discussion focuses on the market for baggage screening solutions; however, we have also provided an overview of the potential market for people portal and cargo screening technology solutions, potential future markets for our PinPoint™ product. Baggage Screening Market Security oversight of airports in the United States is overseen by the Transportation Safety Administration ("TSA") with an annual operating budget in excess of $5 billion. TSA has the responsibility for over 480 U.S. airports with a combined inventory of baggage scanning equipment (checked baggage area and the carry-on baggage area) in excess of 6,000 scanners. While exact statistics on the number of scanners deployed in the rest of the world are not readily available, management estimates that the market is four times greater than the U.S. In addition to baggage scanners, airports worldwide are faced with replacing or supplementing existing metal detectors for passenger processing. Currently, there are limited standards within the aviation security marketplace for the testing and validation of software technology solutions. To date the marketplace has placed a premium on the newest innovations in hardware technology and has failed to grasp how a threat detection software solution can succeed. To date the marketplace has placed a premium on the newest innovations in hardware technology and has failed to grasp how a threat detection software solution can succeed. It was expected that a major joint initiative between the Department of Homeland Security (DHS) and the National Electrical Manufacturers Association (NEMA) would open a path to both increase the interoperability of security equipment as well as provide a mechanism to use third party threat detection software as part of the screening solution. This enabling initiative is the Digital Imaging and Communications in Security (DICOS) standard, similar to the Digital Imaging and Communications in Medicine (DICOM) standard. With a defined standard for the output of each screening device, complimentary automated threat detection software can be appended to any x-ray equipment. Applied Visual Sciences, Inc co-chaired one of the three NEMA working groups drafting the DICOS standard, and the DICOS standard was published in October 2010. To date DHS has not made this standard a mandatory requirement for proposals or procurements which, as a result, has not enabled third party detection software providers the ability to enter the marketplace which has given an undue advantage to the existing security equipment providers. As highlighted below, in a recent NEMA article, "DICOS - Homeland Security Spending Keeps on Growing" - Published by, U.S. government expenditure for security solutions is expected to increase. Management believes that Applied Visual Sciences, Inc. is positioned to be a third-party solution provider leveraging the standard output of all future security equipment procured by the US Government. NEMA stated "Global homeland security spending has received a major boost in light of recent international terrorist events, as countries look at new ways to thwart terrorists and secure borders. Spending in the industry is expected to triple to $178 billion by 2015. Security-related spending will include more sophisticated information technology and the protection of other vulnerable terrorist targets. With the initial focus on airport security, NEMA has stepped up its outreach to DHS and TSA. Currently developing DICOS, the new NEMA standard will capture scans of checked baggage so that scans can be read by threat detection software. The new standard is expected to facilitate interoperability of security-imaging equipment. With DHS/TSA expected to purchase new equipment for over 400 U.S. airports, NEMA members have joined with DHS to develop the standard. With Phase 1 of DICOS expected to be completed this year, NEMA has begun looking at other modalities. The security industry is looking at border, rail, seaport, industrial and nuclear plant security." Management believes that international market acceptance of PinPoint™ as a viable threat detection solution will not only enhance our ability to sell worldwide, but it will open additional opportunities for the development of PinPoint™ as the "intelligent image" analysis solution for areas such as military target acquisition, satellite remote sensing, and additional opportunities within aviation security such as people portals and cargo scanning. Additionally, we will seek support of the U.S. Congress and the equipment manufacturers through lobbying and other efforts. We continue the ongoing development of PinPoint™. This focus must be even sharper when we enter the pilot test arena where the duration of the pilot test, the conditions under which the pilot test is conducted, and the definition of success and failure will vary country-by-country. Information regarding the amount of the TSA's annual budget allocated for the purchase of software solutions that are able to detect threat items at U.S. airports and other similar facilities, such as PinPoint™, is not readily discernible from publicly available information or independent research reports. However, management estimates, based upon information derived from the FY 2006 and requested FY 2007 United States Department of Homeland Security (DHS) budget, that the DHS budget allocation for FY 2006 for software solutions that are able to detect threat items at U.S. airports and other facilities, such as PinPoint™, was approximately .77% of the DHS' $41.1B budget, and that the budget allocation for the proposed FY 2007 DHS budget will be approximately 2.25%. In addition, management estimates that the worldwide market for solutions such as PinPoint™ is estimated to be approximately twice the United States' Homeland Security budget. These estimates have been prepared by Applied Visual's management and reflect certain assumptions 46 of such management. There can be no assurance that these estimates are or will prove to be accurate or that budget allocations or these estimates may not change, based upon changes in government's budget priorities and other factors. In addition to the baggage screening market, management expects to target the following additional markets for PinPoint™. Further evaluation and market studies are required in order for a business plan to be developed and the assessment of development efforts necessary before entering the "People Portal" (whole body imagers) and "Cargo Scanning" markets. Whole Body Imagers Almost every threat that requires people screening is currently monitored by a different system (explosives, weapons, biological, chemical, and nuclear/radiological). Management believes that today's people screening systems deliver unacceptable performance (high 'false alarm' rates, slow processing throughput, continued dependence on human detection, and high transaction costs). Over a period of 10 years (2001-2010) the total U.S. annual people screening outlay is expected to grow to over 15 times its current size. Sales of $590 million in 2001 are forecasted to grow to $3.5 billion in 2006 and to $9.9 billion in 2010. The compound annual growth rate was expected to be over 50% for the 2003-2010 periods. Management believes that the market for people portals that utilize imaging as its detection methodology is a sub-set, and is estimated at 50% of the entire forecasted market of which management believes PinPoint™ can address. See HSRC report, "2003-2010 People Screening Weapon & Explosives Detection Market Report." It is management's belief that the current people portal technology fails to meet the post-9/11 requirements. It is management's belief that the technology will undergo dramatic technological changes when the multiple-threats "checkpoint of the future" is introduced. The accumulated U.S. investment in people screening during the 2003-2010 period is expected to be over $50 billion. During the 2006-2011 periods, over 80% of sales of people portal systems in the US are expected to be for technologies that were not in existence in 2003. Competition The competition between the manufacturers of baggage (hand-held and small parcel) screening, luggage and large parcel screening, people screening for weapons and explosives detection, container and vehicle screening, and cargo screening is intense. These same equipment manufacturers represent Applied Visual Sciences, Inc.'s major competition, and include: AS&E, Smiths-Detection, OSI Rapiscan and L3, each of which is better capitalized and has greater marketing and other resources than Applied Visual Sciences, Inc. The competition between manufacturers is intense in view of amounts appropriated by the U.S. Government for threat detection technologies. What is not so obvious is that the manufacturers that once held the largest share of installed base are at risk due to aging and inadequate technology. Due to the agnostic nature of PinPoint™, we believe we can integrate PinPoint™ with any manufacturer's scanning equipment. We believe our technology improves the efficiency of the underperforming hardware and extends the obsolescence of the existing scanning equipment. Funds previously appropriated for the upgrade or replacement of the in-place scanners could then be redeployed for the acquisition of required technologies such as body scanners or cargo scanners. The equipment manufacturers in conjunction with software companies and academic institutions are attempting to develop sophisticated solutions to aid in the detection of contraband substances. To date there has been no known solution developed. We believe that Applied Visual Sciences, Inc.'s approach is unique in that it is a non-intrusive adjunct to the current manufacturers' products. The enhancement identifies contraband at an accuracy level that is higher than the methodology used today by TSA. The market for contraband detection systems software is anticipated to become intensely competitive and is characterized by continuously developing technology and frequent introductions of new products and features. We expect competition to increase as other companies introduce additional and more competitive products in the aviation security market and as we develop additional capabilities and enhancements for PinPoint™ and new applications for our technology. Historically, the principal competitors in the market for explosive detection systems have been GE-InVision, Vivid Technologies, Inc., EG&G Astrophysics, Smiths-Detection, Thermedics Detection Inc., and Barringer Technologies Inc. Each of these competitors provides aviation security solutions and products for use in the inspection of checked and carry-on luggage. We expect certain major corporations competing in other markets to enter the aviation security market. Applied Visual Sciences, Inc. believes that its ability to compete in the aviation security market is based upon such factors as: product performance, functionality, quality and features; quality of customer support services, documentation and training; and the capability of the technology to appeal to broader applications beyond the inspection of checked and carry-on baggage. Although we believe that PinPoint™ is superior to our competitors' products in its detection capability and accuracy, PinPoint™ must also compete on the basis of price, throughput, and the ease of integration into existing baggage handling systems. Certain of our competitors may have an advantage over our existing technology with respect to these factors. Healthcare Technology Solutions - Signature Mapping™ 47 Market CAD vendors today have developed and sold clinical products in three major applications segments; mammography as a second look for the screening and early detection of breast cancer; chest CT for the early detection of nodules and CT of the colon for the non-endoscope screening of polyps. In 2006, an analyst at Frost & Sullivan stated "Early introduction of integrated CAD solutions is critical for gaining market share and may lead to higher profits…These new systems will enable workflow improvements while providing a smooth migration to the digital solution. This will increase the viability and broaden the appeal of these systems, and is likely to result in increased sales and revenues." These are new markets with new applications. The market is shifting towards CAD as physicians' confidence levels continue to grow. For example, the radiologist who uses CAD for Mammography (one of the most prevalent today) would most likely be very willing to trying new clinical applications. This is true for general radiologists and specialty radiologists. Frost and Sullivan studies published in 2006 estimated world wide radiology imaging procedures for all modalities at slightly a billion procedures per year and estimated that approximately 300 million to 350 million procedures were attributed to the USA. Frost & Sullivan projected CAD sales to reach $600 million by 2009 with a Compound Annual Growth Rate ("CAGR") of +18% by 2010. With replacement expected in full force in the two segments with the most demand by that point, namely, the breast MRI CAD segment and the mammography CAD segment, overall replacement in the total CAD market is expected to reach almost 50 percent of demand by 2012. With each new CAD technology introduced to the market, the potential size of this new market grows exponentially "Given the myriad of body parts and systems that CAD technology could be applied to in the future, as well as the different imaging modalities associated with each, growth in this market could be virtually unstoppable." Such as, new technology introduced for CT would be applicable to the brain, chest, neck, abdominal and other areas of the body; and new technology for Ultrasound would be applicable for the breast, liver, prostate and abdominal. Shalom S. Buchbinder, M.D., FACR, Chairman, Department of Radiology, Staten Island University Hospital, and Clinical Associate Professor of Radiology, Obstetrics, Gynecology and Women's Health, Albert-Einstein College of Medicine of Yeshiva University, New York, U.S.A. (Changing the Way Healthcare is Delivered, RSNA 2004, p89) states "This relatively new technology improves the decision making compatibilities of clinicians…In my opinion mammography CAD has proven its clinical value and the future is about more robust and sophisticated tools that can, in addition to detection, help in the analysis of lesions. Innovative technologies can provide valuable information to support lesion classification." Financial support to fight TB comes from multiple sources world leaders, public health officials and international donors have taken action against TB and financial resources for control and research have increased dramatically in recent years. Public-private partnerships like the Foundation for Innovative New Diagnostics ("FIND") have emerged to bring together key players in these sectors to move research and development forward for the needs of patients. Primarily, the government of each country is financially responsible for fighting TB with outside support of international organizations. Market Conditions Management's review of current market conditions has identified the following trends: · TB is becoming a worldwide epidemic · Automatic differentiation of TB bacilli is a very challenging issue · Currently no such CAD product exists · Steady adoption of digital microscopy · Need for higher throughput and continued cost reduction without sacrificing quality · CAD is evolving as a clinical tool and physicians are adopting it · Current graphics cards and computational processing power are sufficient · Retiring workforce and the current prediction that there will be a shortage of pathologists · Economic pressures and increasing clinical demands · Facilitates productivity gains with inclusion of CAD · Pathologist can performs diagnosis on digital images and monitor · PMA FDA approvals of digital pathology tests is increasing · Facilitates improved workflow efficiency and enhances patient management practices · Pathology lab is poised for digital revolution · Pressures on the anatomical pathology sciences will drive change · STOP TB has stated they want "effective, efficient and validated clinical algorithms" 48 Potential Market For New TB Diagnostics The persistent TB epidemic and expanding global population ensure that the total market for a range of TB diagnostic products is likely to increase yearly over the next decade by approximately 16%. The current international policy on TB case detection recommends the examination of three sputum smears for the diagnosis of pulmonary tuberculosis (PTB). The present definition of a smear-positive case states "Tuberculosis in a patient with at least two initial sputum smear examinations (direct smear microscopy) positive for acid fast bacilli (AFB+)". Worldwide, WHO estimates that the largest potential available market for a new TB diagnostic would be for a test that both detects latent infection and predicts progression to active disease (767 million patient evaluations/year). Such a test, if widely implemented and accompanied by successful treatment, has the potential to revolutionize TB control. The infrastructure to achieve this globally is not available at this moment. (See "Global Tuberculosis Control- surveillance, planning and financing," WHO Reports: 2005 through 2008.) The next largest total available market is for a point-of-care screening test, which is estimated to be 193 million patient's evaluations/year, of which approximately 70%, or 137 million patient's evaluations/year is concentrated in the 22 high-burden countries. Substantial markets also exist for less revolutionary replacement technologies. Specifically, the total available markets for smear, culture, and monitoring and DST replacement tests are 83 million, 57 million, 40 million, and 6 million patient evaluations, respectively in 2005. We estimate that replacement technologies could capture a greater proportion of the market by 2020: smear 59% (49 million), culture 35% (20 million), monitoring 58% (23 million) and DST 45% (3 million). Without exception, between 70%-90% of the potential available markets for these replacement technologies are in the 22 high-burden countries. The continued emphasis on improving market conditions will encourage market growth in the high-burden countries and increase the accessibility to new products. (See "Global Tuberculosis Control - surveillance, planning and financing," WHO Report 2008.) Competition We expect to compete with existing CAD manufactures such as iCAD, Hologic, Medipatten, Confirma, Siemens, or Carestream Health and manufacturers of dipstick or biomarker manufacturers, including SPAN Diagnostics Ltd., India, Yayasan Hati Sehat (YHS), Indonesia and Wiener Laboratorios, Argentina. We may also partner with one or more of these existing CAD manufacturers, or an emerging company with new technology for the CAD arena. Once our products are commercially viable, we anticipate marketing and selling our products through original equipment manufacturers ("OEM"), or system integrators. While we are unaware of any computer-aided-detection for TB sputum microscopy analysis that can be identified that competes with our Signature Mapping™ products, there are substitute technologies that compete with sputum specimen analysis, such as the Cepheid Systems GeneXpert® System, a dip-stick or biomarker approach. Management believes that competition will be driven by cost per procedure, ease-of-use, sensitivity and specificity, and the ability to be used by non-trained or lightly trained personnel in the point of care environment. These emerging tests include: Polymerase Chain Reaction, TB Breathalyzer, Q-Beta Replicase Assay, Transcription-Medicated Amplification, Ligase Chain Reaction, Strand Displacement Amplification, Nucleic Acid Sequence-Based Amplification and Branched DNA. Sales, Marketing, and Distribution Sales Sales for products within our specific markets are conducted through both direct sales and indirect distribution channels worldwide. Product Distribution and Marketing We have entered into the following distributor, strategic partnership, development, and consulting agreements with regard to our products: Preferred International Distributor Agreement with Rodash 136 (Pty) Ltd, of South Africa On May 25, 2010, the Company and Rodash 136 (Pty) Ltd, of South Africa, entered into a Preferred International Distributor Agreement. Under the agreement, Rodash has agreed to promote the licensing and distribution of Applied Visual Sciences' PinPoint™ suite of software. Rodash will also provide support to licensees of the products. The three year agreement provides for automatic successive one year renewal periods, unless either party provides written notice to the other of its intention to terminate or to re-negotiate the agreement no less then one hundred and twenty days prior to the end of the then-current period. The Company appointed Rodash as the exclusive distributor for such products in Africa, Brazil, Argentina, Indonesia and Australia, although the agreement permits Applied 49 Visual Sciences to enter into business relationships with original equipment manufactures for the licensing, distribution, or resale of PinPoint™ products. Preferred International Distributor Agreement Romador 168 (Pty) Ltd, of South Africa On May 25, 2010, the Company and Romador 168 (Pty) Ltd, of South Africa, entered into a Preferred International Distributor Agreement. Under the agreement, Romador has agreed to promote the licensing and distribution of Applied Visual Sciences' Signature Mapping™ suite of software. Romador will also provide support to licensees of the products. The three year agreement provides for automatic successive one year renewal periods, unless either party provides written notice to the other of its intention to terminate or to re-negotiate the agreement no less then one hundred and twenty days prior to the then-current period. The Company appointed Romador as the exclusive distributor for such products in Africa, Brazil, Argentina, Indonesia and Australia, although the agreement permits Applied Visual Sciences to enter into business relationships with original equipment manufactures for the licensing, distribution, or resale of Signature Mapping™ products. Memorandum of Understanding with Aurum Innova (Pty) Limited and the National Health Laboratory Services of South Africa On March 24, 2009, Applied Visual Sciences, Inc. signed a Memorandum of Understanding ("MOU") with Aurum Innova (Pty) Limited ("Innova") and the National Health Laboratory Services of South Africa ("NHLS"). The purpose of the agreement is for the parties to jointly undertake activities for the completion of our Signature Mapping™ Tuberculosis ("TBDx™") product for deployment in the NHLS laboratories. The parties will collaborate to enhance TBDx™'s overall performance, customize its use for application in the National Health Laboratory Services tuberculosis diagnosis and quality management program, and clinically evaluate, measure, and test TBDx™ performance. The collaboration includes conducting the clinical evaluation at selected NHLS laboratories that conduct sputum slide tuberculosis analysis and diagnosis. Master Development Agreement with Aurum Innova (Pty), Ltd. On February 4, 2009, Applied Visual Sciences, Inc. signed a Master Development Agreement Aurum Innova (Pty), Ltd., a company related to the Aurum Institute for Health Research, and installed in February 2009 an alpha product of Signature Mapping™ tuberculosis ("TBDx™") software in a "retrofit configuration" for an evaluation by the National Health Laboratory Services ("NHLS") in South Africa. This agreement extends the Company's contractual relationship with Aurum that was first established with the signing of a Memorandum of Understanding on July 25, 2008. The new agreement provides for the joint development of products and services aimed at the screening, early detection and staging of diseases including TB, silicosis, and malaria. Each product will be the subject of a separate project specifications and the MDA included project specifications for our joint development of an automated TB sputum detection product. Aurum has agreed to clinically evaluate the products, and the parties agreed to jointly market and sell, initially in South Africa but eventually in sub-Saharan Africa, the jointly developed products, including our Signature Mapping™ TBDx™ product, through third parties and/or through Aurum. The Company agreed to pay Aurum a royalty on a product by products basis, based on the net revenue received by us through our distributors, and to be delineated by the parties. Also, the Company agreed to pay Aurum a commission with regard to sales of the products by Aurum. Further, Aurum has agreed to use every reasonable effort to raise funding to complete the development of a product following completion of the initial proof of concept. Any intellectual property jointly developed by us and Aurum will be jointly owned. The agreement may be terminated on one year's prior written notice by either party, automatically terminates upon completion of project specifications and if no products are being marketed under the agreement, or for cause. The agreement also contains certain confidentiality and indemnification provisions. Breast Cancer Detection: BCDx™ Our research to-date includes five programs and studies conducted under the direction of the Image Processing and Informatics Laboratory at the University of Southern California ("USC") using clinical data and images provided by: the Image Processing and Informatics Laboratory at USC, Howard University, and the South Florida Clinical Mammography Data Base. Competition is expected with existing computer-aided-detection ("CAD") manufactures such as iCAD, Hologic, Medipatten, Confirma, Siemens, or Carestream Health. We may partner with one or more of these existing CAD manufacturers, or with an emerging company with new technology for the CAD arena. Once our products are commercially viable, we anticipate marketing and selling our products through original equipment manufacturers ("OEM"), or system integrators. The Disease Breast cancer is the second leading cause of cancer deaths in women (after lung cancer) and is the most common cancer among women, excluding skin cancers, accounting for 1 of every 3 cancers diagnosed. The lifetime probability of developing invasive breast cancer is approximately 1 in 8 (12%). Annual estimates from the American Cancer Society (ACS) indicate that 1.5 million women will 50 develop breast cancer worldwide and 460,000 will die from the disease. In the U.S. the mortality rate is about 1 in 35 women. Ineffective workflow, poor communications and decision-support tools cost over $8.5 billion per year. Breast imaging procedures About 35 million screening exams Biopsy procedures About 1.5 million biopsies conducted 12% - 15% of biopsies are positive 168,000 detected cancers Mortality rate About 40,950 women Biopsy per procedure cost $1,000 - $3,000 dollars Annual gross national biopsy cost $1.5 - $4.5 billion dollars A 10% reduction in biopsies would save $150 - $500 million dollars approximately Source: NIH, Annual breast exams in the U.S. 2011. Detection Early detection is a critical factor for controlling survival. Early detection provides increased therapeutic options and improved probability of survival. Mammography is a reliable and cost-effective screening technology. When properly conducted, mammography has been estimated to reduce breast cancer mortality by 20-30%. Currently, ductal carcinoma-in-situ (DCIS) represents 25%-30% of all reported breast cancers. Approximately 95% of all DCIS are diagnosed because radiologists identify them in mammograms. However, reading mammograms is difficult and prone to misinterpretation, subjectivity, and misreads. Studies have found that screening x-ray exams are about 80% accurate at best and that lesions are simply not detected 10% to 15% of the time. The National Cancer Institute reported that 25% of breast tumors are missed in women in their forties. (See Liu B, Z. M., Document J (2005, "Utilizing data grid architecture for the backup and recovery of clinical image data." Comput Med Imaging Graph. 29(2-3): 95-102, and National Cancer Institute, "Cancer in African American Women.") Dense breasts pose a greater challenge to cancer detection using mammograms, especially early-stage breast cancers. Approximately 25% of women have dense breasts; thus a large number of mammograms, especially in AAW, are more difficult to clinically interpret. The risk of breast cancer associated with the highest category of density is estimated to be two to six times greater than for women with the lowest category of breast density. Clinical Value of Signature Mapping™ On the basis of our initial studies, the signatures of malignant tumors in mammograms exhibit significant differences when compared with cysts, benign lesions, or dense breast tissue after being processed with Signature Mapping™. Measurable differences exist among different breast structures in both the spatial and frequency domains. Signatures of different tissues vary in their entropy, linearity, boundary gradients, and homogeneity. As a result, the internal structure of masses in dense breast tissue can be characterized and identified and displayed radiographically to the clinician. Signature Mapping™ is expected to visually display levels within the tumor and distortions in the breast geometry outside the tumor. The effectiveness of these algorithms was evaluated through a pilot study conducted with the Norris Cancer Center at the University of Southern California. The study consisted of two sets of mammographic cases, a training set and a testing set. Both sets contained 40 normal and 40 confirmed solid cancer masses and were matched for levels of interpretation difficulty and patient age, variations in breast density, and types of tumors. Applied Visual used the training set for the development of its algorithms and for training the participating radiologists in the study. The test set was used in the pilot study to gain clinical feedback and determine the effectiveness of the radiologist's interpretations using Signature Mapping™. Preliminary clinical results based on the visual performance of five highly-skilled and experienced mammographers using the mammography-specific Signature Mapping™ process demonstrated improved accuracy and ease of use in the study. Clustered micro-calcifications may be the only visually detectable manifestation of early breast cancer. Mammography is very responsive to the presence of micro-calcifications, however, the specificity of mammography remains low. Benign calcifications cannot always be distinguished from those indicating malignancy resulting in a large population of women who do not have cancer, but are subjected to biopsy. Using Signature Mapping™ we expect that the miniscule structures within micro-calcifications can be characterized and their potential for pathology identified by the radiologists. While carcinomas are rarely found in cysts, they are difficult to accurately diagnose through the use of mammography because they cannot be distinguished from other well circumscribed solid masses unless they display several characteristic patterns of 51 calcification. Applied Visual is optimizing Signature Mapping™ for the accurate characterization of cysts as part of ongoing development that includes an early-onset cancer detection model. LIQUIDITY AND CAPITAL RESOURCES The following table presents a summary of our net cash provided by (used in) operating, investing and financing activities: Year Ended December 31 Category 2012 2011 Net cash (used) in operating activities $ (223,220) $ (686,287) Net cash provided (used) in investing activities 35,175 (27,997) Net cash provided by financing activities 185,000 715,900 Effect of exchange rates on cash and cash equivalents - - Net increase (decrease) in cash $ (3,045) $ 1,616 Net Cash Used in Operations Net cash used in operating activities for the fiscal year ended December 31, 2012, was $223,220, compared with net cash used in operating activities of $686,287 during the same period for 2011, or a decrease in the use of cash for operating activities of $463,067 (67.5%). The decrease in the use of cash is due to: (i) lower operating costs of $559,159 (25.4%), including but not limited to a decrease in revenue of $6,589 (100.0%), decreases in selling, general and administrative costs (other than depreciation and amortization, and stock based compensation) of $621,379 (28.3%), and an increase in net non-operating expense (other than noncash items) of $55,631 (635.7%); and (ii) offset by a net decrease in components of operating assets and liabilities of $96,092 (6.4%). Net Cash Used in Investing Activities Net cash provided in investing activities of $35,175 was for the net purchase of equipment and costs for patent applications for the year ended December 31, 2012. This compares with net cash used for the same activities of $27,997 for same period for 2011, or an increase in cash provided of $63,172, or 225.6%. The net increase is comprised of proceeds from the sale of furniture of $35,650, lower equipment costs for the TBDx™ project of 5,970 (100.0%), and an decrease in patent costs of $21,552 (97.8%). The Company anticipates it will continue to incur equipment costs during the fiscal year ending December 31, 2013, as we design add-on features that extend our current products into other areas, and ongoing patent costs related to further protection of our PinPoint™ and Signature Mapping™ products. Net Cash Provided by Financing Activities Net proceeds from financing activities were $185,000 for the year ended December 31, 2012, compared with $715,900 for the same period in 2011, or a decrease of $530,900 (74.2%). Of the 2012 net proceeds from financing activities, $25,000 (13.5%) was from the issuance of a new equity financing, and $160,000 (86.5%) from the issuance of short-term promissory note. The decrease in the net cash provided by financing activities is due to (i), a decrease of $319,000 (92.7%) from the issuance of new equity financings, (ii) a decrease in funds of $240,000 (60.0%) from issuance of short-term notes payable, and (iii) a decrease in use of funds of $28,100 to reduce short-term note payable to an executive of the Company in 2011. Management is seeking, and expects to continue to seek to raise additional capital through equity or debt financings or bank borrowings, including through one or more equity or debt financings or bank borrowings to fund its operations, repay or repurchase its debentures, and pay amounts due to its creditors and employees. However, there can be no assurance that the Company will be able to raise such additional equity or debt financing or obtain such bank borrowings on terms satisfactory to the Company or at all. Cash and Cash Equivalents Our cash and cash equivalents decreased during fiscal year ended December 31, 2012 by $3,045, compared to an increase in cash and cash equivalents during the same period in 2011 of $1,616. As outlined above, the decrease in cash and cash equivalents for the current period was the result of; (i) cash used in operating activities of $223,220, (ii) cash provided by investing activities for equipment and patent costs of $35,175, and (iii) cash from financing activities of $185,000. The net change in cash and cash equivalents for the twelve months ended December 31, 2012, as compared to the same period in 2011, was $4,661 (288.4%), and is the result of (i) a decrease in cash used in operating activities of $463,067 (67.5%), (ii) an increase in cash from the net sale of equipment and patent costs incurred of $63,172 (225.6%), and (iii) an offset by a reduction of $530,900 (74.2%) from financing activities. 52 Working Capital Information - The following table presents a summary of our working capital at the end of each fiscal year: As of December 31 Category 2012 2011 Cash and cash equivalents $ 3,445 $ 6,490 Current assets 4,560 9,100 Current liabilities 11,698,331 10,432,552 Working capital (deficit) $ (11,693,771) $ (10,423,452) As of December 31, 2012, the Company had cash and cash equivalents of $3,445, compared to $6,490 on December 31, 2011, or a decrease in cash and cash equivalents of $3,045 (46.9%). The decrease in cash is the net result of our operating, investing and financing activities outlined above. At December 31, 2012, we had a working capital deficit of $11,693,771, compared with a working capital deficit at December 31, 2011 of $10,423,452, or an increase in working capital deficit of $1,270,219 (12.2%). For 2012, overall current assets decreased $4,540 (49.9%), including (i) a decrease in cash and cash equivalents of $3,045 (46.9%), and (ii) a decrease in prepaid expenses of $1,495 (57.3%). Current liabilities increased $1,265,779 (12.1%), with specific decreases in liabilities of $337,545, including: (i) $170,017 for conversion of accrued wages for stock, (ii) $100,000 for conversion of accounts payable for stock, and (iii) $67,528 for the reduction of derivative liabilities due to the revaluation of the beneficial conversion feature of the outstanding debentures, and specific increases in current liabilities of $1,603,324, including: (i) $64,382 in accrued interest, (ii) $314,235 trade and accrued payables, (iii) $188,291 short-term notes payable, net of discounts, and (iv) $1,036,416 for the continued accrual of unpaid wages and related expenses for all employees. Our revenue generating activities during the period, as in previous years, have not produced sufficient funds for profitable operations, and we have incurred operating losses since inception. Accordingly, we have continued to utilize the cash raised in our financing activities to fund our operations. In addition to raising cash through additional financing activities, we may supplement our future working capital needs through the extension of trade payables and increases in accrued expenses. In view of these matters, realization of certain of the assets in the accompanying balance sheet is dependent upon our continued operations, which in turn is dependent upon our ability to meet our financial requirements, raise additional financing, and the success of our future operations. Other Liabilities 2012 Short-Term Promissory Notes During 2012, the Company issued six promissory notes to accredited investors in the aggregate principal amount of $160,000. The notes, as amended, mature on June 30, 2013. The notes accrue interest at a rate of 12% per annum. The Company also issued to the note holders an aggregate of 285,000 shares of common stock. The relative fair value of the common stock of $11,715 will be amortized over the term of the notes. The Company also issued 10,800 shares of common stock as compensation in connection with the financing for a fair value of $2,700. 2011 Short-Term Promissory Notes During the October and November 2011, the Company issued twelve-month promissory notes to accredited investors in the aggregate principal amount of $400,000. The twelve-month notes accrue interest at a rate of 12% per annum. The Company also issued to the two note holders an aggregate of 400,000 shares of common stock. The relative fair value of the common stock of $34,700 will be amortized over the term of the notes. The Company also issued 250,000 shares of common stock as compensation in connection with the financing for a fair value of $25,000. 2011 Securities Purchase Agreement On February 23, 2011, the Company entered into a Securities Purchase Agreement (the "SPA") with an institutional accredited investor for an investment up to $1,000,000, subject to certain stock price and volume conditions. Subsequently on February 24, 2011, we sold to the institutional investor at the first closing of the private placement of securities, an aggregate of 600,000 shares of common stock, and 600,000 common stock purchase warrants to purchase an aggregate of 600,000 shares of common stock, for gross proceeds of $150,000 ($136,000 net of certain expenses and sales commissions in the amount of $14,000). The warrants are exercisable at a price of $0.25 per share for a period of five years after the date of issuance, contain a cashless exercise provision and other customary provisions. Also, we issued to a broker an aggregate of 72,000 placement agent's warrants as compensation in connection with the offering. The placement agent's warrants are under the same terms and conditions as those issued to the institutional investor. 53 In addition, under the SPA, the investor has agreed to provide additional financing to us by purchasing shares of our common stock at seven subsequent closings and subject to certain share price and volume requirements. However, the seven subsequent closings scheduled during March through September 2011, did not take place since the stock price and volume conditions were not met. We granted to the investor piggy back registration right with regard to the shares issued in the financing, including the shares underlying the Warrants. The SPA contains representations and warranties of the Company and investor, certain indemnification provisions and customary conditions to each closing. We may terminate the SPA on ten days prior written notice to the investor, and the investor may terminate the SPA at any time prior to a subsequent financing upon written notice to us if we consummate a reverse stock split or a subsequent financing to which the investor is not a party. We agreed to pay the investor's counsel with regard to the first closing in the amount of $25,000, $5,000 of which was paid at the first closing and $5,000 was to be paid at each of the first four subsequent closings. As mentioned above, the subsequent closings did not take place and the Company did not pay the four additional $5,000 payments to the investor's counsel. We also agreed to pay additional fees for their counsel for each subsequent closing in the amount of $2,500. A broker acted as placement agent for the offering. Under the terms of a Non-Circumvention and Compensation Agreement, dated January 12, 2011, between the Company and the broker, in connection with the offering, we agreed to pay or issue the broker at each subsequent closing a placement fee equal to 6% of the proceeds received by us at each closing and placement agent's warrants equal to 6% of the shares sold at the closing (including the shares underlying the Warrants). 2006 through 2011 Short-Term Promissory Notes, Related Party On April 21, 2006, the Company entered into a Loan Agreement with Mr. Michael W. Trudnak, our Chairman and Chief Executive Officer pursuant to which Mr. Trudnak loaned the Company $200,000. The Company issued a non-negotiable promissory note, dated effective April 21, 2006, to Mr. Trudnak in the principal amount of $200,000. The note is unsecured, non-negotiable and non-interest bearing. The note is repayable on the earlier of (i) six months after the date of issuance, (ii) the date the Company receives aggregate proceeds from the sale of its securities after the date of the issuance of the Note in an amount exceeding $2,000,000, or (iii) the occurrence of an event of default. The following constitute an event of default under the note: (a) the failure to pay when due any principal or interest or other liability under the loan agreement or under the note; (b) the material violation by us of any representation, warranty, covenant or agreement contained in the loan agreement, the note or any other loan document or any other document or agreement to which the Company is a party to or by which the Company or any of our properties, assets or outstanding securities are bound; (c) any event or circumstance shall occur that, in the reasonable opinion of the lender, has had or could reasonably be expected to have a material adverse effect; (d) an assignment for the benefit of our creditors; (e) the application for the appointment of a receiver or liquidator for us or our property; (f) the issuance of an attachment or the entry of a judgment against us in excess of $100,000; (g) a default with respect to any other obligation due to the lender; or (h) any voluntary or involuntary petition in bankruptcy or any petition for relief under the federal bankruptcy code or any other state or federal law for the relief of debtors by or with respect to us, provided however with respect to an involuntary petition in bankruptcy, such petition has not been dismissed within 30 days of the date of such petition. In the event of the occurrence of an event of default, the loan agreement and note shall be in default immediately and without notice, and the unpaid principal amount of the loan shall, at the option of the lender, become immediately due and payable in full. The Company agreed to pay the reasonable costs of collection and enforcement, including reasonable attorneys' fees and interest from the date of default at the rate of 18% per annum. The note is not assignable by Mr. Trudnak without our prior consent. The Company may prepay the note in whole or in part upon ten days notice. On October 21, 2006, Mr. Trudnak extended the due date of the loan to December 31, 2006. Subsequently, on October 3 and October 18, 2006, Mr. Trudnak loaned the Company $102,000 and $100,000, respectively, on substantially the same terms as the April 21, 2006 loan, except that each loan is due six months after the date thereof. Accordingly, following such additional loans, the Company owed an aggregate of approximately $402,000 to Mr. Trudnak. On November 10, 2006, Mr. Trudnak extended the due dates of such loans to May 31, 2007, except that $100,000 of the April 21, 2006, loan becomes due upon the Company raising $2,500,000 in financing after November 6, 2006, and the remaining amount of $202,000 of such loans become due upon the Company raising an aggregate of $5,000,000 in financing after November 6, 2006, and prior to May 31, 2007. Following the first closing of our Debenture and Series D Warrant financing on November 8, 2006, the Company repaid $100,000 on November 20, 2006, in principal amount of the April 1, 2006 loan, and paid an additional $100,000 to Mr. Trudnak on April 17, 2007 upon the second closing of our Debenture and Series D Warrant financing. On May 31, 2007, Mr. Trudnak extended the due dates of the remaining loans to May 31, 2008. Although, the anticipated payment of $202,000 had not been made, and Mr. Trudnak made an additional $24,000 loan to the company on June 25, 2008, and $5,000 on September 14, 2011, for cumulative loans of $231,000. The maturity date of the outstanding loans was extended to May 31, 2009, then to May 31, 2010 and June 30, 2011, and subsequently to December 31, 2011. On December 31, 2011, the outstanding loans were extended to June 30, 2012, then to December 30, 2012, and subsequently to June 30, 2013. The Company repaid an aggregate of $108,900 of the notes during 2010, and repaid an aggregate $33,100 during 2011, resulting in an outstanding balance at December 31, 2012 of $89,000. The terms of the above transaction were reviewed and approved by the Company's audit committee and by the independent members of our Board of Directors. 2006 and 2007 Series A Debentures (as Amended on October 15, 2010) and Series D Common Stock Purchase Warrants 54 Under a securities purchase agreement, dated November 3, 2006, between the Company and certain institutional accredited investors, the Company sold an aggregate of $5,150,000 in principal amount of our Series A Debentures and Series D Common Stock Purchase Warrants to purchase an aggregate of 4,453,709 shares of our common stock. On November 8, 2006, the Company issued to the institutional investors an aggregate of $2,575,000 in principal amount of Series A Debentures and 4,453,709 Series D Warrants. On April 12, 2007, the Company issued an additional $2,575,000 in principal amount of the Series A Debentures, which followed the effectiveness of a registration statement registering the shares of our common stock underlying the Series A Debentures and Series D Warrants. Proceeds of the two offerings were used for the purpose of new personnel, research and development, registration expenses, for general working capital purposes, and repaying $200,000 in loans made to us by Mr. Michael W. Trudnak, our Chairman and CEO. The Company allocated proceeds from each closing to the embedded conversion features of the Series A Debentures and Series D Warrants that were recognizable as a liability under generally accepted accounting principles. We also issued at the first closing an aggregate of 623,520 common stock purchase warrants to the placement agent as compensation in the offering, which were upon terms substantially similar to the Series D Warrants. One-half of the Series D Warrants (2,226,854 warrants) and the placement agent warrants (311,760 warrants) became exercisable on November 8, 2006. The remaining one-half of the Series D Warrants (2,226,855 warrants) and the placement agent warrants (311,760 warrants) became exercisable on April 12, 2007. The Series D Warrants and the placement agent's warrants may be exercised via a cashless exercise if certain conditions are met. Due to milestone-related adjustments, the initial exercise price of $1.15634 may be reset and the maximum number of shares to be issued under the debentures was indeterminable as of December 31, 2007. The Company considered ASC 815-40 (formerly EITF 00-19, relating to the provisions for Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock), and concluded that there were insufficient shares to share settle the contracts. On April 1, 2007, due to the milestone-related provisions, the conversion price of the Series A Debentures and the exercise price of the Series D Warrants and Placement Agent's Warrants were reset to a price $0.7453 per share, to $0.6948 effective October 1, 2007, and the final milestone reset of $0.4089 effective April 1, 2008. As a result of a June 2009 financing in which the Company issued shares of common stock and warrants, the conversion price of our debentures and the exercise price of the Series D Warrants was adjusted under the anti-dilution provisions of such instruments to a price of $0.25 per share, and the number of shares underlying the Series D Warrants (including the warrants the Company issued to the placement agent in the financing) were increased by an aggregate of 2,677,417 Series D warrants. On July 10, 2007, a debenture holder exercised 864,798 Series D Warrants for 864,798 shares of common stock, and 914,798 warrants were exercised during 2010 under the cashless provision for 420,166 shares of common stock. Of the remaining Series D Warrants and Placement Agent Warrants, 3,062,527 warrants expired on November 11, 2011, and 3,012,523 warrants expired on April 12, 2012. As of December 31, 2012, an aggregate of $3,461,795 in principal amount of the Series A Debentures have been converted into 8,730,037 shares of common stock, an aggregate of $663,043 in interest amount have been converted into 2,675,576 shares of common stock, and an aggregate of 1,779,596 Series D Warrants have been exercised resulting in the issuance of 1,284,964 shares of common stock. Accordingly, as of December 31, 2012, an aggregate of $1,688,205 of principal amount of the debentures remain unconverted. Our outstanding Series A 10% Convertible Debentures originally became due on November 7, 2008. On October 15, 2010, we entered into an agreement with our two remaining Series A Debenture holders to amend and effect a restructuring of the debentures that originally became due on November 7, 2008. Under the amendment agreement, the Company and two debenture holders agreed: (i) to an extension of the maturity date of the debentures to June 30, 2011, (ii) that the $1,688,205 of outstanding principal amount will not bear interest from July 1, 2010 through the new maturity date, (iii) that, in exchange for the payment in cash of amounts of accrued but unpaid regular interest of approximately $638,163, and waived all additional interest and late fees, liquidated damages and certain other amounts due under the debentures ("Interest and Default Amounts") the Company issued an aggregate of 2,552,653 shares of common stock, (iv) that all claims with regard to the payment of the Interest and Default Amounts and all prior events of default under the Debentures and breaches of any covenant, agreement, term or condition ("Defaults") under our debentures and debenture transaction documents would be waived and the Company was released from any claims with respect to the Additional Interest and Late Fees of approximately $773,314, and Default Amounts of approximately $2,541,739, and prior Defaults Events, (v) to terminate the registration rights agreements between the Company and each debenture holder, and (vi) that the Company may force a conversion of the debentures if our common stock equals or exceeds certain price and volume conditions. There were no conversions of our debentures during 2012. Under the Debenture amendment agreement, the Debenture holders agreed, commencing March 3, 2011, that the Company may force a conversion of the Debentures. Such a forced conversion may only be effected once every 90 days and the ability of the Company to force any such conversion is subject to certain equity conditions, which conditions were amended under the terms of the Debenture Amendment Agreement in accordance with the following: · if the variable weighted average price for the Company's common stock ("VWAP") for any five consecutive trading days exceeds $0.50 and the average daily dollar trading volume for the Company's common stock during such period equals or exceeds $50,000, the Company may require a Holder to convert up to 25% of the outstanding principal amount of its Debenture on September 3, 2010, plus any liquidated damages or other amounts owing under the Debenture; 55 · if the VWAP for any five consecutive trading days exceeds $0.75 and the average daily dollar trading volume for the common stock during such period equals or exceeds $75,000, the Company may require a Holder to convert up to an additional 25% of the outstanding principal amount of its Debenture on September 3, 2010, plus any liquidated damages or other amounts owing under the Debenture; · if the VWAP for any five consecutive trading days exceeds $1.00 and the average daily dollar trading volume for the common stock during such period equals or exceeds $100,000, the Company may require a Holder to convert up to 100% of the outstanding principal amount of its Debenture on September 3, 2010, plus any liquidated damages or other amounts owing under the Debenture. The principal amount of our outstanding Series A Debentures of $1,688,205 became due on July 1, 2011, and such amount was not paid. Therefore, the Company may be considered in default. The debentures provide that any default in the payment of principal, which default is not cured within the five trading days of the receipt of notice of such default or ten trading days after the Company becomes aware of such default, will be deemed an event of default and may result in enforcement of the debenture holders' rights and remedies under the debentures and applicable law. We are in discussions with the debenture holders to re-negotiate the terms of the debentures, including the repayment or repurchase of the debentures and/or seek to extend their maturity date, although we have not reached any agreement with the debenture holders with regard to any such repayment, repurchase or extension. Our ability to repay or repurchase the debentures is contingent upon our ability to raise additional financing, of which there can be no assurance. Also, as a condition to any such extension, debenture holders may seek to amend or modify certain other terms of the debentures. If an event of default occurs under the debentures, the debenture holders may elect to require us to make immediate repayment of the mandatory default amount, which equals the sum of (i) the greater of either (a) 120% of the outstanding principal amount of the debentures, or (b) the outstanding principal amount unpaid divided by the conversion price on the date the mandatory default amount is either (1) demanded or otherwise due or (2) paid in full, whichever has the lower conversion price, multiplied by the variable weighted average price of the common stock on the date the mandatory default amount is either demanded or otherwise due, whichever has the higher variable weighted average price, and (ii) all other amounts, costs, expenses, and liquidated damages due under the debentures. In anticipation of such election by the debenture holders, due to the nonpayment of principal amount on the due date of July 1, 2011, we measured the mandatory default at approximately $337,641 and subsequently on each balance sheet date, which is reflected in the carrying value of the debentures and also recognized as interest expense. We remeasured the mandatory default amount as of December 31, 2012 at approximately $337,641. As of the date of this report, the debenture holders have not made an election requiring immediate repayment of the mandatory amount, although there can be no assurance they will not do so. The Company currently has insufficient funds to repay the outstanding amount in the event the debenture holders make a demand for payment. Prior to the Debenture amendment agreement and absent a default, the Debentures bore interest at the rate of 10% per annum. The Debenture agreement, as amended on October 15, 2010, continues to permit the payment of interest due under the Debentures in cash or registered shares of our common stock. If we elected to pay the interest due in shares of our common stock, the number of shares to be issued in payment of interest is determined on the basis of 85% of the lesser of the daily volume weighted average price of our common stock as reported by Bloomberg LP ("VWAP") for the five trading days ending on the date that is immediately prior to (a) date the interest is due or (b) the date such shares are issued and delivered to the holder. We could pay interest in shares of our common stock only if the equity conditions, described below, have been met during the 20 consecutive trading days prior to the date the interest is due and through the date the shares are issued. The payment of interest in shares of our stock, the redemption of the Debentures and the occurrence of certain other events, was subject to a requirement that certain equity conditions ("equity conditions") were met, as follows: (i) we have honored all conversions and redemptions of a Debenture by the holder, (ii) we have paid all liquidated damages and other amounts due to the holder, (iii) the registration statement covering the resale of the shares underlying the Debentures and Series D Warrants is effective permitting a holder to utilize the registration statement to resell its shares, (iv) our stock is traded on the OTC Bulletin Board or other securities exchange and all of the shares upon conversion or exercise of the Debentures and Series D Warrants are listed for trading, (v) we have sufficient authorized but unreserved shares of our common stock to cover the issuance of the shares upon conversion or exercise of the Debentures and Series D Warrants, (vi) there is no event of default under the Debentures, (vii) the issuance of the shares would not violate a holder's 4.99% or 9.99% ownership restriction cap, (viii) we have not made a public announcement of a pending merger, sale of all of our assets or similar transaction or a transaction in which a greater than 50% change in control of the Company may occur and the transaction has not been consummated, (ix) the holder is not in possession of material public information regarding us, and (x) the daily trading volume of our shares for 20 consecutive trading days prior to the applicable date exceeds 100,000 shares. Under the terms of the Debenture Amendment Agreement, (A) the equity condition in (iii) above was amended to provide that such condition is met if, in the alternative, the shares issuable upon conversion of the Debentures may then be resold pursuant to Rule 144 without restriction or limitation and the Company has delivered to a holder an opinion of the Company's counsel that such resale may legally be made and provided the holder has furnished a representation letter reasonable acceptable to the Company's counsel that the holder is not an "affiliate" for purposes of Rule 144; (B) the equity condition in (vi) above was amended to except an event of default that has previously been waived; and (C) the equity condition in (x) above was amended to except circumstances where another volume condition is applicable. 56 The Debentures contain a limitation on the amount of Debenture that may be converted at any one time in the event the holder owns beneficially more than 4.99% of our common stock without regard to the number of shares underlying the unconverted portion of the Debenture. This limitation may be waived upon 61 days' notice to us by the holder of the Debenture permitting the holder to change such limitation to 9.99%. An event of default may occur under the Debentures if (a) the Company defaults in the payment of principal or, liquidated damages , (b) the Company fails to materially observe or perform a covenant or agreement in the Debentures, (c) a default or event of default occurs under any other transaction document related to the financing or in any other material agreement to which the Company is a party that results in a material adverse effect on the Company, (d) any representation or warranty the Company made to investors in the transaction documents related to the financing is materially untrue or incorrect, (e) a bankruptcy event occurs with regard to the Company, (f) the Company defaults on any other loan, mortgage, or credit arrangement that involves an amount greater than $150,000 and results in the obligation becoming declared due prior to the due date, (g) the Company's common stock is not eligible for quotation on the OTC Bulletin Board or other exchange on which the Company's shares are traded, (h) a transaction occurs in which the control of the Company changes, the Company effects a merger or consolidation, the Company sells substantially all of the assets, a tender offer is made for the Company's shares, the Company reclassify their shares or a compulsory share exchange, or the Company agrees to sell more than 33% of the assets, unless the Company receives the consent of holders of 67% of then outstanding principal of the Company's Debentures, (i) the Company fails to deliver certificates for shares to be issued on conversion within seven trading days, (j) the Company has a judgment against it for more than $150,000. We have agreed to compensate a holder of a Debenture in the event our transfer agent fails to deliver shares upon conversion of the Debentures within three trading days of the date of conversion, and the holder's broker is required to purchase shares of our common stock in satisfaction of a sale by a holder. As outlined above, the Series D Warrants and placement agent warrants were exercisable at the same price as the conversion price of the debentures. If certain milestones are not met, the exercise price of such warrants may be reset. Also, the exercise price may be adjusted under anti-dilution and other price reset provisions contained in the warrants. The warrants initial exercise price of $1.15634 was reset to $0.7453 on April 1, 2007, due to the milestone-related provisions, to $0.6948 effective October 1, 2007, and the final milestone reset of $0.4089 effective April 1, 2008. As a result of a June 2009 financing, in which the Company issued shares of common stock and warrants below the then current exercise price of the Series D Warrants, the exercise price of the outstanding Series D Warrants and placement agent warrants were adjusted under the anti-dilution provisions of such instruments to a price of $0.25 per share, and the number of shares underlying the outstanding Series D Warrants and the placement agent warrants, issued under the Debenture agreement, were increased to an aggregate of 6,889,848 shares. As disclosed above, 1,779,596 Series D warrants were exercised, and the remaining 4,955,222 Series D warrants and 1,019,828 related placement agent warrants expired April 12, 2012. The Series D Warrants contained a cashless exercise provision in the event (i) at any time after one year following the date the Series D Warrants are first exercisable there is no registration statement effective covering the resale of the shares underlying the Series D Warrants or (ii) at any time after four years following the date the Series D Warrants were issued. The Series D Warrants contained a limitation on the amount of Series D Warrants that may be exercised at any one time in the event the holder owns beneficially more than 4.99% of our common stock without regard to the number of shares underlying the unconverted portion of the warrants. This limitation may be waived upon 61 days' notice to us by the holder of the Series D Warrants permitting the holder to change such limitation to 9.99%. The conversion price of the Debentures and the exercise price of the Series D Warrants or the number of shares to be issued upon conversion or exercise of the Debentures and Series D Warrants are subject to adjustment in the event of a stock dividend, stock split, subdivision or combination of our shares of common stock, reclassification, sales of our securities below their then conversion or exercise price ("subsequent equity sales anti-dilution adjustment provisions"), a subsequent rights offering, or a reclassification of our shares. Also, if we effect a merger or consolidation with another company, we sell all or substantially all of our assets, a tender offer or exchange offer is made for our shares, or we effect a reclassification of our shares or a compulsory share exchange, a holder that subsequently converts its Debenture will be entitled to receive the same kind and amount of securities, cash or property as if the shares it is entitled to receive on the conversion had been issued and outstanding on the date immediately prior to the date any such transaction occurred. Except as discussed above, no such events have occurred through the date of this report. We were not required to make an adjustment to the conversion or exercise price or the number of shares to be issued upon conversion or exercise of the Debentures and Series D Warrants pursuant to the subsequent equity sales anti-dilution adjustment provisions related to an "exempt issuance," which is defined as: (A) any stock or options that are issued under our stock option plans or are approved by a majority of non-employee directors and issued (i) to employees, officers or directors or (ii) to consultants, but only if the amount issued to consultants does not exceed 400,000 shares in a 12 month period, (B) securities issued under the Debentures or Series D Warrants, (C) shares of common stock issued upon conversion or exercise of, or in exchange for, securities outstanding on the date we entered into the securities purchase agreement, (D) the issuance of the Midtown placement agent's warrants or the shares underlying the placement agent's warrants, or (E) the issuance of securities in an acquisition or strategic transaction approved by our 57 disinterested directors. Under the Debenture Amendment Agreement, commencing October 15, 2010, Debenture holders agreed that an "exempt issuance" shall also include the issuance of stock or common stock equivalents authorized and approved in advance by the Company's disinterested directors at a price per share or at a conversion or exercise price per share equal to or greater than $0.25. In connection with our Series A Debenture financing, we entered into a registration rights agreement with purchaser of our debentures pursuant to which we agreed we would use our best efforts to file a registration statement under the Securities Act within 45 days of the first closing to permit the public resale by debenture holders of the shares that may be issued upon conversion of the Debentures and upon exercise of the Series D Warrants, including the shares of our common stock underlying the Debentures to be issued at the second closing. Pursuant to the amendments we entered into with the current debenture holders on October 15, 2010, the debenture holders agreed to terminate their registration rights agreements with us. Accordingly, we are not required to register or maintain the registration of the shares underlying the Series A Debentures and Series D warrants held be such debenture holders; however, the Company was obligated under the terms of the Registration Rights Agreement that the Company entered into with each purchaser that has fully converted its Debenture. As outlined above, the related Series D Warrants that continued to be held by the debenture holders have expired. We also granted to each purchaser of the Debentures and Series D Warrants the right to participate in any offering by us of common stock or common stock equivalents until the later of (i) 12 months after the effective date of the registration statement and (ii) the date a purchaser holds less than 20% of the principal amount of the Debenture the purchaser originally agreed to purchase, except for an exempt issuance or an underwritten public offering of our common stock. Purchasers may participate in such an offering up to the lesser of 100% of the future offering or the aggregate amount subscribed for under the securities purchase agreement by all purchasers. Although such common stock offerings have occurred, the Debenture holders have notified the Company that they do not want to participate in any future financings. The securities purchase agreement also contained representations and warranties of both us and purchasers, conditions to closing, certain indemnification provisions, and other customary provisions. Also the Debenture Amendment Agreement amended certain provisions covering events of default under the Debentures, contained certain representations and warranties of the Company, a reaffirmation of certain of the representations and warranties in the securities purchase agreement, contained certain conditions to closing, and certain other customary provisions. We were prohibited from effecting a reverse or forward stock split or reclassification of our common stock except as may be required to comply with the listing standards of any national securities exchange. Midtown Partners & Co., LLC acted as placement agent for the financing pursuant to the terms of a Placement Agent Agreement, dated July 14, 2006, between us and Midtown. At the first closing, we paid or issued the following compensation to Midtown for its services as placement agent in connection with the offering: (i) sales commissions in the amount of $180,250; (ii) non-accountable expense reimbursement and legal fees of $30,000 of which $10,000 was paid prior to closing, (iii) placement agent's warrants to purchase an aggregate of 623,520 shares (one half of the placement agent warrants were exercisable on November 6, 2006 and the remaining one-half became exercisable on April 12, 2007). The second closing took place on April 12, 2007, at which time we paid the following compensation to Midtown for its services as placement agent in connection with the offering: (i) sales commissions in the amount of $180,250; (ii) non-accountable expense reimbursement and legal fees equal to 1% of the second closing or $25,750, (iii) the remaining one-half of the placement agent's warrants to purchase an aggregate of 311,760 shares. The Midtown placement agent's warrants were initially exercisable at a price of $1.15634 per share for a period of five years from the date they become exercisable, the exercise price was reset as disclosed above for the convertible debentures, contain a piggyback registration right, a cashless exercise provision and are substantially identical to the warrants issued to purchasers in the Debenture and Warrant offering. As a result of the June 2009 financing, the exercise price of the placement agent's warrants were adjusted under the anti-dilution provisions of such warrants to a price of $0.25 per share and the number of shares underlying the placement agent's warrants would be increased to an aggregate of 1,019,828 shares. As disclosed above, an aggregate of 509,914 of the placement agent warrants expired on November 8, 2011, and the remaining 509,914 of the placement agent warrants expired on April 12, 2012. The securities, including certain securities issued to Midtown, were not registered under the Securities Act of 1933 or any state laws and may not be offered or sold in the United States absent registration or an applicable exemption from registration requirements. Additional Capital To the extent that additional capital is raised through the sale of our equity or equity-related securities of our subsidiaries, the issuance of our securities could result in dilution to our stockholders. No assurance can be given that we will have access to the capital markets in the future, or that financing will be available on terms acceptable to satisfy our cash requirements, implement our business strategies, and meet the restrictive requirements of the debenture financing described above. If we are unable to access the capital markets or obtain acceptable financing, our results of operations and financial condition could be materially and adversely affected. We 58 may be required to raise substantial additional funds through other means. We have not begun to receive material revenues from our commercial operations associated with the software products. Management may seek to raise additional capital through one or more equity or debt financings or have discussions with certain investors with regard thereto. We cannot assure our stockholders that our technology and products will be commercially accepted or that revenues will be sufficient to fund our operations. If adequate funds are not available to us, we may be required to curtail operations significantly or to obtain funds through entering into arrangements with collaborative partners or others that may require us to relinquish rights to certain of our technologies or products. Financial Condition, Going Concern Uncertainties and Events of Default During the year ended December 31, 2012, Applied Visual Sciences' revenue generating activities have not produced sufficient funds for profitable operations and we have incurred operating losses since inception. In view of these matters, realization of certain of the assets in the accompanying consolidated balance sheet is dependent upon continued operations, which in turn is dependent upon our ability to meet our financial requirements, raise additional financing on acceptable terms, and the success of future operations. Our independent registered public accounting firm's report on the consolidated financial statements included herein, and in our annual report on Form 10-K for the year ended December 31, 2010, contains an explanatory paragraph wherein they expressed an opinion that there is substantial doubt about our ability to continue as a going concern. Accordingly, careful consideration of such opinions should be given in determining whether to continue or become our stockholder. As of December 31, 2012, we have outstanding trade and accrued payables of $1,570,639, other accrued liabilities of $621,311, and accrued salaries due to our employees and management of $6,629,246. Also, the Company has an outstanding noninterest-bearing loan from its Chief Executive Officer of $89,000, and $560,000 short-tern notes from five investors. The principal amount of our outstanding Series A Debentures of $1,688,205 became due on July 1, 2011, and such amount was not paid. Therefore, the Company may be considered in default. The debentures provide that any default in the payment of principal, which default is not cured within the five trading days of the receipt of notice of such default or ten trading days after the Company becomes aware of such default, will be deemed an event of default and may result in enforcement of the debenture holders' rights and remedies under the debentures and applicable law. We are in discussions with the debenture holders to re-negotiate the terms of the debentures, including the repayment or repurchase of the debentures and/or seek to extend their maturity date, although we have not reached any agreement with the debenture holders with regard to any such repayment, repurchase or extension. Our ability to repay or repurchase the debentures is contingent upon our ability to raise additional financing, of which there can be no assurance. Also, as a condition to any such extension, debenture holders may seek to amend or modify certain other terms of the debentures. If an event of default occurs under the debentures, the debenture holders may elect to require us to make immediate repayment of the mandatory default amount, which equals the sum of (i) the greater of either (a) 120% of the outstanding principal amount of the debentures, or (b) the outstanding principal amount unpaid divided by the conversion price on the date the mandatory default amount is either (1) demanded or otherwise due or (2) paid in full, whichever has the lower conversion price, multiplied by the variable weighted average price of the common stock on the date the mandatory default amount is either demanded or otherwise due, whichever has the higher variable weighted average price, and (ii) all other amounts, costs, expenses, and liquidated damages due under the debentures. In anticipation of such election by the debenture holders, due to the nonpayment of principal amount on the due date of July 1, 2011, we measured the mandatory default amount at approximately $337,641 and subsequently on each balance sheet date, which is reflected in the carrying value of the debentures and also recognized as interest expense. We remeasured the mandatory default amount as of December 31, 2012 at approximately $337,641. As of the date of this report, the debenture holders have not made an election requiring immediate repayment of the mandatory amount, although there can be no assurance they will not do so. The Company currently has insufficient funds to repay the outstanding amount in the event the debenture holders make a demand for payment. During 2012, the Company issued promissory notes to four accredited investors in the aggregate principal amount of $160,000 ($157,300, net of accrued commissions and expenses in the amount of $2,700), of which $100,000 initially matured on December 31, 2012, and was subsequently extended to June 30, 2013, $50,000 matures on January 24, 2013, and $10,000 matures on April 11, 2013. The short-term notes accrue interest at a rate of 12% per annum. The Company also issued to the note holders an aggregate of 285,000 shares of common stock, and 10,800 shares of common stock to a placement agent in exchange for cash compensation of $2,700. On March 15, 2012, we received $25,000 from an accredited investor, and issued an aggregate of 100,000 shares of common stock and 300,000 Class Q Warrants. The Class Q Warrants are exercisable at a price of $0.25 per share; contain a conditional call provision if the market price of each share exceeds $3.00, certain anti-dilution and other customary provisions. The warrants expire three years after the date of issuance. As of December 31, 2012, we had a cash balance of $3,445. Subsequently and through May 10, 2013, we received $135,000 from accredited investors upon the issuance of promissory notes, and the notes accrue interest at a rate of 12% per annum. Management believes these funds to be insufficient to fund our operations for the next twelve months absent any cash flow from operations or funds from the sale of our equity or debt securities. Currently, we are spending or incurring (and accruing) expenses of approximately $190,000 per month on operations and the continued research and development of our 3i technologies and products, including with regard to 59 salaries and consulting fees. Management believes that we will require an aggregate of approximately $2,280,000 to fund our operations for the next 12 months and to repay certain outstanding trade payables and accrued expenses. This assumes that holders of our outstanding debentures convert such debt into shares of our common stock or that we are able to extend the term of the debentures, of which there can be no assurance. In the event we are unable to extend the term of the debentures beyond their new maturity date, the debenture holders do not convert such debt or require payment of principal, partially convert such debt, or effect the buy-in provision related to the warrants and the debentures, we shall be required to raise additional financing. Also, this assumes that we are able to continue to defer the amounts due to our employees for accrued and unpaid salaries and that we are able to continue to extend or defer payment of certain amounts due to our trade creditors, of which there can be no assurance. In view of our limited revenues to date, the Company has relied and continues to rely substantially upon equity and debt financing to fund its ongoing operations, including the research and development conducted in connection with its products and conversion of accounts payable for stock. The proceeds from our financings have been and continue to be insufficient to fund our operations, pay our trade payables, repayment of our unconverted debentures, or accrued and unpaid wages to our employees. Therefore, the debentures holders, our employees, or trade creditors may seek to enforce payment of amounts due to them, and our results of operations and financial condition could be materially and adversely affected and we may be unable to continue our operations. Also, in the event we continue to be unable to pay our employees, we may suffer further employee attrition. There can be no assurances that we will be successful in our efforts to raise any additional financing, any bank borrowing, and research or grant funding. Moreover, in view of the current market price of our stock, we may have limited or no access to the capital markets. Furthermore, under the terms of our agreements with the debenture holders, we are subject to restrictions on our ability to engage in any transactions in our securities in which the conversion, exercise or exchange rate or other price of such securities is below the current conversion price or is based upon the trading price of our securities after initial issuance or otherwise subject to re-set. In view of the foregoing, we may be required to curtail operations significantly, or obtain funds through entering into arrangements with collaborative partners or others that may require us to relinquish rights to certain of our technologies or products. During Fiscal 2012, our total stockholders' deficit increased by $1,409,544 to $11,235,351, our consolidated net loss for the period was $1,804,101 or a $649,725 increase in net loss from 2011. Notwithstanding the foregoing discussion of management's expectations regarding future cash flows, Applied Visual Sciences' insolvency continues to increase the uncertainties related to its continued existence. Both management and the Board of Directors are carefully monitoring the Company's cash flows and financial position in consideration of these increasing uncertainties and the needs of both creditors and stockholders. CONSOLIDATED RESULTS OF OPERATIONS The following analysis reflects the consolidated results of operations of Applied Visual Sciences, Inc. and its subsidiaries. Fiscal 2012 as Compared with Fiscal 2011 Net Revenues. There were no revenues for fiscal 2012. Net revenue for the same period in 2011 of $6,589 was from the sale of hardware and related, specifically freight, duty and taxes reimbursed by the customer for the shipment of TBDx™. Cost of Sales. There was no cost of sales for fiscal 2012, and the same period in 2011. The freight, duty and taxes billed during 2011 were expensed in December 2010. Selling, General and Administrative Expenses. Selling, general and administrative expenses for fiscal 2012 of $1,752,254, decreased by $809,295 (36.1%), as compared to $2,741,778 for the same period in 2011. The table below details the components of selling, general and administrative expense, as well as the dollar and percentage changes for the fiscal years ended December 31. Cumulative From April 1, 2012 (date of Twelve Months Ended December 31 inception) To December 31, 2012 2011 $ Change % Change 2012 Payroll and relatedcosts $ 984,482 $ 1,073,527 $ (89,045) (8.3) $ 718,995 Professional fees 368,171 630,953 (262,782) (41.6) 190,869 Research and development costs 82,300 233,330 (151,030) (64.7) 64,288 Other operating expenses 140,414 258,936 (118,522) (45.8) 106,077 Depreciation and amortization 91,763 93,419 (1,656) (1.8) 67,082 Stock-based compensation 85,124 451,613 (366,489) (81.2) 84,291 Total $ 1,752,254 $ 2,741,778 $ (989,524) (36.1) $ 1,231,602 60 Payroll and related costs, which includes salaries, commissions, taxes and benefits, decreased $89,045 (8.3%), due to two employees being on a leave of absence effective April 1, 2011 and cancellation of some employee benefits. The Company currently employs five full-time and one part-time employee, compared to six full-time and one part-time employee for the same period in 2011. Professional fees include legal, accounting, stock transfer agent, SEC filing, and general consulting fees. Professional fees decreased for the twelve months ended December 31, 2012 versus the same period last year by $262,782 (41.6%) due to: (i) a decrease in legal fees of $217,408 for services related to financing activities not incurred during the same period in 2011, including legal fees for SEC compliance reporting of $14,348, non-refundable formation fee of $200,000 related to negotiations of a strategic partnership for BCDx™, and 3,060 various legal services, (ii) decrease in general consultants of $37,966, and (iii) a net decrease of $7,408 for various miscellaneous services and fees. Research and development ("R&D") costs decreased for fiscal 2012, compared to the same period last year by $151,030 (64.7%), due to redirecting R&D activities for Signature Mapping TBDx™ and TBDxV™ projects. Other operating expenses decreased by $118,522 (45.8%) to $140,414 for fiscal 2012 as compared to $258,936 for the same period in 2011. The decrease is attributed to reduced insurance costs by $69,756 in not renewing various business policies, a decrease in travel costs of $42,034, and administrative expenses of $6,732. Depreciation and amortization expense in selling, general, and administrative for the twelve months ended December 31, 2012, is $91,763, compared to the same period for 2011 of $93,419, or a decrease of $1,656 (1.8%). Stock-based compensation, which represents a noncash expense category, is the amortization of the estimated fair value of stock-based compensation to employees, non-employee members of our Board of Directors, and consultants in lieu of cash compensation. During the twelve months ended December 31, 2012, the Company recognized an expense of $74,000 associated with employees and directors stock-based compensation, and recognized $11,124 of consulting expense. During the same period of 2011, the Company recognized stock-based compensation expense for employees and directors of $164,241 and consultants of $287,372. The decrease in stock-based compensation for employees and non-employee directors of $90,241 (54.9%) is due to no issuance of incentive stock options to: (i) employees in 2010 through 2012, whereas stock options were issued to employees during prior years and amortized over the two year vesting period, and (ii) non-employee directors during 2011 through 2012, whereas such stock options were issued in 2010 and amortized over the one year vesting period. Stock-based compensation expense for consultants decreased $276,248 (96.1%) during 2012 as a result of reduced use of stock-based compensation versus cash compensation for consultants. Employee stock option expense in 2012 and 2011 represents the amortization of the Black-Scholes fair value as outlined above in accordance with ASC 718-10. ASC 718-10 requires the recognition of all share-based payments to employees, or to non-employee directors for service on the Board of Directors, as compensation expense in the consolidated financial statements. The amount of compensation is measured based on the estimated fair values of such stock-based payments on their grant dates, and is amortized over the estimated service period to vesting. Consulting expense for stock-based payments to consultants is based on the fair value of the stock-based compensation at inception and amortized over the estimated service period but, in accordance with ASC 505-50, is remeasured on each reporting date until the performance commitment is complete. Other Income (Expense). Other income (expense) includes interest income, interest expense and other non-operating income and expense. Other expense for fiscal 2012 was $51,847 compared to other income of $1,508,813 for the same period last year, for a net decrease in other income of $1,620,373 (102.5%). There was no interest income from interest bearing accounts for the fiscal 2012, or for the same period in 2011, due to low average daily cash balances in interest bearing accounts during the periods. For the twelve months ended December 31, 2012, the Company had other non-operating expense of $51,847, compared to non-operating income of $1,580,813 for the same period in 2011, or a decrease in other non-operating income of $1,620,373 (102.5%). The components of 2012 and the variances to the same period in 2011 include: (i) financing costs in 2012 of $2,700 for placement agent commission related to the 2012 promissory notes or a reduction of $22,300 from the same period in 2011, (ii) debt discount amortization costs in 2012 of $40,006, or an increase from 2011 of $33,893, (iii) interest expense for 2012 of $64,382 as a result of additional short-term notes during 2012, compared to $8,751 during the same period in 2011, (iv) income of $67,528 in 2012 for the revaluation of beneficial conversion feature of the outstanding debentures, compared to $1,958,318 in 2011, (v) no expense in 2012 for an event of default related to the convertible debentures, whereas an expense of $337,641 for the same period in 2011, and (vi) a loss on sale of fixed assets in 2012 of $12,287 with no such expense in 2011. Non-cash non-operating income included above for fiscal 2012 was $24,822, compared the same period in 2011 of $1,589,564. 61 Net Income (Loss) and Net Income (Loss) per Common Share. Net loss for fiscal 2012 was $1,804,101, compared to the same period in 2011 of $1,154,376, for an increase in net loss of $649,275 (56.3%). Net income (loss) for the Company per common share ("basic EPS") is computed by dividing net income (loss) by the weighted average number of shares outstanding. Net income (loss) per common share assuming dilution ("diluted EPS") is computed by reflecting potential dilution from contingently issuable shares (i.e. common stock purchase warrants and stock options issued and outstanding). Reconciliation between the numerators and denominators of the basic and diluted EPS computations is as follows: Year Ended December 31 2012 2011 Numerator: Net loss $ (1,804,101) $ (1,154,376) Denominator: Weighted average common shares outstanding - basic & diluted 94,486,673 85,456,082 Weighted average common shares outstanding - Diluted 139,246,542 110,690,895 Net loss per common share: Basic & diluted $ (0.02) $ (0.01) Diluted (0.01) (0.01) CONTRACTUAL OBLIGATIONS AND COMMITMENTS The following table summarizes scheduled maturities of our contractual obligations extending beyond one year for which cash flows are fixed and determinable as of December 31, 2012. Payments Due in Fiscal Category Total 2013 2014 2015 2016 2017 Thereafter Short-term convertible $ $ debentures (1) 1,688,205 1,688,205 $ - $ - $ - $ - $ - Interest payments (2) - - - - - - - Operating lease commitments (3) 5,864 5,864 - - - - - Unconditional purchase obligations (4) - - - - - - - Total contractual $ $ obligations 1,694,069 1,694,069 $ - $ - $ - $ - $ - (1) Represents the outstanding Series A Convertible Debentures that originally matured November 8, 2008, and were amended October 15, 2010. Under terms of the amendment, the Company and the debenture holders agreed to an extension of the maturity date to June 30, 2011. The Company is currently in default under the amendment agreement and is negotiating with the debenture holders to extend the maturity date. Commencing March 3, 2011, the Company may force a conversion of the debentures if certain trading price and volume conditions are met. (2) The outstanding Series A convertible debentures, under the October 15, 2010 amendment, did not bear interest through the new maturity date of June 30, 2011, and the amendment agreement does not require interest after the maturity date. The Company is in negotiations with the debenture holders to extend the maturity date of the convertible debentures, and the holders may require interest to be paid for such extension. (3) Represents projected rent cost for the existing office lease, which expires on January 31, 2013. Total rental expense included in the accompanying consolidated statements of earnings was $71,738 in fiscal 2012, and $70,160 in fiscal 2011. (4) The company currently does not have any outstanding unconditional purchase obligations. They would though include inventory commitments, future royalty, consulting agreements, other than month-to-month arrangements or those that expire in less then one year, or commitments pursuant to executive compensation arrangements. CRITICAL ACCOUNTING POLICIES The discussion and analysis of our financial condition at December 31, 2012 and our results of operations for the two fiscal years ended December 31, 2012, are based upon our consolidated financial statements, which have been prepared in conformity with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and assumptions that affect the amounts of assets, liabilities, revenues and expenses reported in those financial statements. These estimates and assumptions can be subjective and complex and, consequently, actual results could differ from those estimates. We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements. Revenue Recognition. Revenues are derived primarily from the sublicensing and licensing of computer software, installations, training, consulting, software maintenance and sales of PACS, RIS and RIS/PACS solutions. Inherent in the revenue recognition process are significant management estimates and judgments, which influence the timing and amount of revenue recognized. 62 For software arrangements, we recognize revenue according to the ASC 985-605, "Software Revenue Recognition," and related amendments. ASC 985-605 generally requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair values of those elements. Revenue from multiple-element software arrangements is recognized using the residual method. Under the residual method, revenue is recognized in a multiple element arrangement when vendor-specific objective evidence of fair value exists for all of the undelivered elements in the arrangement, but does not exist for one or more of the delivered elements in the arrangement. We allocate revenue to each undelivered element in a multiple element arrangement based on its respective fair value, with the fair value determined by the price charged when that element is sold separately. Specifically, we determine the fair value of the maintenance portion of the arrangement based on the renewal price of the maintenance offered to customers, which is stated in the contract, and fair value of the installation based upon the price charged when the services are sold separately. If evidence of the fair value cannot be established for undelivered elements of a software sale, the entire amount of revenue under the arrangement is deferred until these elements have been delivered or vendor-specific objective evidence of fair value can be established. Revenue from sublicenses sold on an individual basis and computer software licenses is recognized upon shipment provided that evidence of an arrangement exists, delivery has occurred and risk of loss has passed to the customer, fees are fixed or determinable and collection of the related receivable is reasonably assured. Revenue from software usage sublicenses sold through annual contracts and software maintenance is deferred and recognized ratably over the contract period. Revenue from installation, training, and consulting services is recognized as services are performed. Cost of goods sold incorporates our direct costs of raw materials, consumables, staff costs associated with installation and training services, and the amortization of the intangible assets (developed software) related to products sold. Research and Development. Costs incurred in connection with the development of software products that are intended for sale are accounted for in accordance with ASC 985-20, "Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed." Costs incurred prior to technological feasibility being established for the product are expensed as incurred. Technological feasibility is established upon completion of a detail program design or, in the absence, completion of a working model. Thereafter, as long as no high-risk development issues exist, all software production costs are capitalized and subsequently reported at the lower of unamortized cost or net realizable value. Capitalized costs are amortized based on current and future revenue for each product with an annual minimum equal to the straight-line amortization over the remaining estimated economic life of the product. Amortization commences when the product is available for general release to customers. Stock-Based Compensation. We adopted on January 1, 2006, the provisions of ASC 718-10, which requires recognition of stock-based compensation expense for all share-based payments based on fair value. ASC 718-10, "Share-Based Payment" defines fair value-based methods of accounting for stock options and other equity instruments. This method measures compensation costs based on the estimated fair value of the award and recognizes that cost over the service period. We also consider ASC 505-50, "Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods, or Services" ("ASC 505-50"), establishes the measurement principles for transactions in which equity instruments are issued in exchange for the receipt of goods or services. We relied upon the guidance provided under ASC 505-50 to determine the measurement date and the fair value re-measurement principles to be applied. Based on these findings, we determined that the unamortized portion of the stock compensation should be re-measured on each interim reporting date and proportionately amortized to stock-based compensation expense for the succeeding interim reporting period until goods are received or services are performed. We recognize compensation costs, net of an estimated forfeiture rate, on a pro rata basis over the requisite service period of each vesting tranche of each award. We consider voluntary termination behavior as well as trends of actual option forfeitures when estimating the forfeiture rate. Valuation of Long-Lived Assets Including Acquired Intangibles. We evaluate the carrying value of long-lived assets for impairment, whenever events or changes in circumstances indicate that the carrying value of an asset within the scope of ASC 360-10, "Accounting of the Impairment or Disposal of Long-Lived Assets" may not be recoverable. Our assessment for impairment of assets involves estimating the undiscounted cash flows expected to result from use of the asset and its eventual disposition. An impairment loss recognized is measured as the amount by which the carrying amount of the asset exceeds the fair value of the asset, and considers year-end the date for its annual impairment testing. The Company prepared this analysis as of the year ended December 31, 2012, and 2011, and concluded that the intangible assets are not impaired. Therefore, there was no impairment expense during Fiscal 2012 and 2011 Impairment of Excess of Purchase Price Over Net Assets Acquired. We follow the provisions of ASC 805-10, "Business Combinations" and ASC 350-10, "Goodwill and Other Intangible Assets." These statements establish financial accounting and reporting standards for acquired goodwill. Specifically, the standards address how acquired intangible assets should be accounted for both at the time of acquisition and after they have been recognized in the financial statements. Effective January 1, 2002, with the adoption of ASC 350-10, goodwill must be evaluated for impairment and is no longer amortized. Excess of purchase price over net assets acquired ("goodwill") represents the excess of acquisition purchase price over the fair value of the net assets acquired. To the extent possible, a portion of the excess purchase price is assigned to identifiable intangible assets. We determine impairment by comparing the fair value of 63 the goodwill, using the undiscounted cash flow method, with the carrying amount of that goodwill. Impairment is tested annually or whenever indicators of impairment arise. There was no goodwill on the consolidated balance sheet of the Company during Fiscal 2012 and 2011, as a net realizable value analysis was made for goodwill in prior years and such asset was considered fully impaired during those prior years. Therefore, there was no amortization expense of goodwill during Fiscal 2012 and 2011. OFF-BALANCE SHEET ARRANGEMENTS We do not maintain any off-balance sheet arrangements, transactions, obligations or other relationships with unconsolidated entities that would be expected to have a material current or future effect upon our financial condition or results of operations. RECENTLY ISSUED ACCOUNTING STANDARDS Refer to "Notes to Consolidated Financial Statements, Note 2 - Significant Accounting Policies" for discussion regarding the impact of Accounting Standards that were recently issued but not yet effective, on our Consolidated Financial Statements. [ Back To TMCnet.com's Homepage ]