Cavitation Technologies, Inc. - Quarter Report: 2013 December (Form 10-Q)

See accompanying notes,which are an integral part of these condensed consolidated financial statements

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CAVITATION TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Six months ended December 31, 2013 and 2012

Hydrodynamic Technology, Inc. was incorporated January 29, 2007 as a California corporation. It is a wholly owned subsidiary of Cavitation Technologies, Inc. (referred to herein, unless otherwise indicated, as "the Company," "CTi," "we," "us," and "our") a Nevada corporation originally incorporated under the name Bio Energy, Inc. CTi has developed, patented, and commercialized proprietary technology that may be used in liquid processing applications. CTi's patented Nano Reactor® is the critical component of CTi Nano Neutralization® System which is commercially proven to reduce operating costs and increase yields in refining vegetable oils. CTi has two patented systems and has filed several national and international patents to employ its proprietary technology in applications including, vegetable oil refining, waste water treatment, biodiesel, algae oil extraction, and alcoholic beverage enhancement.

The accompanying unaudited condensed consolidated financial statements of Cavitation Technologies, Inc. have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Regulation S-K for scaled disclosures for smaller reporting companies. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in United States of America for complete financial statements. However, such information reflects all adjustments (consisting solely of normal recurring adjustments), which are, in the opinion of management, necessary for the fair presentation of the consolidated financial position and the consolidated results of operations. Results shown for interim periods are not necessarily indicative of the results to be obtained for a full fiscal year.

The consolidated balance sheet information as of June 30, 2013 was derived from the audited consolidated financial statements included in the Company's Annual Report on Form 10-K filed with the SEC on October 15, 2013. These interim financial statements should be read in conjunction with that report.

The accompanying condensed consolidated financial statements have been prepared in conformity with generally accepted accounting principles which contemplate continuation of the Company as a going concern.  During the six months ended December 31, 2013, the Company incurred a net loss of $1,030,935 and utilized $129,190 of cash in operations. As of December 31, 2013, the Company had a working capital deficiency of $2,549,492 and a stockholders' deficit of $2,313,158.   These factors, among others, raise substantial doubt about the Company's ability to continue as a going concern. Our independent auditors, in their report on our audited financial statements for the fiscal year ended June 30, 2013 expressed substantial doubt about our ability to continue as a going concern. The accompanying condensed consolidated financial statements do not include adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from an inability of the Company to continue as a going concern.

Management's plan is to generate income from operations by continuing to license our technology globally through our strategic partner, the Desmet Ballestra Group (Desmet). Desmet has agreed to provide us monthly advances of $125,000 against future sales. During the six months ended December 31, 2013, advances received from Desmet amounted to $625,000. We will also attempt to raise additional debt and/or equity financing to fund operations and to provide additional working capital. However, there is no assurance that such financing will be consummated or obtained in sufficient amounts necessary to meet the Company's needs, that the Company will be able to achieve profitable operations or that the Company will be able to meet its future contractual obligations. Should management fail to obtain such financing, the Company may curtail its operations.

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Note 2 - Significant Accounting Policies

The consolidated financial statements include the accounts of Cavitation Technologies, Inc. and its wholly owned subsidiary Hydrodynamic Technology, Inc. Inter-company transactions and balances have been eliminated through consolidation.

FASB Accounting Standards Codification ("ASC") 820-10 requires entities to disclose the fair value of financial instruments, both assets and liabilities recognized and not recognized on the balance sheet for which it is practicable to estimate fair value. ASC 820-10 defines the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties. As of December 31, 2013, the carrying value of certain accounts such as inventory, accounts payable, accrued expenses, accrued payroll and short-term loans approximate fair value due to the short-term nature of such instruments.

The following table presents information about the Company's assets and liabilities measured and reported in the financial statements at fair value on a recurring basis as of December 31, 2013 and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value. The three levels of the fair value hierarchy are as follows:

• Level 1 - Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the entity has the ability to access.
• Level 2 - Valuations based on quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable data for substantially the full term of the assets or liabilities.
• Level 3 - Valuations based on inputs that are unobservable, supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the U.S requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the financial statement date, and reported amounts of revenue and expenses during the reporting period. Significant estimates are used in valuing our stock options, warrants, convertible notes, and common stock issued for services, among other items. Actual results could differ from these estimates.

Revenues are recognized when persuasive evidence of an agreement exists; delivery has occurred, including transfer of title and risk of loss for product sales, or services have been rendered for service revenues; the price to the buyer is fixed or determinable; and collectability is reasonably assured.

Prior to May 2012, under our agreement with Desmet, we recorded our revenues pursuant to ASC 605-28-15 describes the Milestone Method as pertaining to R&D deliverables under which the Company satisfies its performance obligations over a period of time and which a portion or all of the consideration is contingent upon uncertain future events or circumstances.

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Patents

Capitalized patent costs represent legal fees associated with procuring and filing patent applications. The Company accounts for patents in accordance with ASC 350-30, General Intangibles Other Than Goodwill. The Company has two patents issued in fiscal 2012 and 2011, and another 3 patents granted in fiscal 2014. As of December 31, 2013, we have a total of 15 patents pending. The patents have duration of twenty years from filing date.

We amortize our patents over a four year estimated life. As of December 31 and June 30, 2013 the Company had remaining unamortized patent costs of $73,157 and $70,315 respectively.

In accordance with ASC 350-30 (General Intangibles Other than Goodwill), the Company evaluates amortizable intangibles and long-lived assets for impairment whenever events or changes in circumstances indicate that their net book value may not be recoverable. When such factors and circumstances exist, the Company compares the projected undiscounted future cash flows associated with the related asset or group of assets over their estimated useful lives against their respective carrying amount. Impairment, if any, is based on the excess of the carrying amount over the fair value, based on market value when available, or discounted expected cash flows, of those assets and is recorded in the period in which the determination is made. Based on the Company annual impairment tests, management believes there is no impairment of its intangibles and long-lived assets as of December 31, 2013. There can be no assurance, however, that market conditions will not change or demand for the Company's products under development will continue. Either of these could result in future impairment of intangibles and long-lived assets.

The Company periodically issues stock options and warrants to employees and non-employees in non-capital raising transactions for services and for financing costs. The Company accounts for stock option and warrant grants issued and vesting to employees based on the authoritative guidance provided by the Financial Accounting Standards Board whereas the value of the award is measured on the date of grant and recognized over the vesting period. The Company accounts for stock option and warrant grants issued and vesting to non-employees in accordance with the authoritative guidance of the Financial Accounting Standards Board whereas the value of the stock compensation is based upon the measurement date as determined at either a) the date at which a performance commitment is reached, or b) at the date at which the necessary performance to earn the equity instruments is complete. Non-employee stock-based compensation charges generally are amortized over the vesting period on a straight-line basis. In certain circumstances where there are no future performance requirements by the non-employee, option grants are immediately vested and the total stock-based compensation charge is recorded in the period of the measurement date.

The fair value of the Company's common stock option grant is estimated using the Black-Scholes option pricing model, which uses certain assumptions related to risk-free interest rates, expected volatility, expected life of the common stock options, and future dividends. Compensation expense is recorded based upon the value derived from the Black-Scholes option pricing model, and based on actual experience. The assumptions used in the Black-Scholes option pricing model could materially affect compensation expense recorded in future periods.

The Company accounts for income taxes in accordance with ASC 740-10, Income Taxes.  The Company recognizes deferred tax assets and liabilities to reflect the estimated future tax effects, calculated at anticipated future tax rates, of future deductible or taxable amounts attributable to events that have been recognized on a cumulative basis in the financial statements. A valuation allowance related to a deferred tax asset is recorded when it is more likely than not that some portion of the deferred tax asset will not be realized. Deferred tax assets and liabilities are adjusted for the effects of the changes in tax laws and rates of the date of enactment.

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ASC 740-10 prescribes a recognition threshold that a tax position is required to meet before being recognized in the financial statements and provides guidance on recognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition issues. The Company classifies interest and penalties as a component of interest and other expenses. To date, there have been no interest or penalties assessed or paid.

The Company measures and records uncertain tax positions by establishing a threshold for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  Only tax positions meeting the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized.

The Company provides a limited warranty with every set of reactors sold, typically 2 years. The Company has not experienced significant claims under its warranty policy, and management determined no accrual for warranty reserve was necessary at December 31, 2013.

Our revenue is almost entirely dependent on Desmet Ballestra who is our exclusive distribution agent with regard to the CTi Nano Neutralization® System for edible oils. During fiscal 2013 and for the six months ended December 31, 2013, 97% and 100% of revenue, respectively, were derived from Desmet sales efforts (see Note 3).

The Company computes the loss per common share using ASC 260, Earnings per Share.  The net loss per common share, both basic and diluted, is computed based on the weighted average number of shares outstanding for the period.  The diluted loss per common share is computed by dividing the net loss attributable to common stockholders by the weighted average shares outstanding assuming all potential dilutive common shares were issued.

As of December 31, 2013, the Company had 16,611,815 stock options and 37,633,867 stock warrants outstanding to purchase shares of common stock that were not included in the diluted net loss per common share because their effect would be anti-dilutive.

In January 2013, the FASB issued ASU 2013-01, Balance Sheet (Topic 210): Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities. This ASU clarifies which instruments and transactions are subject to the offsetting disclosure requirements established by ASU 2011-11. This guidance is effective for annual and interim reporting periods beginning January 1, 2013. We do not believe the adoption of this update will have a material effect on our financial position and results of operations.

On March 4, 2013, the FASB issued ASU 2013-05, "Foreign Currency Matters (Topic 830): Parent's Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity" ("ASU 2013-05"). ASU 2013-05 updates accounting guidance related to the application of consolidation guidance and foreign currency matters. This guidance resolves the diversity in practice about what guidance applies to the release of the cumulative translation adjustment into net income. This guidance is effective for interim and annual periods beginning after December 15, 2013. We do not believe the adoption of this update will have a material effect on our financial position and results of operations.

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In July 2013, the FASB issued ASU No. 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Loss, or a Tax Credit Carryforward Exists. Topic 740, Income Taxes, does not include explicit guidance on the financial statement presented of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. There is diversity in practice in the presentation of unrecognized tax benefits in those instances and the amendments in this update are intended to eliminate that diversity in practice. The amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. The amendments should be applied prospectively to all unrecognized tax benefits that exist at the effective date. Early adoption is permitted. We do not believe the adoption of this update will have a material effect on our financial position and results of operations.

Other accounting pronouncements did not or are not believed by management to have a material impact on the Company's present or future consolidated financial statements.

On May 14, 2012 we signed a global Research and Development, Marketing and Technology License Agreement with the n.v. Desmet Ballestra Group s.a. (Desmet), a Belgian company that is actively marketing the NANO Neutralization System, the key component of which is the Company's reactor to soybean and other vegetable oil refiners. The Agreement provides Desmet (licensee) a limited, exclusive license and right to develop, design and supply Nano Reactor® systems which incorporate Nano Reactor® devices on a global basis but is limited to oils and fats and oleo chemical applications. CTi (licensor) remains owner of the current patents and patent applications but Desmet will be co-owner of any new process patent applications jointly developed. Desmet has agreed to provide, under certain conditions, limited monthly advance payments of $125,000 against future sales to CTi. Desmet shall be entitled to immediately terminate the present agreement in case the claims of current US Patent Application Number 12/484,981 are not granted as such or are cancelled. In addition, Desmet may terminate the agreement on August 1 of any particular year if they have not installed at least 6 Nano Reactor® devices in the previous 12 month period. CTi may terminate the Agreement for material default. This Agreement supersedes a previous agreement dated November 1, 2010, amended on June 1, 2011 and on September 2, 2011.

Desmet, together with its affiliates, is a global engineering and equipment supply firm engaged in the development, design and supply of process equipment for oils and fats processing facilities including vegetable oil refining, biofuel, oleo chemical, seed crushing, surfactant and detergent markets. Desmet supplies these markets with competitive services based on the latest globally sourced technologies.

The Company and Desmet have worked together to determine the appropriate sales approach and installation process. The Company's Nano Neutralization is designed to be used as an add-on process to an existing neutralization system within soybean and other vegetable oil refineries. Desmet purchases Nano Reactor Systems from the Company and installs them at the refinery as part of an integrated neutralization system. We are therefore substantially dependent on Desmet to identify prospects, complete sales contracts, install the system and manage relationships with end-users.

During the six months ended December 31, 2013 and 2012, we recorded revenues of $495,266 and $693,788 from Desmet. The Company received advances of $625,000 in each six month periods ended December 31, 2013 and 2012. As of December 31, 2013, Desmet has advanced to us an excess of funds of $1,345,397 which will be recognized as revenue as sales orders are shipped.

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Note 4 - Property and Equipment

Property and equipment consisted of the following as of December 31, 2013 and June 30, 2013:

Depreciation expense for the six months ended December 31, 2013 and 2012 amounted to $35,258 and $27,195, respectively.

On December 17, 2012 we issued a convertible promissory note payable to a private party, in the amount of $100,000 with an interest rate of 12% per annum and due May 31, 2014. The note is unsecured, convertible into shares of our common stock at a conversion price of $0.03 any time during the life of the note. Upon issuance of the note, the trading price of the Company's common stock was also $0.03/share which is the same as the note's conversion price. As such, there was no cost of beneficial conversion feature recorded. Also, 3,333,333 fully vested warrants with a fair value of $90,106 were issued in connection with this note. The warrants are exercisable at $0.07/share and will expire in 3 years. The fair value of the warrants was recorded as a note discount and was being amortized to interest expense over the term of the note. As of June 30, 2013, the outstanding balance of note amounted $100,000 less discount of $55,174 resulting in a net balance of $44,826.

On December 2, 2013 the $100,000 Note was converted into 3,333,333 shares of the Company's common stock and the unamortized balance of the note discount of $55,174 was recognized as interest expense.

As of December 31, 2013, we had received a loan of $185,000 from West Point Partners, LLC, whose managing partner is the Company's Principal Accounting Officer. The loan is due on demand, unsecured and pays an annual interest rate of 12% per annum. Accrued interest as of December 31, 2013 amounted to $37,750.

During the six months ended December 31, 2013, the Company recognized interest expense of $11,100. As of December 31, 2013, the entire loan of $185,000 is still outstanding with unpaid interest of $37,750.

Note 7 - Short-Term Loan

As of December 31, 2013, we had received a loan of $34,521 from a third party, Strategic IR. The loan is due on demand, unsecured and pays an annual interest rate of 12% per annum. Accrued interest as of December 31, 2013 amounted to $7,021.

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During the six months ended December 31, 2013, the Company recognized interest expense of $2,071. As of December 31, 2013, the entire loan of $34,521 is still outstanding with unpaid interest of $7,021.

As of December 31, 2013 and June 30, 2013, the Company had accrued unpaid salaries due to officers amounting to $966,966. In addition, the Company also accrued the estimated payroll taxes due to this unpaid payroll of $79,357.

The Company has not adopted a formal stock option plan, however, it has assumed outstanding stock options resulting from the acquisition of its wholly-owned subsidiary, Hydrodynamic Technology, Inc. In addition, the Company has made periodic non- plan grants. A summary of the stock option activity from December 31, 2013 is as follows:

The intrinsic value of the outstanding options was $826,060 as of December 31, 2013. The following table summarizes additional information concerning options outstanding and exercisable at December 31, 2013.

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Warrants

A summary of the Company's warrant activity and related information for the six months ended on December 31, 2013 is as follows.

In October 2013, the Company granted employees warrant to purchase 9,100,000 shares of common stock at $0.04/share, vesting immediately and expiring in 5 and 10 years from grant date. The fair value of the warrants amounted to $363,882 using the Black-Scholes Merton valuation model with the following average assumptions: risk-free interest rate of 0.90%; dividend yield of 0%; volatility of 232%; and an expected life of 3.75 years.

In October 2013, the Company granted consultants warrant to purchase 13,100,000 shares of common stock at $0.04 up to $0.45/share, vest over a period of one year and expiring in 5 and 10 years from grant date. The fair value of the warrants that vest during the six month period ended December 31, 2013 amounted to $380,425 using the Black-Scholes Merton valuation model with the following average assumptions: risk-free interest rate of 2.50%; dividend yield of 0%; volatility of 223%; and an expected life of 8.54 years. As of December 31, 2013, total compensation cost related to non-vested warrant award not yet recorded is approximately $633,000. The intrinsic value of the outstanding warrants was $2,038,530 as of December 31, 2013.

The following table summarizes additional information concerning warrants outstanding and exercisable at December 31, 2013.

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ITEM 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations.

Hydrodynamic Technology, Inc. was incorporated January 29, 2007 as a California corporation. It is a wholly owned subsidiary of Cavitation Technologies, Inc., a Nevada corporation originally incorporated under the name Bio Energy, Inc. We design and engineer environmentally friendly technology based systems that are designed to serve large, growing, global markets such as vegetable oil refining, renewable fuels, water treatment, algae oil extraction, biodiesel production, water-oil emulsions and crude oil yield enhancement.  Our systems are designed to process industrial liquids at a lower cost and higher yield than conventional technology. We are a process and product development firm that has developed, patented, and commercialized proprietary technology.

CTi has developed, patented, and commercialized proprietary technology that can be used for processing of industrial fluids. CTi's patented Nano Reactor® is the critical components of the CTi Nano Neutralization® System which is commercially proven to reduce operating costs and increase yields in processing oils and fats. CTi has two issued patents relating to our Nano Reactor® systems and has filed several national and international patents to employ its proprietary technology in applications including, vegetable oil refining, biodiesel production, waste water treatment, algae oil extraction, and alcoholic beverage enhancement.

During the six months ended December 31, 2013, we recorded revenue of $495,266. Our loss from operations in six months of fiscal 2014 is $1,030,935. Net cash used in operating activities of $129,190 and net cash used in investing activities of $38,643 was funded largely with Company's cash reserves at the beginning of the period as well advances from Desmet.

We are engaged in merchandising our Neutralization System which is designed to help refine vegetable oils such as soybean, canola, sunflower and rapeseed.  Our near term goal is to continue to merchandise our systems through our partner, Desmet Ballestra. Even though the Company's revenue increased significantly in last fiscal year, the Company incurred a net loss of $1,030,935 during the six months ended December 31, 2013. As of December 31, 2013, the Company had a working capital deficiency of $2,549,492 and a stockholders' deficit of $2,313,158.   The accompanying financial statements have been prepared in conformity with generally accepted accounting principles which contemplate continuation of the Company as a going concern.

Management's plan is to generate income from operations by licensing our technology globally through our strategic partner, the Desmet Ballestra Group (Desmet). Desmet has agreed to provide us monthly advances of $125,000 against future sales. During the six months ended December 31, 2013, advances received from Desmet amounted to $625,000 and we received a total of $2,250,000 as of February 15, 2014. These funds service interest plus a portion of operational expenses on a monthly basis. Desmet shall be entitled to immediately terminate the present agreement in case the claims of current US Patent Application Number 12/484,981 are not granted as such or are cancelled. In addition, Desmet may terminate the agreement on August 1 of any particular year if they have not installed at least 6 Nano Reactor® devices in the previous 12 month period. CTi may terminate the Agreement for material default. This Agreement supersedes a previous agreement dated November 1, 2010, amended on June 1, 2011 and on September 2, 2011. In addition to these advances, we anticipate that we will need additional funding, and we will attempt to raise additional debt and/or equity financing to fund operations and to provide additional working capital. However, there is no assurance that such financing will be consummated or obtained in sufficient amounts necessary to meet the Company's needs, or that the Company will be able to meet its future contractual obligations. Should management fail to obtain such financing, the Company may curtail its operations.

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The accompanying condensed consolidated financial statements do not include adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from an inability of the Company to continue as a going concern. As a result of the aforementioned factors, our independent auditors, in their report on our audited financial statements for the fiscal year ended June 30, 2013, expressed substantial doubt about our ability to continue as a going concern.

CTi's critical accounting policies and estimates are included in its Annual Report on Form 10-K for the year ended June 30, 2013, and did not change for the six months ended December 31, 2013.

The following is a comparison of our results of operations for the three months ended December 31, 2013 and 2012.

During the three months ended December 31, 2013, our revenue consisted primarily of NANO Neutralization System reactor sales of $495,266 to Desmet customers in in Uruguay, South Korea and Ecuador. This compares with $693,788 recorded during the same period in fiscal 2013.

Operating expenses for the three months ended December 31, 2013 amounted to $1,094,438 compared with $404,536 for the same period in 2012, an increase of $689,902, or 170%. In both periods, the major expense component was salaried compensation. Another major expense item was non-salaried compensation in Second Quarter 2014 to officers and consultants, issued in the form of stock warrants with fair value of $744,307. In the second quarter of fiscal 2014, compensation amounted to $888,930 or 76% of total costs compared with $220,316, or 48% of total costs in the second quarter of fiscal 2013. This increase in compensation in the second quarter of fiscal 2014 was attributable largely to the issuance of warrants to officers and consultants.

During the second quarter of 2014, the other major component of operating expense was professional service fees related to auditors, accounting, and legal services which amounted to $50,198 or 4.5% versus $39,770, or 9% of total operating expenses in the second quarter of fiscal 2013. These expenses were slightly higher in the current period as we increased reliance on third-party service providers rather than management, and the new auditor firm was engaged.

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Research and Development (R&D) expenses remained relatively low as we continued to rely on Desmet Ballestra for support in R&D. It is our intention to pursue R&D as our cash position permits.

Interest expense of $49,367 during current quarter was composed almost entirely of non-cash expenses of $47,367, $40,781 of which related to convertible note amortization, and $6,585 to accrued interest on short term loans outstanding. Cash interest of $2,000 was paid to a Convertible Note holder. In the second quarter of fiscal 2013, Interest Expense of $20,133 consisted of a non-cash expense of $12,972 relating to convertible notes, $10,336 in non-cash, accrued interest relating primarily to short term loans, and cash interest paid to convertible note holders in the amount of $19,995. Cash interest payments on our loan from the National Bank of California were $5,250 in Q2 2013.

The following is a comparison of our results of operations for the six months ended December 31, 2013 and 2012.

Revenue

During the six months ended December 31, 2013, our revenue consisted primarily of NANO Neutralization System reactor sales to Desmet customers in Uruguay, South Korea and Ecuador. This compares with $693,788 recorded during the same period in fiscal 2012 associated primarily with the sale of a NANO Neutralization System to a customer located in Argentina.

During the three months ended December 31, 2013, our cost of sales amounted to $16,633 which was the result of the revenue transactions described above for the three of the units for which licensing revenue was recognized.

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Operating Expenses

Operating expenses for the six months ended December 31, 2013 amounted to $1,434,222 compared with $832,295 for the same period in 2012, an increase of $601,927, or 72%. The increase was attributable largely to a $641,012 increase in General & Administrative Expenses (G&A) (attributable mostly to non-cash costs of $744,307 relating to the vesting of options and warrants issued for services) and $39,085 decrease in R&D expenses.

The primary expenditures during the first half of fiscal 2014 were approximately $127,000 for professional service fees such as auditors, attorneys, and SEC related services, $66,000 in consulting fees, $75,000 in Interest expenses, $46,000 in Insurance expenses and $183,000 in salaries and salary related expenses and $744,000 relating to the vesting of options and warrants issued for services. The expenses for the first half of fiscal 2013 were $495,000 for salaries and salary related expenses, $180,000 for professional, consulting, automobile and travel expenses. The increase in compensation in the first half of fiscal 2014 was attributable largely to the issuance of options and warrants to officers and consultants and decrease in salaries expense was mostly due to reduction in management.

Interest expense increased by $8,256, or 12%, for the six months ended December 31, 2013 as compared to 2012. Interest expense for the six months ended December 31, 2013 consisted of a non-cash expense of $55,174 relating to convertible notes, $13,171 in mostly non-cash, accrued interest relating primarily to short term loans, and cash interest paid to convertible note holders in the amount of $5,000.

The major uses of cash in the first half of fiscal 2013, by comparison, included a non-cash expense of $22,125 relating to convertible notes, $20,936 in mostly non-cash, accrued interest relating primarily to short term loans, and cash interest paid to convertible note holders in the amount of $47,710. Cash interest payments on our loan from the National Bank of California declined to $11,020.

The accompanying condensed consolidated financial statements have been prepared in conformity with generally accepted accounting principles which contemplate continuation of the Company as a going concern.  During the six months ended December 31, 2013, the Company incurred a net loss of $1,030,935 and utilized $129,190 pf cash in operations. As of December 31, 2013, the Company had a working capital deficiency of $2,549,492 and a stockholders' deficit of $2,313,158.   These factors, among others, raise substantial doubt about the Company's ability to continue as a going concern. Our independent auditors, in their report on our audited financial statements for the fiscal year ended June 30, 2013 expressed substantial doubt about our ability to continue as a going concern. The accompanying condensed consolidated financial statements do not include adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from an inability of the Company to continue as a going concern.

Management's plan is to generate income from operations by continuing to license our technology globally through our strategic partner, the Desmet Ballestra Group (Desmet). Desmet has agreed to provide us monthly advances of $125,000 against future sales. During the six months ended December 31, 2013, advances received from Desmet amounted to $625,000. We will also attempt to raise additional debt and/or equity financing to fund operations and to provide additional working capital. However, there is no assurance that such financing will be consummated or obtained in sufficient amounts necessary to meet the Company's needs, that the Company will be able to achieve profitable operations or that the Company will be able to meet its future contractual obligations. Should management fail to obtain such financing, the Company may curtail its operations.

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On December 31, 2013, we had cash on hand in the amount of $74,143. In addition to the funds on hand, we will require additional funds to continue to operate our business. This includes expenses we will incur in connection with costs to manufacture and ship our products; costs to design and implement an effective system of internal controls and disclosure controls and procedures; costs of maintaining our status as a public company by filing periodic reports with the SEC and costs required to protect our intellectual property. In addition, we have contractual commitments for salaries to our executive officers. In light of our financial commitments over the next several months and its liquidity constraints, we have implemented cost reduction measures in all areas of operations. We intend to review these measures on an ongoing basis and make additional decisions as may be required.

Net cash used in operating activities during the six months ended December 31, 2013 amounted to $129,190 compared with $278,717 for the same period in fiscal 2013. Funding for the operating and investing activities was provided by $625,000 in advances from our distributor, and partially from cash reserves. For the first six months of fiscal 2014, we paid approximately $183,000 in compensation, $210,000 in fixed operating costs, $127,000 in professional services fees, $46,000 in various insurance premiums, and $5,000 in interest payments, and other obligations, including consulting fees, of about $200,000. For the first half of fiscal 2013, cash was used to pay approximately $163,000 in fixed operating costs, $94,000 in compensation, $128,000 in professional service fees, $33,000 in manufacturing costs, $32,000 in marketing and sales and $79,000 in interest payments. We paid other obligations amounting to $32,000.

Net cash used in investing activities during the six months ended December 31, 2013 was relating to $15,776 in capitalized patents and $22,867 for property, plant, and equipment. During the same period ended December 31, 2012, we invested $12,654 in capitalized patents and $51,182 in property, plant and equipment.

For the first half of fiscal 2014, funding was provided advances from Desmet of $625,000 and cash reserves. For the first half of fiscal 2013, financing activities were funded by $625,000 in advances against sales from Desmet along with $153,000 in convertible debt. We used the convertible note funding to repay $55,000 in existing convertible debt. We used the advances from Desmet and convertible note proceeds to pay off $350,000 of principal on the bank loan and $53,000 in repayment of a convertible note payable as well as interest on various notes and $55,000 in short term loans. Net cash provided by financing activities during the six months ended December 31, 2012 amounted to approximately $266,000.

Not applicable for smaller reporting companies.

In accordance with rule 13a-15(a), CTi management must maintain disclosure controls and procedures as defined in Rule 13a-15(e) of the Securities and Exchange Act of 1934, or the Exchange Act, to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms, and accumulated and communicated to the Company's management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

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In accordance with Rule 13a-15(b) and (c), management must also evaluate the effectiveness of these disclosure control and procedures at the end of each fiscal year. As of December 31, 2013, the Company carried out an evaluation, under the supervision and with the participation of its principal executive officer and principal financial officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based upon that evaluation, the Company's principal executive officer and principal financial officer concluded that these disclosure controls and procedures were not effective as of December 31, 2013.

There were no changes in internal control over financial reporting during the second quarter of fiscal 2014 that have materially affected or are reasonably likely to materially affect the company's internal control over financial reporting.

We know of no material, existing or pending legal proceeding against our Company, nor are we involved as a plaintiff in any material proceeding or pending litigation. There are no proceedings in which any of our directors, officers or affiliates, or any registered or beneficial shareholder, is an adverse party or has a material interest adverse to our interest.

None.

None

None

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Item 6 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES

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SIGNATURES

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

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