Genasys Inc. - Quarter Report: 2005 June (Form 10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

Commission File Number: 000-24248

AMERICAN TECHNOLOGY CORPORATION
(Exact name of registrant as specified in its charter)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YESx  NO o

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of August 2, 2005.

1

AMERICAN TECHNOLOGY CORPORATION

INDEX

2

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

American Technology Corporation
BALANCE SHEETS
(Unaudited)

3

American Technology Corporation
STATEMENTS OF OPERATIONS
(Unaudited)

See accompanying notes to interim financial statements.

4

American Technology Corporation
STATEMENTS OF CASH FLOWS
(Unaudited)

See accompanying notes to interim financial statements.

5

1. OPERATIONS

American Technology Corporation (the Company) is engaged in design, development and commercialization of sound, acoustic and other technologies. The Company produces products based on its HyperSonic® Sound (HSS®), Long Range Acoustic Device (LRAD™), Medium Range Acoustic Device (MRAD^TM), NeoPlanar® and other sound technologies.

The Company’s operations are organized into two segments by the end-user markets they serve. The Commercial Products Group, (Commercial Group), formerly known as the Business Products and Licensing Group, markets and licenses HSS and NeoPlanar products to companies that employ audio in consumer, commercial and professional applications. The Government and Force Protection Systems Group (Government Group) markets LRAD, MRAD, NeoPlanar, SoundCluster™ and HSS products to government and military customers and to the expanding force protection and commercial security markets.

The Company’s principal markets for its proprietary sound reproduction technologies and products are in North America, Europe and Asia.

The Company continues to be subject to certain risks, including history of net losses and expectation to continue to incur net losses; dependence on a limited number of customers; reliance on third-party suppliers and manufacturers; competition; the uncertainty of the market for new sound products; limited manufacturing, marketing and sales experience; uncertainty regarding future warranty costs; and the substantial uncertainty of ability to achieve profitability and positive cash flow.

2.  STATEMENT OF PRESENTATION AND MANAGEMENT’S PLAN

The accompanying unaudited interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information. In the opinion of management, the interim financial statements reflect all adjustments of a normal recurring nature necessary for a fair presentation of the results for interim periods. Operating results for the three and nine months are not necessarily indicative of the results that may be expected for the year. The interim financial statements and notes thereto should be read in conjunction with the Company’s audited financial statements and notes thereto for the year ended September 30, 2004 included in the Company’s annual report on Form 10-K. Certain amounts reported in prior periods have been reclassified to be consistent with the current period presentation.

Other than cash of $2,369,591 at June 30, 2005, accounts receivable collections and the net proceeds of the equity financing completed in July 2005 (see Note 15 below) (the 2005 Equity Financing), the Company has no other material unused sources of liquidity at this time. The Company has financed its operations primarily through cash generated from product sales and from financing activities. Management expects to incur additional operating losses during the balance of fiscal 2005 as a result of expenditures for research and development and marketing costs. The timing and amounts of these expenditures and the extent of the Company’s operating losses will depend on future product sales levels and other factors, some of which are beyond management’s control. Based on the Company’s cash position at June 30, 2005 and the proceeds of the 2005 Equity Financing, and assuming currently planned expenditures and level of operations, management believes the Company will have sufficient capital resources for at least the next twelve months. Management believes product sales will provide additional operating funds. If required, management has significant flexibility to adjust the level of research and development and selling and administrative expenses based on the availability of resources.

3.  NET LOSS PER SHARE

Basic earnings (loss) per share includes no dilution and is computed by dividing income (loss) available to common stockholders, after deduction for cumulative imputed and accreted dividends, by the weighted average number of common shares outstanding for the period. Diluted earnings (loss) per share reflects the potential dilution of securities that could share in the earnings of an entity. The Company’s losses for the periods presented cause the inclusion of potential common stock instruments outstanding to be antidilutive. Stock options and warrants exercisable into 4,442,044 shares of common stock were outstanding at June 30, 2005 and stock options, warrants and convertible preferred stock exercisable or convertible into 5,071,647 shares of common stock were outstanding at June 30, 2004. These securities are not included in the computation of diluted earnings (loss) per share because of the losses but could potentially dilute earnings (loss) per share in future periods.

6

The Company allocated the proceeds from prior preferred stock issuances between the preferred stock and warrants and also calculated the beneficial conversion discount for each series of preferred stock. The value of the beneficial conversion discount and the value of the warrants were recorded as a deemed dividend and were accreted over the conversion period of the preferred stock. Net loss available to common stockholders was increased in each period presented in computing net loss per share by the accretion of the value of these imputed deemed dividends. Such imputed deemed dividends were not included in the Company’s stockholders’ equity as the Company has an accumulated deficit. Amounts were included in net loss available to common stockholders. The imputed deemed dividends were not contractual obligations of the Company to pay such imputed dividends. All of the Company’s outstanding shares of Series D and E Preferred Stock were converted to common stock during the quarter ending March 31, 2005.

The provisions of each of the Company’s series of preferred stock also provided for a 6% per annum accretion in the conversion value (similar to a dividend). These amounts also increased the net loss available to common stockholders. Net loss available to common stockholders is computed as follows:

On January 18, 2005, the Company gave notice to all holders of Series D and Series E Preferred Stock that it had elected to convert all of the outstanding shares of Series D and Series E Preferred Stock to common stock. The designations, rights and preferences of the Series D and Series E Preferred Stock permitted the Company to exercise this conversion option if the market price of its common stock exceeded $9.50 for ten consecutive trading days and certain other conditions were satisfied. The price condition was satisfied on January 6, 2005. The conversion of the Series D Preferred Stock was effective on January 18, 2005 and resulted in all 50,000 issued and outstanding shares of Series D Preferred Stock converting into an aggregate of 129,259 shares of common stock. The conversion of the Series E Preferred Stock was effective on February 1, 2005, and resulted in all 233,250 issued and outstanding shares of Series E Preferred Stock converting into an aggregate of 801,306 shares of common stock.

As all the Series D and Series E Preferred Stock were called for conversion as described above, $1,504,711 of deemed dividends were accelerated and accreted in the quarter ending March 31, 2005, in addition to the accretion of $13,940 at the stated rate of 6%, increasing the net loss available to common stockholders for that period.

7

4.  STOCK-BASED COMPENSATION

The Company accounts for employee stock-based compensation using the intrinsic value method. In most cases, the Company does not recognize compensation expense for its employee stock option grants, as they have been granted at the fair market value of the underlying common stock at the grant date. Had compensation expense for the Company’s employee stock option grants been determined based on the fair value at the grant date for awards through June 30, 2005 consistent with the provisions of Statement of Financial Accounting Standards No. 123, its after-tax net income and after-tax net income per share would have been reduced to the pro forma amounts indicated below:

The Company estimates the fair value of each stock award at the grant date by using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants in 2005 and 2004, respectively: dividend yield of zero percent for each period; expected volatility of 53 to 58 percent in 2005 and 60 to 75 percent in 2004; risk-free interest rates of 3.82 to 1.84 percent; and expected lives of 2.5 years for each period. The estimated fair value of the options so determined is then amortized to expense over the options’ vesting periods.

5.  RECENT ACCOUNTING PRONOUNCEMENTS

In December 2004, the Financial Accounting Standards Board (FASB) issued Financial Accounting Standard (FAS) 123R, “Share Based Payment” (“Statement 123R”) Although Statement 123R states that it is effective for public companies at the beginning of the first interim or annual period after June 15, 2005, the Securities and Exchange Commission has adopted a rule delaying the required compliance date to the first interim or annual reporting period of the registrant’s first fiscal year beginning on or after June 15, 2005. Therefore, the Company will first be required to comply with Statement 123R in the quarter ending December 31, 2005. This statement eliminates the ability to account for share-based compensation using the intrinsic value-based method under APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Statement 123R would require the Company to calculate equity-based compensation expense for stock options and employee stock purchase plan rights granted to employees based on the fair value of the equity instrument at the time of grant. Currently, the Company discloses the pro forma net income (loss) and the related pro forma income (loss) per share information in accordance with FAS 123 and FAS 148, “Accounting for Stock-Based Compensation Costs-Transition and Disclosure.” The Company has not evaluated the impact that Statement 123R will have on its financial position and results of operations.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs an amendment of ARB 43, Chapter 4.” SFAS No. 151 clarifies that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges and requires the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005. The Company is currently evaluating the financial statement impact of the implementation of SFAS No. 151.

8

In December 2004, the FASB issued SFAS No. 153, “Exchanges of Non-monetary Assets, an Amendment of APB Opinion No. 29”, which is effective for non-monetary exchanges occurring in fiscal periods beginning after June 15, 2005. SFAS No. 153 amends APB Opinion No. 29, “Accounting for Non-monetary Transactions” to eliminate the exception for non-monetary exchanges of similar productive assets and replaces it with a general exception for exchanges of non-monetary assets that do not have commercial substance. A non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The Company does not expect SFAS No. 153 to affect the Company’s financial condition or results of operations.

In September 2004, the Emerging Issues Task Force (EITF) reached consensus on EITF Issue 04-8, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share”, which provides guidance on when the dilutive effect of contingently convertible debt securities with a market price trigger should be included in diluted earnings per share. The guidance is effective for all periods ending after December 15, 2004. The Company’s adoption of EITF 04-8 did not have an impact on the Company’s loss per share calculation for the periods presented herein and is not expected to have an impact in the future.

In March 2005, the FASB issued Interpretation No. 47 (“FIN 47”), “Accounting for Conditional Asset Retirement Obligations.” FIN 47 clarifies that an entity must record a liability for a “conditional” asset retirement obligation if the fair value of the obligation can be reasonably estimated. The provision is effective no later than the end of fiscal years ending after December 15, 2005. The Company does not expect FIN 47 to affect the Company’s financial condition or results of operations.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections”, applying to all voluntary accounting principle changes as well as the accounting for and reporting of such changes. SFAS No. 154 replaces APB Opinion No. 20, “Accounting Changes”, and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements.” SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company does not expect SFAS No. 154 to affect the Company’s financial condition or results of operations.

In March 2005, the Securities and Exchange Commission (“SEC”) issued staff accounting bulletin 107 (“SAB 107”) which expresses views of the SEC staff regarding the interaction between Statement 123R and certain SEC rules and regulations and provide the staff’s views regarding the valuation of share-based payment arrangements for public companies. SAB 107 provides guidance related to share-based payment transactions with non-employees, the transition from nonpublic to public entity status, valuation methods (including assumptions such as expected volatility and expected term), the accounting for certain redeemable financial instruments issued under share-based payment arrangements, the classification of compensation expense, non-GAAP financial measures, first-time adoption of Statement 123R in an interim period, capitalization of compensation cost related to share-based payment arrangements, the accounting for income tax effects of share-based payment arrangements upon adoption of Statement 123R, the modification of employee share options prior to adoption of Statement 123R and disclosures in Management’s Discussion and Analysis subsequent to adoption of Statement 123R. The Company has not evaluated the impact that SAB 107 will have on its financial position and results of operations.

9

6.  INVENTORIES AND CONTRACT MANUFACTURING

Inventory is stated at the lower of cost, which approximates actual costs on a standard cost basis, or market. At June 30, 2005 $104,535 of inventory was located at the Company’s contract manufacturer.

Inventories consisted of the following:

During the nine months ended June 30, 2005, the Company shipped materials to its contract manufacturer, booked an amount due from the contract manufacturer and reduced inventory by $439,312. The Company did not recognize any revenue on these transactions. At June 30, 2005, the remaining balance due from the contract manufacturer, for shipments made to it, was $67,619. The contract manufacturer is using these materials to build products for the Company. The amount due from the contract manufacturer of $67,619 has been netted against the payable due to the contract manufacturer.

7.  CUSTOMER CONCENTRATION

For the three months ended June 30, 2005, sales to one customer in the Government Group accounted for 62% of total revenues. At June 30, 2005, this customer accounted for 21% of accounts receivable, net, and three other customers accounted for 30%, 21% and 14% of accounts receivable, net, respectively. No other customer accounted for more than 10% of accounts receivable, net, at June 30, 2005. For the three months ended June 30, 2004, sales to three customers in the Government Group accounted for 62%, 22% and 13% of total revenues. At June 30, 2004 the accounts receivable from these three customers accounted for 40%, 28% and 6% of accounts receivable, net, respectively and no other customer accounted for more than 10% of accounts receivable, net. For the nine months ended June 30, 2005, sales to one customer in the Government Group accounted for 79% of total revenues and sales to a second customer in the Government Group, including affiliates of the customer, accounted for 10% of total revenues. For the nine months ended June 30, 2004, sales to two customers in the Government Group accounted for 51% and 28% of total revenues, respectively. Management believes that the loss of any one of these significant customers would have a material adverse effect on the Company’s results of operations and financial condition.

8.  INTANGIBLES

Patents are carried at cost and, when granted, are amortized over their estimated useful lives. The carrying value of patents is periodically reviewed and impairments, if any, are recognized when the expected future benefit to be derived from an individual intangible asset is less than its carrying value. Patents consisted of the following:

10

9.  PRODUCT WARRANTY COST

The Company establishes a warranty reserve based on anticipated warranty claims at the time product revenue is recognized. Factors affecting warranty reserve levels include the number of units sold and anticipated cost of warranty repairs and anticipated rates of warranty claims. The Company evaluates the adequacy of the provision for warranty costs each reporting period.

Changes in the warranty reserve during the three and nine months ended June 30, 2005 and 2004 were as follows:

10.  UNSECURED SUBORDINATED PROMISSORY NOTES AND RELATED PARTY TRANSACTION

In December 2004, the Company sold an aggregate of $2,000,000 of 8% unsecured subordinated promissory notes due December 31, 2006. Interest on these notes accrues at the rate of 8% per year and is due and payable quarterly in arrears. For the three and nine months ended June 30, 2005, the Company recorded interest on these notes of $39,890 and $82,849, respectively. The Company was required to use 40% of the net proceeds of any future equity financing to prepay these notes, and the balance due on the notes and accrued interest were paid in full in July 2005 following the completion of the 2005 Equity Financing (see Note 15). In connection with the issuance of the notes, the purchasers were granted warrants to purchase an aggregate of 150,000 shares of common stock. The exercise price of the warrants was $9.28 per share for purchasers who were directors, officers, employees or consultants of the Company, or affiliates of such persons, and $8.60 per share for other purchasers. Warrants exercisable for 75,000 shares were issued at each such exercise price. The fair value of such warrants, which amounted to $723,000, and closing costs of $20,977 were recorded as debt discount and amortized over the term of the notes. The following variables were used to determine the fair value of the warrants under the Black-Scholes option pricing model: volatility of 56%, term of five years, risk free interest of 2.97% and underlying stock price equal to fair market value at the time of grant. For the three and nine months ended June 30, 2005, $91,737 and $190,530, respectively, of debt discount was amortized.

A trust affiliated with an officer, director and significant stockholder of the Company purchased one of the aforementioned promissory notes in the principal amount of $500,000 and received a warrant exercisable for 37,500 shares with an exercise price of $9.28 per share.

11

11.  STOCKHOLDERS’ EQUITY

Summary

The following table summarizes changes in equity components from transactions during the nine months ended June 30, 2005:

During the quarter ended March 31, 2005, all previously outstanding shares of Series D and Series E Preferred Stock were converted into an aggregate of 930,565 shares of common stock and no preferred stock was outstanding at June 30, 2005.

Committed Equity Financing Facility

In December 2004, the Company entered into a common stock purchase agreement, registration rights agreement and warrant as part of a Committed Equity Financing Facility (CEFF) with Kingsbridge Capital Ltd., pursuant to which Kingsbridge committed to purchase up to $25 million of the Company’s common stock. As part of the arrangement, the Company issued a warrant to Kingsbridge to purchase 275,000 shares of its common stock at a price of $8.60 per share. The warrant was exercisable beginning six months after the date of grant and for a period of five years thereafter. Subject to certain conditions, including the effectiveness of a registration statement registering the shares issuable to Kingsbridge, the Company had the right to require Kingsbridge to purchase a maximum of 3,684,782 newly-issued shares of its common stock at a price between 88% and 92% of the volume weighted average price during a 15 day purchase period. The 3,684,782 share maximum also included any shares that the Company may have issued in lieu of paying Kingsbridge liquidated damages in the event that a registration statement was unavailable for the resale of the securities purchased by Kingsbridge under the CEFF once the registration statement had been declared effective. The Company had no obligation to draw down all or any portion of the commitment during its 24-month term.

As part of the arrangement, the Company also agreed to file a registration statement, within 45 days after entering into the agreement for the CEFF, for the resale of shares to be acquired under the CEFF, or upon exercise of the warrant. In January 2005, the Company filed the required resale registration statement. In June 2005, the Company decided to terminate the CEFF; and on July 1, 2005, the Company requested withdrawal of the registration statement.

12

In July 2005, the Company entered into a termination, settlement and release agreement with Kingsbridge. Under the terms of this agreement, the Company and Kingsbridge agreed that the common stock purchase agreement entered into with Kingsbridge in December 2004, and the related registration rights agreement and warrant issued to Kingsbridge of the same date would be terminated, and Kingsbridge would return the warrant, which was not exercised, to the Company for cancellation. No shares were sold to Kingsbridge under the CEFF prior to the termination. The Company incurred no early termination penalties in connection with this termination. The termination agreement contains a mutual release of claims.

The fair value of the warrant at the date of issuance, which amounted to $843,105, and legal, audit and associated fees of $293,826, were recorded as prepaid transaction costs. The following variables were used to determine the fair value of the warrant under the Black-Scholes option pricing model: volatility of 56%, term of 5.5 years, risk free interest of 2.97% and underlying stock price equal to fair market value at the time of issuance. The warrant has been accounted for as a derivative instrument in accordance with Emerging Issues Task Force (EITF) 00-19 “Accounting for Derivative Financial Instruments, Indexed to, and Potentially Settled in a Company’s Own Stock.” As a derivative, the fair value of the warrant is recorded as a liability at its estimated fair value at each balance sheet date until the effective date of the related registration statement, or upon warrant exercise, when the warrant liability, as may be further revalued, would have been reclassified to equity. Changes in the fair value of the warrant are recorded as other income or expense in the accompanying income statement. For the three and nine months ended June 30, 2005, $451,190 and $183,259, respectively, was recorded as unrealized gain on derivative revaluation for the change in valuation of the fair value of the warrant.

Due to the decision to terminate this financing, the Company determined that the value of the prepaid transaction cost asset was impaired at June 30, 2005. Accordingly, the Company recognized an impairment charge in the total amount of $477,085, of which $293,826 is legal, audit and associated fees and is recorded as selling, general and administrative expense for the three and nine months ended June 30, 2005, and $183,259,is the excess of the fair value of the warrant over the associated derivative instrument liability and is recorded as warrant impairment expense for the three and nine months ended June 30, 2005. The remaining asset of $659,846 in prepaid transaction costs will be offset against the derivative instrument liability of the same amount during the quarter ending September 30, 2005, with no net effect on other income or expense.

Stock Options

During the nine months ended June 30, 2005, the Company recorded non-cash compensation expense of $266,963 for the extension of time to exercise stock options for former employees relating to an aggregate of 92,675 shares of common stock and $57,619 for option expense relating to options for 68,125 shares held by an officer of the Company who transitioned from employee to consultant. For the three and nine months ended June 30, 2005, the Company also recognized $1,540 and $4,620 of non-cash compensation expense, respectively, for the value of options granted to non-employees. These options were valued in the same manner as described in Note 4 for employee options. There were no non-cash compensation expenses for the quarter ended June 30, 2004 or for the nine months ended June 30, 2004.

The following table summarizes information about stock option activity during the nine months ended June 30, 2005:

Options outstanding are exercisable at prices ranging from $2.50 to $10.06 and expire over the period from 2005 to 2010 with an average life of 3.1 years.

13

Stock Purchase Warrants

The following table summarizes information about warrant activity during the nine months ended June 30, 2005:

At June 30, 2005, the following stock purchase warrants were outstanding arising from offerings and other transactions:

As a result of the termination of the Kingsbridge Agreement (see Committed Equity Financing Facility section above), the warrant for 275,000 shares which was exercisable until June 14, 2010 at $8.60 per share was cancelled on July 11, 2005.

The warrants exercisable for 272,729 shares which expire on July 10, 2007 contain anti-dilution provisions, and as a result of the 2005 Equity Financing (see Note 15 below) the exercise price of those warrants will adjust from $6.75 to $6.55 at the option of the holders.

12.  BUSINESS SEGMENT DATA

The Company is engaged in design, development and commercialization of sound, acoustic and other technologies. The Company’s operations are organized into two segments by the end-user markets they serve. The Company’s reportable segments are strategic business units that sell the Company’s products to distinct distribution channels. The Commercial Products Group (Commercial Group) markets and licenses HSS, NeoPlanar and other sound products incorporating the Company’s technologies to companies that employ audio in consumer, commercial and professional applications. The Government and Force Protection Systems Group (Government Group) markets LRAD, MRAD, NeoPlanar, Sound Cluster and HSS sound products to government and military customers and to the expanding force protection and commercial security markets. The segments are managed separately because each segment requires different selling and marketing strategies as the class of customers within each segment is different.

The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company does not allocate operating expenses or assets between its two reportable segments. Accordingly the measure of profit for each reportable segment is gross profit.

14

13.  LEGAL PROCEEDINGS

In September 2003, the Company filed a complaint against eSoundIdeas, Inc., in the Superior Court of California, County of San Diego, alleging breach of contract and seeking a declaratory judgment to the effect that a License, Purchase and Marketing Agreement dated September 28, 2000 (the “ESI License Agreement”) with eSoundIdeas, a California partnership, was properly terminated in May 2003. The principals of eSoundIdeas are Greg O. Endsley and Douglas J. Paschall. The principals also founded a corporation, eSoundIdeas, Inc., which purported to assume the contractual obligations of eSoundIdeas.

In April 2005, the Company, ESI and its two principals entered into a Settlement Agreement and Mutual Release. As part of the settlement, the Company agreed to pay $150,000, which was previously accrued and recorded as a general and administrative expense, and to issue 17,500 shares of common stock to ESI. The fair market value of these as of April 27, 2005 of $140,175 was recorded in the quarter ended March 31, 2005 as a general and administrative expense. In addition, Mr. Endsley and Mr. Paschall will be entitled to receive an aggregate commission equal to 1% of net sales from April 1, 2005 to September 28, 2007, of the Company’s HSS products specifically targeted for use in North America in the point of sale/purchase, kiosk, display, event, trade show and exhibit markets, subject to a maximum aggregate commission of $500,000. The Company also granted the recipients of the shares “piggyback” rights to have their shares included on future registration statements that the Company might file.

The Company may at times be involved in litigation in the ordinary course of business. The Company will also, from time to time, when appropriate in management’s estimation, record adequate reserves in the Company’s financial statements for pending litigation. Except as set forth above, there are no pending material legal proceedings to which the Company is a party or to which any of its property is subject.

14.  INCOME TAXES

At June 30, 2005, a valuation allowance has been provided to offset the net deferred tax asset as management has determined that it is more likely than not that the deferred tax asset will not be realized. At September 30, 2004 the Company had for federal income tax purposes net operating loss carryforwards of approximately $37,400,000, which expire through 2025 of which certain amounts are subject to significant limitations under the Internal Revenue Code of 1986, as amended.

15.  SUBSEQUENT EVENTS

On July 18, 2005, the Company sold 2,868,851 shares of common stock at a purchase price of $4.88 per share (the 2005 Equity Financing). The Company also issued warrants in two series to the investors to purchase 1,581,919 shares of common stock. The “A” Warrants are exercisable for an aggregate of 717,213 shares of common stock at an exercise price of $6.36 per share until July 18, 2009. The “B” Warrants are exercisable for an aggregate of 864,706 shares of common stock at an exercise price of $7.23 per share and are exercisable from the date the registration statement referred to below becomes effective until the date six months after that effective date.

15

The gross proceeds from this financing were approximately $14 million. The Company incurred financing and closing costs of approximately $740,000. The Company used approximately $2.0 million of the gross proceeds to discharge the principal balance of and accrued interest on the 8% unsecured subordinated promissory notes due December 31, 2006 (see Note 10). The Company entered into a registration rights agreement with the investors, and agreed to prepare and file, within 30 days following the issuance of the securities, a registration statement covering the resale of the shares of common stock sold and the common stock issuable upon the exercise of the warrants. Failure to have an effective registration statement within 90 days obligates the Company to pay liquidated damages to the purchasers in the amount of 0.5% of the gross proceeds per month until 180 days after the closing and 1% of the gross proceeds per month thereafter.

The Company has also agreed to submit the financing to a vote of its stockholders for approval prior to June 2006. The Company further agreed that, subject to certain exceptions, if during the next year it sells shares of its common stock, or options or warrants to purchase shares of its common stock, in a private placement or in a public offering using a Form S-3, the purchasers will have certain rights of first refusal to participate in the financing. The Company has also agreed to indemnify the purchasers for certain losses.

The “A” Warrants and “B” Warrants contain provisions that would adjust the exercise price, and in inverse proportion adjust the number of shares subject to the warrant, in the event the Company pays or effects stock dividends or splits, or in the event the Company sells shares of its common stock at a purchase price, or options or warrants to purchase shares of its common stock having an exercise price, less than the exercise price of the applicable warrant. The “A” Warrants also feature a net exercise provision, which enables the holder to choose to exercise the warrant without paying cash by surrendering shares subject to the warrant with a market value equal to the exercise price. This right is available only if a registration statement covering the shares subject to the “A” Warrants is not available after it is initially declared effective. The Company has the right to redeem the “B” Warrants if the closing price of the shares of its common stock is $10.00 or greater for 15 consecutive trading days and the holder does not exercise within 20 days after the Company gives notice of redemption.

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

The following discussion should be read in conjunction with the accompanying unaudited interim financial statements and the related notes included under Item 1 of this Quarterly Report on Form 10-Q, together with Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2004.

The following discussion provides an overview of our results of operations for the three and nine months ended June 30, 2005 and 2004. Significant period-to-period variances in the statements of operations are discussed under the caption “Results of Operations.” Our financial condition and cash flows are discussed under the caption “Liquidity and Capital Resources.”

Forward Looking Statements

This report contains certain statements of a forward-looking nature relating to future events or future performance. Words such as  “expects,”“anticipates,”“intends,”“plans,”“believes,”“seeks,”“estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the only means of identifying forward-looking statements. Prospective investors are cautioned that such statements are only predictions and that actual events or results may differ materially. In evaluating such statements, prospective investors should specifically consider various factors identified in this report, including the matters set forth below under the caption“Business Risks”, which could cause actual results to differ materially from those indicated by such forward-looking statements.

16

Overview

We are an innovator of proprietary sound reproduction technologies and products. We believe our sound technologies provide us a significant competitive advantage in our principal markets. We believe we are the leader in developing and commercializing parametric loudspeakers, branded as HyperSonic® Sound or HSS®. We believe we are also the leader in developing and commercializing high intensity directed acoustical devices, branded as Long Range Acoustic Device or LRAD™ and Medium Range Acoustic Device or MRAD™. We have more than 55 patents issued world-wide covering our various sound technologies, of which over 45 are patents issued in the United States. We also have over 265 pending patent applications world-wide, of which over 110 are pending patent applications in the United States.

We make significant investments in research and development to expand our technology and product portfolio. We have recently expanded our acoustic device product family by (a) introducing a new force protection product, the MRAD, a smaller and more portable product that complements our existing LRAD device; (b) introducing and signing the first license agreement for our new SoundVector scaleable, directional sound product; and (c) introducing a new NeoPlanar product line for emergency notification and general announcing markets that require high intelligibility. In our fiscal quarter ending September 30, 2005, we expect to begin deliveries of the H450, our latest generation HSS product model employing a new plastic emitter. The H450 provides improved performance over our previous models at approximately half the cost. We are utilizing our technologies and products to provide solutions for difficult acoustic challenges.

The four major products from our technology portfolio are listed below.

17

We believe we are uniquely equipped to provide our technologies and products in rapidly growing markets for new sound applications not currently served by conventional sound devices and as an alternative to conventional loudspeakers. We believe market factors such as the rapid growth of plasma and flat panel screens offer significant growth opportunities for our HSS focused sound solutions. We also believe that the growth in defense and homeland security and related protection spending by commercial customers provides a growing market for our sound products to be used for intelligible communication over long distances.

Our primary products sold to date have been LRAD and HSS products. During the nine months ended June 30, 2005, these products were manufactured for us by Pemstar, Inc., an established contract manufacturer with multiple locations worldwide. However, during the quarter ended June 30, 2005, we terminated the relationship with Pemstar, and starting in our fiscal fourth quarter expect to start manufacturing our products at a new contract manufacturer.

Our sales have been highly dependent on large orders from a small number of customers. We target our products for sale worldwide, but expect the largest markets to be the U.S., Europe and Asia. To date, our sales have been made in U.S. dollars and we do not expect currency fluctuations to have a material impact on our operations.

Overall Performance

For our third fiscal quarter ended June 30, 2005, revenues were 34% lower than the same period in the prior fiscal year primarily as a result of reduced LRAD deliveries to government customers. Operating expenses for the third fiscal quarter were 66% higher than the comparable prior year period, and as a result, our net loss for the quarter ended June 30, 2005, was 158% higher than for the comparable prior year period. Our revenues for the three months ended June 30, 2005 were $1,393,797, compared to $2,107,281 for the three months ended June 30, 2004. Our gross profit for the three months ended June 30, 2005 was 29% of revenues, compared to 52% of revenues for the comparable period in the prior fiscal year. We recorded a gross profit of $402,007 for the three months ended June 30, 2005, which was $698,955 lower than the gross profit of $1,100,962 for the three months ended June 30, 2004. Operating expenses increased from $2,504,650 for the three months ended June 30, 2004 to $4,147,489 for the three months ended June 30, 2005. In addition, for the three months ended June 30, 2005, there was $115,217 of net interest expense associated with subordinated notes sold in December 2004. Our net loss increased from $1,390,411 for the three months ended June 30, 2004 to $3,592,768 for the three months ended June 30, 2005.

As a result of our performance for the quarter and the substantial completion of major development projects such as MRAD, HSS 450 and SoundVector, we initiated an effort to reduce expenses while we continue to focus our efforts on near-term revenue and gross margin improvement from our existing, marketable products. As a result we decreased our headcount from 71 employees at March 31, 2005, to 46 employees as of June 30, 2005. The majority of the reductions were in research and development. At June 30, 2005, 9 employees were in research and development, 13 were in production, quality assurance and materials control, 11 were in general and administrative and 13 were in marketing, sales and licensing. We are closely monitoring expenses for all of our departments. Our policy is to establish a compelling business case for all initiatives.

Our various technologies are high risk in nature. Our future is largely dependent upon the success of our sound technologies. We invest significant funds in research and development, marketing and sales and on patent applications related to our proprietary technologies. Unanticipated technical or manufacturing obstacles can arise at any time and disrupt sales or licensing activities and result in lengthy and costly delays. See “Business Risks” below.

18

Recent Developments

In May 2005, Carl Gruenler, Vice President, Government and Force Protection Systems Group, left our company. Kalani Jones, President and Chief Operating Officer, assumed Mr. Gruenler’s duties. In July 2005, A.J. Ballard was appointed as Senior Director of the Government and Force Protection Systems Group, reporting to Kalani Jones.

In June 2005 we entered into a design and manufacturing licensing agreement with ECCO Group (ECCO), the world’s largest manufacturer of backup alarms for commercial vehicles. The agreement covers the initial licensing and product development of our SoundVector technology to ECCO and its affiliates for backup vehicle alarms and similar uses. The agreement includes technology transfer, product development assistance and upfront licensing fees, with royalties payable, based on unit volume production. The agreement is renewable on an annual basis after an initial three-year term, with further fees due upon each renewal.

In July 2005 we entered into an agreement to terminate the Committed Equity Financing Facility with Kingsbridge Capital Limited entered into in December 2004. The termination agreement resulted from our determination that the common stock purchase agreement was no longer consistent with our financing plans.

In July 2005 we completed an institutional financing providing gross proceeds of $14 million. After paying financing and closing costs and retiring approximately $2 million of unsecured subordinated promissory notes, we expect to use the net proceeds for marketing, sales and deliveries of our proprietary directed sound products and for general working capital.

Critical Accounting Policies

We have identified the policies below as critical to our business operations and the understandings of our results of operations. Our accounting policies are more fully described in our financial statements located in Item 1 of Part I, “Financial Statements.”

The methods, estimates and judgments we use in applying our accounting policies, in conformity with generally accepted accounting principles in the United States, have a significant impact on the results we report in our financial statements. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. The estimates affect the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions. We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require our most difficult, subjective, and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

Revenue Recognition.  We currently derive our revenue primarily from two sources: (i) component and product sale revenues and associated engineering and installation, which we refer to collectively as Product Sales and (ii) contract and license fee revenue. Product Sales revenues are recognized in the periods that products are shipped to customers, FOB shipping point or destination, when a signed contract exists, the fee is fixed and determinable, collection of resulting receivables is probable and there are no remaining obligations. Revenues from engineering contracts are recognized based on milestones or completion of the contracted services. Revenues from ongoing per unit license fees are earned based on units shipped incorporating our patented proprietary technologies and are recognized in the period when the ultimate customer accepts the product and collectibility is reasonably assured. Revenues from up-front license and other fees and annual license fees are generally recognized ratably over the specified term of the particular license or agreement.

Valuation of Intangible Assets.  Intangible assets include purchased technology and patents, which are amortized over their estimated useful lives. We must make judgments and estimates regarding the future utility and carrying value of intangible assets. The carrying values of such assets are periodically reviewed and impairments, if any, are recognized when the expected future benefit to be derived from an individual intangible asset is less than its carrying value. Our judgments and estimates regarding carrying value and impairment of intangible assets have an impact on our financial statements.

19

Warranty Reserve.  We establish a warranty reserve based on anticipated warranty claims at the time product revenue is recognized. These warranties require us to make estimates regarding the amount and costs of warranty repairs we expect to make over a period of time. Factors affecting warranty reserve levels include the number of units sold and anticipated cost of warranty repairs and anticipated rates of warranty claims. We evaluate the adequacy of the provision for warranty costs each reporting period. See Note 9 to our financial statements for additional information regarding warranties. The estimates we use have an impact on our financial statements. In the three and nine months ended June 30, 2005, we recorded a net warranty reduction of $10,350 and $103,430, respectively, as a result of the following: (a) we reduced the warranty reserve that we had previously established in fiscal 2003 for HSS Generation 1 products, primarily as a result of the expiration of the warranty period for HSS Generation 1 products sold, and (b) we recorded a warranty provision for current sales.

Guarantees and Indemnifications. Under our bylaws, we have agreed to indemnify our officers and directors for certain events. We also enter into certain indemnification agreements in the normal course of our business. We have no liabilities recorded for such indemnities.

Deferred Tax Asset. We have provided a full valuation reserve related to our substantial deferred tax asset as management has determined that it is more likely than not that the deferred tax asset will not be realized. In the future, if sufficient evidence of our ability to generate sufficient future taxable income in certain tax jurisdictions becomes apparent, we may be required to reduce our valuation allowances, resulting in income tax benefits in our statement of operations. We evaluate the realizability of the deferred tax assets and assess the need for valuation allowance quarterly. The utilization of the net operating loss carryforwards could be substantially limited due to restrictions imposed under federal and state laws upon a change in ownership. Congress passed the American Jobs Creation Act of 2004 in October 2004. The new law contains numerous changes to existing tax laws, including both domestic and foreign tax incentives. We have not yet determined what impact, if any, this new law may have on our deferred tax asset, or our future results of operations and financial condition.

Valuation of Inventory. Our inventory is comprised of raw materials, assemblies and finished products that we intend to sell to our customers. We must periodically make judgments and estimates regarding the future utility and carrying value of our inventory. The carrying value of our inventory is periodically reviewed and impairments, if any, are recognized when the expected future benefit from our inventory is less than its carrying value. In the quarter ended June 30, 2005, we reviewed the carrying value of our inventory and decreased the reserve for obsolescence to $293,535 from the level of $349,986 at March 31, 2005. The reserve is primarily for raw materials and finished goods that were used on older HSS and PMT products for which there is anticipated to be reduced demand.

Results of Operations

Revenues

Revenues for the three months ended June 30, 2005 were $1,393,797, representing a 34% decrease from $2,107,281 in revenues for the three months ended June 30, 2004. Revenues for the three months ended June 30, 2005 included $1,378,648 of product sales and $15,149 of contract and license revenues. Revenues for the three months ended June 30, 2004 consisted of $2,089,359 of product sales and $17,922 of contract and license revenues. The decrease in revenues was due to reduced sales of LRAD products by our Government Group and reduced sales of HSS products by our Commercial Products Group. The prior year period also included revenues from the sale of a 5MC public address system which we did not market during the current period. Our revenues are highly dependent on the timing of large orders from a small number of customers. We expect continued uneven quarterly revenues in future periods due to the lack of established markets for our proprietary products.

At June 30, 2005, we had $450,000 in deferred revenue consisting of deposits for existing contracts, agreements and licenses.

20

Revenues for the nine months ended June 30, 2005 were $8,620,104, representing a 97% increase from $4,375,309 in revenues for the nine months ended June 30, 2004. Revenues for the nine months ended June 30, 2005 and June 30, 2004 included $8,539,855 and $4,201,193 of product sales, and $80,249 and $174,116 of contract and license revenues, respectively. The increase in product sales was due primarily to increased sales of LRAD products by our Government Group.

We have only a limited record of recurring sales, so we do not consider order backlog to be an important index of future performance at this time. Our backlog is affected by the timing of large orders and order deliveries, especially to government customers. Our order backlog was approximately $660,000 at June 30, 2005 and approximately $46,800 at June 30, 2004. Backlog orders are subject to modification, cancellation or rescheduling by our customers. Future shipments may also be delayed due to production delays, component shortages and other production and delivery related issues.

Our Commercial Products Group, or Commercial Group, markets and licenses HSS, NeoPlanar and SoundVector products to companies, which employ audio in consumer, commercial and professional applications. Our Government and Force Protection Systems Group, or Government Group, markets LRAD, NeoPlanar, SoundCluster and HSS products to government and military customers and to the expanding force protection and commercial security markets.

Presented below is a summary of revenues by business segment:

Commercial Group revenues for all reported periods consisted primarily of HSS and Neoplanar product sales. Commercial Group revenues for the three and nine month periods ended June 30, 2004 consisted of multiple small volume sales. Commercial Group revenues for the three and nine month periods ended June 30, 2005 reflect a shift in our marketing focus to high volume contracts. These contracts require much longer sales cycles, and we had not at June 30, 2005 recognized significant revenues from such contracts.

Government Group revenues for all reported periods consisted primarily of sales of LRAD, NeoPlanar, and 5MC products and engineering services such as installation design and support. These revenues are derived primarily from a limited number of large orders, and the timing of follow-on orders, if any, is difficult to predict. Government Group sales for the three and nine month periods ended June 30, 2005 consisted primarily of LRAD and NeoPlanar product sales and, to a much lesser extent, engineering services.

For the three months ended June 30, 2005, sales to one customer in the Government Group accounted for 62% of total revenues and sales to a second customer in the Government Group, including affiliates of the customer, accounted for 12% of total revenues. For the nine months ended June 30, 2005, sales to one customer in the Government Group accounted for 79% of total revenues and sales to a second customer in the Government Group, including affiliates of the customer, accounted for 10% of total revenues. For the three months ended June 30, 2004, sales to three customers accounted for 62%, 22% and 13% of total revenues, respectively. For the nine months ended June 30, 2004, sales to two customers in the Government Group accounted for 51% and 28% of total revenues, respectively. The loss of any one of these significant customers would have a material adverse effect on our results of operations and financial condition.

21

Gross Profit

Presented below is the gross profit or loss by business segment:

The overall gross profit for the three months ended June 30, 2005 was $402,007, or 29% of revenues, compared to gross profit of $1,100,962, or 52% of revenues, for the comparable period of the prior fiscal year. Gross profit as a percentage of revenues declined over the comparable period of the prior fiscal year as a result of reduced gross profit in our Government Group, offset in part by decreased gross losses in our Commercial Group.

The overall gross profit for the nine months ended June 30, 2005 was $4,646,643, or 54% of revenues, compared to gross profit of $2,015,288, or 46% of revenues, for the comparable period of the prior fiscal year. The significant improvement in gross profit as a percentage of revenues reflected improved gross profit in our Government Group, offset in part by increased gross losses in our Commercial Group and increased expenses for inventory reserves.

We experienced gross losses in our Commercial Group for the three and nine months ended June 30, 2005 of $91,184 and $703,617, respectively, as limited sales were not sufficient to absorb fixed manufacturing overhead costs and substantial reserves were taken for obsolete and slow moving inventory, particularly for our older HSS products. For the three and nine months ended June 30, 2004, we had gross losses in our Commercial Group of $167,833 and $244,625 respectively, primarily as a result of limited sales compared to fixed overhead and warranty costs. During fiscal year 2003 and fiscal 2004 we changed our HSS Generation 1 emitter design to eliminate the requirement for a vacuum in the emitter, and we improved film quality. During fiscal 2004, we made further raw material improvements in the electronics and the manner in which the film and emitters are produced. In May 2005 we introduced a new, lower-cost model of our HSS product. We believe that the latest generation of our products will be more reliable. We expect that warranty costs will decrease in fiscal 2005, and that as the volume of HSS product sales grow, we will achieve positive gross margins in future periods.

Gross profit for our Government Group for the three and nine months ended June 30, 2005, was $493,191 and $5,350,260, respectively, compared to $1,268,795 and $2,259,913 for the three and nine months ended June 30, 2004. Cost of revenues for the three and nine months ended June 30, 2005 included $127,214 of costs associated with the partial shipment of an order.  The revenue associated with the order will be recognized upon shipment of complete products which is expected to occur in our fiscal fourth quarter. Gross profit percentage continues to be highly dependent on sales prices, sales volumes, purchasing costs and overhead allocations. Our various sound products have different margins, so product sales mix will materially affect gross profits. In addition, we continue to make model updates and changes including raw material and component changes, which change product costs and may result in expense for raw material and products that are deemed obsolete. We therefore do not believe that historical gross profit margins should be relied upon as an indicator of future gross profit margins.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were 207% of revenues for the three months ended June 30, 2005 compared to 77% of revenues for the three months ended June 30, 2004. These costs for the three months ended June 30, 2005 totaled $2,879,021, which represents an increase of $1,264,670 from selling, general and administrative expenses of $1,614,351 for the three months ended June 30, 2004.

22

The overall increase for the three months ended June 30, 2005 included the following:

Selling, general and administrative expenses were 81% of revenues for the nine months ended June 30, 2005 compared to 86% for nine months ended June 30, 2004. These costs for the nine months ended June 30, 2005 totaled $6,968,972, which represents an increase of $3,202,835 from selling general and administrative expenses of $3,766,137 for the nine months ended June 30, 2004. The overall increase for the nine months ended June 30, 2005 included the following:

We expect selling, general and administrative expenses to increase in future periods as we increase our marketing efforts for our proprietary sound technologies. We will also incur substantial additional expense over the remainder of fiscal 2005 to improve and document our internal control over financial reporting in anticipation of management’s required assessment of the effectiveness of our internal control over financial reporting and the attestation of such assessment by our independent registered public accounting firm, required by Section 404 of the Sarbanes-Oxley Act of 2002 in connection with our report on Form 10-K for the fiscal year ending September 30, 2005.

23

Research and Development Expenses

Research and development expenses increased by $378,169 from $890,299 to $1,268,468 for the three months ended June 30, 2005. Research and development expenses as a percentage of sales were 91% for the three months ended June 30, 2005 compared to 42% for the three months ended June 30, 2004.

The overall increase for the three months ended June 30, 2005 included the following:

Research and development expenses increased by $2,197,958 from $1,983,518 for the nine months ended June 30, 2004 to $4,181,476 for the nine months ended June 30, 2005. Research and development expenses as a percentage of sales were 49% for the nine months ended June 30, 2005 compared to 45% for the nine months ended June 30, 2004.

The overall increase for the nine months ended June 30, 2005 included the following:

Research and development expenses vary period to period due to the timing of projects, the availability of funds for research and development and the timing and extent of use of outside consulting, design and development firms. We expect our research and development expenses to decrease in future periods as a result of the completion of major projects and the reduction in the number of employees who are directly involved in product development and technology development.

Loss From Operations

Loss from operations was $3,745,482 for the three months ended June 30, 2005 compared to $1,403,688 for the three months ended June 30, 2004. The increase in loss from operations reflected a $1,642,839 increase in total operating expenses, and a decrease of $698,955 in gross profit.

Loss from operations was $6,503,805 for the nine months ended June 30, 2005 compared to $3,734,367 for the nine months ended June 30, 2004. The increase in loss from operations was due to a $5,400,793 increase in total operating expenses, offset in part by an increase of $2,631,355 in gross profit. Losses from operations are expected to continue in the current fiscal year.

24

Other Income (Expense)

We recorded $152,714 of other income and $228,830 of other expense for the three and nine months ended June 30, 2005, compared with $13,277 and $42,333 of other income for the three and nine months ended June 30, 2004. Other income for the three and nine months ended June 30, 2005 included $451,190 and $183,259, respectively, of unrealized gain on derivative revaluation related to the decrease in the fair value of the warrant issued to Kingsbridge Capital Limited in December 2004. Other income for the three and nine month periods ended June 30, 2005 was also reduced by a warrant impairment charge of $183,259 in each period, which represented the difference at June 30, 2005 between the fair value of the warrant determined at the date of issuance and the derivative instrument liability associated with such warrant. The impairment resulted from our decision in June 2005 to terminate that Kingsbridge financing arrangement, which termination became effective in July 2005. The remaining asset of $659,846 in prepaid transaction costs representing the unimpaired fair value of the warrant at June 30, 2005, and the remaining derivative instrument liability of the same amount, will be offset during the quarter ending September 30, 2005, with no net effect on other income or expense. We also incurred interest expense of $131,904 and $274,865 in the three and nine months ended June 30, 2005, primarily due to interest earned on the notes issued in December 2004 and the amortization of the debt discount on those notes. We recognized $16,687 and $46,035 of interest income from invested cash balances during the three and nine months ended June 30, 2005. During the three and nine months ended June 30, 2004, we recorded interest expense of $454 and $2,263, respectively, and $13,731 and $44,596, respectively, of interest income from invested cash balances.

Net Loss

Net loss for the three months ended June 30, 2005 was $3,592,768 compared to net loss of $1,390,411 for the three months ended June 30, 2004. The increase in net loss resulted primarily from higher operating expenses and decreases in gross margins from the comparable prior period. The unrealized derivative revaluation credit to expense of $451,190 offset in part by the $183,259 warrant impairment expense recorded for the three months ended June 30, 2005 also reduced the net loss for the period. Net loss for the nine months ended June 30, 2005 was $6,732,635 compared to net loss of $3,692,034 for the nine months ended June 30, 2004. The increase in net loss for the nine months ended June 30, 2005 as compared to the comparable period in the prior year resulted primarily from higher operating expenses, offset in part by increases in gross margins.

Net Loss Available to Common Stockholders

Net loss available to common stockholders was increased in each affected period in computing net loss per share by the accretion of the value of imputed deemed dividends arising from the beneficial conversion discount and the value of warrants associated with convertible preferred stock outstanding during each period. The imputed deemed dividends were not contractual obligations to pay such imputed dividends. Net loss available to common stockholders was also increased by the 6% accretion (similar to a dividend) on outstanding preferred stock. These amounts aggregated $-0-and $1,796,426 for the three and nine months ended June 30, 2005, and $387,019 and $1,087,570 for the three and nine months ended June 30, 2004. Accordingly, the net loss available to common stockholders was $3,592,768 and $8,529,061 for the three and nine months ended June 30, 2005, and $1,777,430 and $4,779,604 for the three and nine months ended June 30, 2004.

On January 18, 2005, we gave notice to all holders of Series D and Series E Preferred Stock that we had elected to convert the shares of Series D and Series E Preferred Stock to common stock. All 50,000 issued and outstanding shares of Series D Preferred Stock converted into an aggregate of 129,259 shares of common stock on the date of notice, and all 233,250 issued and outstanding shares of Series E Preferred Stock converted into an aggregate of 801,306 shares of common stock on February 1, 2005. As all the Series D and Series E Preferred Stock was called for conversion as described above, $1,504,711 was accreted in the second fiscal quarter, in addition to the accretion of $13,940 at the stated rate of 6%, and increased the net loss available to common stockholders.

Liquidity and Capital Resources

We have experienced significant negative cash flow from operating activities including developing and introducing our proprietary sound technologies. Our net cash used in operating activities was $5,455,018 for the nine months ended June 30, 2005 compared to $4,909,532 for the nine months ended June 30, 2004. For the nine months ended June 30, 2005, the net loss of $6,732,635 included certain expenses not requiring the use of cash totaling $1,226,685. For the nine months ended June 30, 2005, cash was used in operating activities through an increase of $1,104,060 in inventory, an increase of $173,157 in prepaid expenses and $86,515 in warranty deductions. Cash was provided in operating activities through a decrease of $339,439 in accounts receivable, an increase of $1,075,225 in accounts payable and accrued liabilities.

At June 30, 2005, we had accounts receivable of $507,308 as compared to $926,747 at September 30, 2004. The balance at June 30, 2005 represented approximately 37 days of revenues. One customer accounted for 30% of accounts receivable, two other customers accounted for 21% each of accounts receivable and a fourth customer accounted for 14% of accounts receivable at June 30, 2005. No other customer accounted for more than 10% of accounts receivable at June 30, 2005. Terms with individual customers vary greatly. We typically require pre-payment or a maximum of thirty-day terms for our proprietary sound technology products. Our receivables can also vary substantially due to overall sales volumes and due to quarterly and seasonal variations in sales and timing of shipments to and receipts from large customers and the timing of contract payments.

25

For the nine months ended June 30, 2005 and June 30, 2004 we used cash of $448,535 and $299,623, respectively, for the purchase of equipment and software and made investments of $187,579 and $254,096, respectively, in patents and new patent applications. We anticipate a continued investment in patents for the balance of fiscal 2005.

Cash from financing activities provided $4,281,755 and $1,099,026 for the nine months ended June 30, 2005 and June 30, 2004. During the nine months ended June 30, 2005, we received $2,000,000 from the sale of unsecured promissory notes, $1,661,277 from the exercise of common stock warrants and $649,577 from the exercise of stock options. During the nine months ended June 30, 2004, we received $50,000 from the exercise of common stock warrants and $1,056,367 from the exercise of common stock options.

At June 30, 2005, we had working capital of $1,365,194 compared to working capital of $3,472,984 at September 30, 2004.

In December 2004, we sold for cash in a private offering an aggregate of $2,000,000 of unsecured subordinated promissory notes due December 31, 2006. In connection with the financing, we also issued five-year warrants to purchase an aggregate of 150,000 shares, 75,000 of which have an exercise price of $9.28 per share, and 75,000 of which have an exercise price of $8.60 per share. A trust affiliated with Elwood G. Norris, our Chairman and the beneficial owner of 19.5% of our common stock before the financing, purchased a note in the principal amount of $500,000 and received a warrant exercisable for 37,500 shares with an exercise price of $9.28 per share. In July 2005, we redeemed the notes and paid all interest due using proceeds from the financing described below.

In July 2005, we sold 2,868,851 shares of common stock at a purchase price of $4.88 per share. We also issued warrants in two series to the investors to purchase 1,581,919 shares of common stock. The “A” Warrants are exercisable for an aggregate of 717,213 shares of common stock at an exercise price of $6.36 per share until July 18, 2009. The “B” Warrants are exercisable for an aggregate of 864,706 shares of common stock at an exercise price of $7.23 per share and are exercisable from the date the registration statement referred to below becomes effective until the date six months after that effective date.

The gross proceeds from this financing were $14 million. We incurred financing and closing costs of approximately $740,000. We entered into a registration rights agreement with the investors, and agreed to prepare and file, within 30 days a registration statement covering the resale of the shares of common stock sold and the common stock issuable upon the exercise of the warrants. Failure to have an effective registration statement within 90 days obligates us to pay liquidated damages to the purchasers in the amount of 0.5% of the gross proceeds per month until 180 days after the closing, and 1% of the gross proceeds per month thereafter. We used approximately $2.0 million of the gross proceeds to discharge the principal balance of and accrued interest on the unsecured subordinated promissory notes described above.

We have also agreed to submit the financing to a vote of our stockholders for approval prior to June 2006. We further agreed that, subject to certain exceptions, if during the next year we sell shares of our common stock, or options or warrants to purchase shares of our common stock, in a private placement or in a public offering using a Form S-3, the purchasers will have certain rights of first refusal to participate in the financing. We have also agreed to indemnify the purchasers for certain losses.

The “A” Warrants and “B” Warrants contain provisions that would adjust the exercise price, and in inverse proportion adjust the number of shares subject to the warrant, in the event we pay or effect stock dividends or splits, or in the event we sell shares of our common stock at a purchase price, or options or warrants to purchase shares of our common stock having an exercise price, less than the exercise price of the applicable warrant. The “A” Warrants also feature a net exercise provision, which enables the holder to choose to exercise the warrant without paying cash by surrendering shares subject to the warrant with a market value equal to the exercise price. This right is available only if a registration statement covering the shares subject to the “A” Warrants is not available after it is initially declared effective. We have the right to redeem the “B” Warrants if the closing price of the shares of our common stock is $10.00 or greater for 15 consecutive trading days and the holder does not exercise within 20 days after we give notice of redemption.

26

Other than cash and cash equivalents, we have no other unused sources of liquidity at this time. We expect to incur additional operating losses as a result of expenditures for research and development and marketing costs for our sound products and technologies. The timing and amounts of these expenditures and the extent of our operating losses will depend on many factors, some of which are beyond our control.

In July 2005 we entered into a termination, settlement and release agreement with Kingsbridge Capital Limited. Under the terms of this agreement, we and Kingsbridge agreed that the common stock purchase agreement we entered into with Kingsbridge in December 2004, and the related registration rights agreement and warrant we issued to Kingsbridge of the same date, would be terminated, and Kingsbridge would return the warrant, which has not been exercised, to us for cancellation. We incurred no early termination penalties in connection with this termination. The termination agreement contains a mutual release of claims.

The termination agreement resulted from our determination that the common stock purchase agreement was no longer consistent with our financing plans, due to various factors, including anticipated capital requirements and timing, market conditions, and SEC requirements for transaction structure.

Based on our current cash position, and assuming currently planned expenditures and level of operations, we believe we will have sufficient cash for operations for at least the next twelve months. We believe sales of LRAD, MRAD, HSS and, to a lesser extent, NeoPlanar products, will continue to contribute cash in fiscal 2005. In the event that we need additional funds, there can be no guarantee that we will be able to raise funds on terms acceptable to us, or at all. We have flexibility to adjust the level of research and development and selling and administrative expenses based on the availability of resources. However, reductions in expenditures could delay development and adversely affect our ability to generate future revenues.

Contractual Commitments and Commercial Commitments

The following table summarizes our contractual obligations at June 30, 2005, and the effect such obligations are expected to have on our liquidity and cash flow in future periods:

The Company had no material purchase obligations at June 30, 2005.

New Accounting Pronouncements

A number of new pronouncements have been issued for future implementation as discussed in the footnotes to our interim financial statements (see Note 5).

Business Risks

An investment in our company involves a high degree of risk. In addition to the other information included in this report, you should carefully consider the following risk factors in evaluating an investment in our company. You should consider these matters in conjunction with the other information included or incorporated by reference in this report. Our results of operations or financial condition could be seriously harmed, and the trading price of our common stock may decline due to any of these or other risks.

27

We have a history of net losses. We expect to continue to incur net losses and we may not achieve or maintain profitability.

We have incurred significant operating losses and anticipate continued losses in the remainder of fiscal 2005. At June 30, 2005, we had an accumulated deficit of $49,060,128. We need to generate additional revenue to be profitable in future periods. Failure to achieve profitability, or maintain profitability if achieved, may cause our stock price to decline.

We may need additional capital for growth.  

Our current plans indicate that depending on sales, we may need additional capital to support our growth. We may generate a portion of these funds from operations.

The actual amount of funds that we will need will be determined by many factors, some of which are beyond our control, and we may need funds sooner than currently anticipated. Principal factors that could affect the availability of our internally generated funds include:

When we require additional funds, general market conditions or the then-current market price of our common stock may not support capital raising transactions. If we require additional funds and we are unable to obtain them on a timely basis or on terms favorable to us, we may be required to scale back our research and development efforts, sell or license some or all of our technology or assets or curtail or cease operations. If we raise additional funds by selling additional shares of our capital stock or securities convertible into common stock, the ownership interest of our stockholders will be diluted.

Our equity financings impose certain liquidated damages which may impair our liquidity and ability to raise capital.  

In connection with our July 2005 equity financing, we entered into a registration rights agreement with some of the investors, pursuant to which we agreed to prepare and file a registration statement covering the resale of the shares of common stock sold in the financing as well as the shares of common stock issuable upon the exercise of the warrants sold in the financing. If, among other reasons, those selling stockholders are unable to re-sell their shares purchased in the financing or acquired upon exercise of their related warrants, we may be obligated to pay liquidated damages to those selling stockholders in the amount of 0.5% of the gross proceeds we received in that financing per month until January 14, 2006, and 1% of those gross proceeds per month thereafter. Similar provisions regarding the payment of liquidated damages apply to a financing we entered into in July 2003. The registration statement for that financing has been filed and is currently effective.

Two customers and their affiliates accounted for approximately 74% of our revenues for the three months ended June 30, 2005, the same two customers and their affiliates accounted for 89% of our revenues for the nine months ended June 30, 2005, and we continue to be dependent on a few large customers.

ADS, Inc., a prime vendor to the U. S. military, accounted for 62% of net revenues for the three months ended June 30, 2005 and a second customer and its affiliates accounted for 12% of revenues for the period. For the nine months ended June 30, 2005, ADS accounted for 79% of our revenues and a second customer and its affiliates accounted for 10% of our revenues. These customers have the right to cease doing business with us at any time. If this were to occur and we could not replace them, our net revenues would decline substantially. Any such decline could result in us incurring net losses, increasing our accumulated deficit and causing us to need to raise additional capital to fund our operations.

28

We must expand our customer base in order to grow our business.

To grow our business, we must fulfill orders from our existing customers, obtain additional orders from our existing customers, develop relationships with new customers and obtain and fulfill orders from new customers. We cannot guarantee that we will be able to increase our customer base. Further, even if we do obtain new customers, we cannot guarantee that those customers will purchase from us enough quantities of our product or at product prices that will enable us to recover our costs in acquiring those customers and fulfilling those orders. Whether we will be able to sell more of our products will depend on a number of factors, including:

The growth of our Government Group revenues is materially dependent on acceptance of our LRAD and MRAD products by government, military and developing force protection and emergency response agencies, and if these agencies do not purchase our products, our revenues will be adversely affected.

Although our LRAD and MRAD products are designed for use by both government and commercial customers, the products have, to date, been predominantly sold for government use. Within the Government Group, our largest customer is a reseller of our products to end users in various branches of the military such as the U.S. Navy, U.S. Marine Corps, U.S. Army and the Department of Homeland Security. We have only recently achieved significant sales of LRAD products and are beginning to offer MRAD products for sale in our fiscal fourth quarter, and neither of the products have been widely accepted in the government market. Furthermore, the force protection and emergency response market is itself an emerging market which is changing rapidly. If our LRAD and MRAD products are not widely accepted by the government, military and the developing force protection and emergency response markets, we may not be able to identify other markets, and we may fail to achieve our sales projections.

Perceptions that long range hailing devices are unsafe or may be used in an abusive manner may hurt sales of our LRAD and MRAD products which could cause our revenues to decline.

Potential customers for our LRAD and MRAD products, including government, military and force protection and emergency response agencies may be influenced by claims or perceptions that long range hailing devices are unsafe or may be used in an abusive manner. These claims or perceptions could cause our product sales to decline. In addition, if these agencies have these perceptions, it will be difficult for us to grow our customer base beyond these markets. These factors could reduce future revenues, adversely affecting our financial condition and results of operations.

We are an early stage company introducing new products and technologies. If commercially successful products are not produced in a timely manner, we may be unprofitable or forced to cease operations.

Our HSS, NeoPlanar, LRAD and MRAD technologies have only recently been introduced to market and are still being improved. Commercially viable sound technology systems may not be successfully and timely produced by us due to the inherent risks of technology development, new product introduction, limitations on financing, manufacturing problems, competition, obsolescence, loss of key technical personnel and other factors. Revenues from our sound products have been limited to date and we cannot guarantee significant revenues in the future. The development and introduction of our products took longer than anticipated by management and the introduction of new products could also be subject to delays. Customers may not wait for newer versions of existing products or new products and may elect to purchase products from competitors. We experienced quality control problems with some of our initial commercial HSS units, and we may not be able to resolve future similar problems in a timely and cost effective manner. Products employing our sound technology may not achieve market acceptance. Our various sound projects are high risk in nature, and unanticipated technical obstacles can arise at any time and result in lengthy and costly delays or result in a determination that further exploitation is unfeasible. If we do not successfully exploit our technology, our financial condition, results of operations and business prospects would be adversely affected.

29

Our products have never been produced in quantity, and we may incur significant and unpredictable warranty costs as these products are mass produced.

None of our products has been produced in sufficient quantities to be considered mass produced. Our technologies are substantially different from proven, mass produced sound transducer designs. We may incur substantial and unpredictable warranty costs from post-production product or component failures. We generally warrant our products to be free from defects in materials and workmanship for a period up to one year from the date of purchase, depending on the product.

At June 30, 2005, we had a warranty reserve of $228,487. We recorded substantial warranty reserves for early versions of our HSS products and have little history to predict future warranty costs. Future warranty costs could further adversely affect our financial position, results of operations and business prospects.

We could incur charges for excess and obsolete inventory.

Due to rapidly changing technology and uneven customer demand, product cycles tend to be short and the value of our inventory may be adversely affected by changes in technology that affect our ability to sell the products in our inventory. Therefore, periodically, it may be necessary to write off inventory as excess or obsolete.

While we will make every attempt to successfully manage product transition, including inventory control of older generation products when introducing new products, we have previously experienced and may, in the future, experience reductions in sales of older generation products as customers delay or defer purchases in anticipation of new product introductions. We currently have established reserves for slow moving or obsolete inventory. The reserves we have established for potential losses due to obsolete inventory may, however, prove to be inadequate and may give rise to additional charges for obsolete or excess inventory.

We do not have the ability to predict future operating results. Our quarterly and annual revenues will likely be subject to fluctuations caused by many factors, any of which could result in our failure to achieve our revenue expectations.

We expect our sound proprietary reproduction technologies will be the source of substantially all of our future revenues. Revenues from our sound proprietary reproduction technologies are expected to vary significantly due to a number of factors. Many of these factors are beyond our control. Any one or more of the factors listed below or other factors could cause us to fail to achieve our revenue expectations. These factors include:

30

Some or all of these factors could adversely affect demand for our products or technologies, and therefore adversely affect our future operating results.

Most of our operating expenses are relatively fixed in the short term. We may be unable to rapidly adjust spending to compensate for any unexpected sales or license revenue shortfalls, which could harm our quarterly operating results. We do not have the ability to predict future operating results with any certainty.

Our expenses may vary from period to period, which could affect quarterly results and our stock price.

If we incur additional expenses in a quarter in which we do not experience increased revenue, our results of operations would be adversely affected and we may incur larger losses than anticipated for that quarter. Factors that could cause our expenses to fluctuate from period to period include: 

Many potential competitors who have greater resources and experience than we do may develop products and technologies that make ours obsolete.

Technological competition from other and longer established electronic and loudspeaker manufacturers is significant and expected to increase. Most of the companies with which we expect to compete have substantially greater capital resources, research and development staffs, marketing and distribution programs and facilities, and many of them have substantially greater experience in the production and marketing of products. In addition, one or more of our competitors may have developed or may succeed in developing technologies and products that are more effective than any of ours, rendering our technology and products obsolete or noncompetitive.

Sound reproduction markets are subject to rapid technological change, so our success will depend on our ability to develop and introduce new technologies.

Technology and standards in the sound reproduction markets evolve rapidly, making timely and cost-effective product innovation essential to success in the marketplace. The introduction of products with improved technologies or features may render our technologies obsolete and unmarketable. If we cannot develop products in a timely manner in response to industry changes, or if our technologies do not perform well, our business and financial condition will be adversely affected. The life cycles of our technologies are difficult to estimate, particularly those such as HSS, LRAD and MRAD for which there are no well established markets. As a result, our technologies, even if successful, may become obsolete before we recoup our investment.

Our competitive position will be seriously damaged if we cannot obtain patent protection for important differentiating aspects of our products or otherwise protect intellectual property rights in our technology.

We rely on a combination of contracts and trademark, patent and trade secret laws to establish and protect our proprietary rights in our technology. However, we may not be able to prevent misappropriation of our intellectual property, our competitors may be able to independently develop and the agreements we enter into may not be enforceable.

31

Our success, in part, depends on our ability to obtain and enforce intellectual property protection for our technology, particularly our patents. There is no guarantee any patent will issue on any patent application that we have filed or may file. Claims allowed from existing or pending patents may not be of sufficient scope or strength to protect the economic value of our technologies. Further, any patent that we may obtain will expire, and it is possible that it may be challenged, invalidated or circumvented. If we do not secure and maintain patent protection for our technology and products, our competitive position will be significantly harmed because it will be much easier for competitors to sell products similar to ours. Alternatively, a competitor may independently develop or patent technologies that are substantially equivalent to or superior to our technology. For example, patent protection on our LRAD and MRAD products is limited, and we may not be able to prevent others from introducing products with similar functionality. If this happens, any patent that we may obtain may not provide protection and our competitive position could be significantly harmed.

As we expand our product line or develop new uses for our products, these products or uses may be outside the protection provided by our current patent applications and other intellectual property rights. In addition, if we develop new products or enhancements to existing products we cannot assure you that we will be able to obtain patents to protect them. Even if we do receive patents for our existing or new products, these patents may not provide meaningful protection. In some countries outside of the United States where our products can be sold or licensed, patent protection is not available. Moreover, some countries that do allow registration of patents do not provide meaningful redress for violations of patents. As a result, protecting intellectual property in these countries is difficult and our competitors may successfully sell products in those countries that have functions and features that infringe on our intellectual property.

We may initiate claims or litigation against third parties in the future for infringement of our proprietary rights or to determine the scope and validity of our proprietary rights or the proprietary rights of our competitors. These claims could result in costly litigation and divert the efforts of our technical and management personnel. As a result, our operating results could suffer and our financial condition could be harmed.

Our competitive position will be seriously damaged if our products are found to infringe on the intellectual property rights of others.

Other companies and our competitors may currently own or obtain patents or other proprietary rights that might prevent, limit or interfere with our ability to make, use or sell our products. As a result, we may be found to infringe the intellectual property rights of others. The electronics industry is characterized by vigorous protection and pursuit of intellectual property rights or positions, which have resulted in significant and often protracted and expensive litigation. In the event of a successful claim of infringement against us and our failure or inability to license the infringed technology, our business and operating results could be adversely affected. Any litigation or claims, whether or not valid, could result in substantial costs and diversion of our resources. An adverse result from intellectual property litigation could force us to do one or more of the following:

If we are forced to take any of the foregoing actions, we could face substantial costs and shipment delays and our business could be seriously harmed. Although we carry general liability insurance, our insurance may not cover potential claims of this type or be adequate to indemnify us for all liability that may be imposed.

In addition, it is possible that our customers or end users may seek indemnity from us in the event that our products are found or alleged to infringe the intellectual property rights of others. Any such claim for indemnity could result in substantial expenses to us that could harm our operating results.

32

Our HSS technology is subject to government regulation, which could lead to unanticipated expense or litigation.

Our HyperSonic sound technology emits ultrasonic vibrations, and as such is regulated by the Food and Drug Administration. In the event of certain unanticipated defects in an HSS product, a customer or we may be required to comply with FDA requirements to remedy the defect and/or notify consumers of the problem. This could lead to unanticipated expense, and possible product liability litigation against a customer or us. Any regulatory impediment to full commercialization of our HSS technology, or any of our other technologies, could adversely affect our results of operations.

We may face personal injury and other liability claims that harm our reputation and adversely affect our sales and financial condition.

Some of our products are capable of sufficient acoustic output to cause damage to human hearing or human health if used improperly, such as when the products are used at close ranges or for long periods of exposure. A person injured in connection with the use of our products may bring legal action against us to recover damages on the basis of theories including personal injury, negligent design, dangerous product or inadequate warning. We may also be subject to lawsuits involving allegations of misuse of our products. Our product liability insurance coverage may be insufficient to pay all such claims. Product liability insurance may become too costly for us or may become unavailable for us in the future. We may not have sufficient resources to satisfy any product liability claims not covered by insurance which would materially and adversely affect our financial position. Significant litigation could also result in a diversion of management’s attention and resources, and negative publicity.

We may not be successful in obtaining the necessary licenses required for us to sell some of our products abroad.

Licenses for the export of certain of our products may be required from government agencies in accordance with various statutory authorities, including, for example, the Trading with the Enemy Act of 1917, the Arms Export Control Act of 1976, the Export Administration Act of 1979, or the International Emergency Economic Powers Act, as well as their implementing regulations and executive orders.

In the case of certain agreements involving equipment or services controlled under the International Traffic in Arms Regulations (ITAR) and sold at specified dollar volumes, the U.S. Department of State must notify Congress at least fifteen to thirty days, depending on the intended overseas destination, prior to authorizing these sales. During that time, Congress may take action to block the proposed sale. Based on our current product lines, we do not anticipate the congressional notification requirement to have an immediate impact; however, as our product lines expand, this notification requirement could impact our ability to sell certain controlled products or services in the international market.

The need for export licenses and, when required, Congressional notification, can introduce a period of delay in our ability to consummate international transactions. Because issuance of an export license is wholly within the discretion of the controlling U.S. government agency, it is possible that, in some circumstances, we may not be able to obtain the necessary licenses for some potential transactions.

Our operations could be harmed by factors including political instability, natural disasters, fluctuations in currency exchange rates and changes in regulations that govern international transactions.

We expect to sell our products worldwide. The risks inherent in international trade may reduce our international sales and harm our business and the businesses of our customers and our suppliers. These risks include:

33

These and other risks may preclude or curtail international sales or increase the relative price of our products compared to those manufactured in other countries, reducing the demand for our products.

Commercialization of our proprietary sound technologies depends on collaborations with other companies. If we are not able to maintain or find collaborators and strategic alliance relationships in the future, we may not be able to develop our proprietary sound technologies and products.

An important part of our strategy is to establish business relationships with leading participants in various segments of the electronics, government and sound reproduction markets to assist us in producing, distributing, marketing and selling products that include our proprietary sound technologies.

Our success will therefore depend on our ability to maintain or enter into new strategic arrangements with partners on commercially reasonable terms. If we fail to enter into such strategic arrangements with third parties, our financial condition, results of operations, cash flows and business prospects will be adversely affected. Any future relationships may require us to share control over our development, manufacturing and marketing programs or to relinquish rights to certain versions of our sound and other technologies.

We are dependent on third - party manufacturers.  

We do not have the capacity to manufacture all of our products internally and we are therefore dependent on third-party manufacturers. At present, we manufacture NeoPlanar and SoundCluster internally only in small quantities and would need to outsource our manufacturing if sales of these products were to increase significantly. We have historically used a single third - party contract manufacturer to manufacture our other products, and we intend to continue to use a single manufacturer for these products in the future. A contract manufacturing partner, may not be able or willing to manufacture products for us in the quantities and at the level of quality that we require. If we need to seek additional third-party manufacturers for our products, we may not be able to obtain acceptable replacement manufacturing sources on a timely basis. An extended interruption in the supply of our products could result in a substantial loss of sales. In addition, any actual or perceived degradation of product quality as a result of our reliance on third-party manufacturers may have an adverse effect on sales or result in increased product returns and buybacks. Failure to maintain quality contract manufacturing could reduce future revenues, adversely affecting financial condition and results of operations.

We rely on outside suppliers to provide a large number of components incorporated in our products.

Our products have a large number of components produced by outside suppliers. In addition, for certain of these items, we qualify only a single source, which can magnify the risk of shortages and decrease our ability to negotiate with our suppliers on the basis of price. In particular, we depend on our HSS piezo-film supplier to provide expertise and materials used in our proprietary HSS emitters. If shortages occur, or if we experience quality problems with suppliers, then our production schedules could be significantly delayed or costs significantly increased, which would have a material adverse effect on our business, liquidity, results of operation and financial position.

Our contracts and subcontracts that are funded by the U.S. government or foreign governments are subject to government regulations and audits and other requirements.

Government contracts require compliance with various contract provisions and procurement regulations. The adoption of new or modified procurement regulations could have a material adverse effect on our business, financial condition or results of operations or increase the costs of competing for or performing government contracts. If we violate any of these regulations, then we may be subject to termination of these contracts, imposition of fines or exclusion from government contracting and government-approved subcontracting for some specific time period. In addition, our contract and subcontract costs and revenues may be subject to adjustment as a result of audits by government auditors.

34

We derive revenue from government contracts and subcontracts, which are often non-standard, may involve competitive bidding, may be subject to cancellation with or without penalty and may produce volatility in earnings and revenue.

Our Government Group business has involved and is expected in the future to involve providing products and services under contracts or subcontracts with U.S. federal, state, local and foreign government agencies. Obtaining contracts and subcontracts from government agencies is challenging, and contracts often include provisions that are not standard in private commercial transactions. For example, government contracts may:

Securing government contracts can be a protracted process involving competitive bidding. In many cases, unsuccessful bidders may challenge contract awards, which can lead to increased costs, delays and possible loss of the contract for the winning bidder.

If our key employees do not continue to work for us, our business will be harmed because competition for replacements is intense.

Our performance is substantially dependent on the performance of our executive officers and key technical employees, including Elwood G. Norris, our Chairman, and Kalani Jones, our President and Chief Operating Officer. We are dependent on our ability to retain and motivate high quality personnel, especially highly skilled technical personnel. Our future success and growth also depends on our continuing ability to identify, hire, train and retain other highly qualified technical, managerial and sales personnel. Competition for such personnel is intense, and we may not be able to attract, assimilate or retain other highly qualified technical, managerial or sales personnel in the future. The inability to attract and retain the necessary technical, managerial or sales personnel could cause our business, operating results or financial condition to suffer.

We may not address successfully the problems encountered in connection with any potential future acquisitions.

We expect to continue to consider opportunities to acquire or make investments in other technologies, products and businesses that could enhance our capabilities, complement our current products or expand the breadth of our markets or customer base. We have limited experience in acquiring other businesses and technologies. Potential and completed acquisitions and strategic investments involve numerous risks, including:

If we fail to properly evaluate and execute acquisitions and strategic investments, our management team may be distracted from our day-to-day operations, our business may be disrupted and our operating results may suffer. In addition, if we finance acquisitions by issuing equity or convertible debt securities, our stockholders would be diluted.

35

We are subject to increased costs as a result of newly adopted accounting and Securities and Exchange Commission regulations.

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, our management will be required by the end of fiscal 2005 to perform an evaluation of our internal control over financial reporting and have our independent auditor attest to that evaluation. Compliance with these requirements is expected to be expensive and time consuming. If we fail to timely complete this evaluation, or if our independent registered public accounting firm cannot timely attest to our evaluation, we could be subject to regulatory scrutiny and a loss of public confidence in our internal control over financial reporting.

In designing and evaluating our internal control over financial reporting, we recognize that any internal control or procedure, no matter how well designed and operated, can provide only reasonable assurance of achieving desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. No system of internal control can be designed to provide absolute assurance of effectiveness and any material failure of internal control over financial reporting could materially impact our reported financial results and the market price of our stock could significantly decline. In addition, adverse publicity related to a material failure of internal control over financial reporting would have a negative impact on our reputation and business.

Changes in stock option accounting rules may adversely impact our reported operating results prepared in accordance with generally accepted accounting principles, our stock price and our competitiveness in the employee marketplace.

Technology companies in general and our company in particular have a history of depending upon and using broad based employee stock option programs to hire, incentivize and retain employees in a competitive marketplace. Currently, we do not recognize compensation expense for stock options issued to employees or directors, except in limited cases involving modifications of stock options, and we instead disclose in the notes to our financial statements information about what such charges would be if they were expensed. An accounting standard setting body has recently adopted a new accounting standard that will require us to record equity-based compensation expense for stock options and employee stock purchase plan rights granted to employees based on the fair value of the equity instrument at the time of grant. We will be required to record these expenses beginning with our first quarter of fiscal 2006, which ends December 31, 2005. The change in accounting rules will lead to increased reported net loss or, should we become profitable, a decrease in reported earnings. This may negatively impact our future stock price. In addition, this change in accounting rules could impact our ability to utilize broad based employee stock plans to reward employees and could result in a competitive disadvantage to us in the employee marketplace.

There are a large number of shares that we sold in our 2005 Equity Financing that must be registered in a registration statement, and the sale of these shares may depress the price of our common stock.

To the extent that the investors in our 2005 Equity Financing sell shares of our common stock under an effective registration statement, our stock price may decrease due to the additional selling pressure in the market. The perceived risk of additional shares available for sale in the market may cause holders of our common stock to sell their shares, which could contribute to a decline in our stock price.

The sale of material amounts of shares by the 2005 Equity Financing selling stockholders could encourage short sales by third parties. These sales could contribute to the future decline of our stock price.

The sale of material amounts of common stock by selling stockholders under the registration statement for the 2005 Equity Financing could also encourage short sales by third parties. In a short sale, a prospective seller borrows stock from a stockholder or broker and sells the borrowed stock. The prospective seller hopes that the stock price will decline, at which time the seller can purchase shares at a lower price to repay the lender. The seller profits when the stock price declines because the seller can purchase the shares at a price which is lower than the price at which the seller sold the borrowed stock. Short sales could place downward pressure on the price of our common stock by increasing the number of shares being sold, which could contribute to the future decline of our stock price.

36

We may issue additional common stock in the future and this stock may reduce the value of your common stock.  

We may issue additional shares of common stock without further action by our stockholders. Moreover, the economic and voting interests of each stockholder will be diluted as a result of such issuances. Although the number of shares of common stock that stockholders presently own will not decrease, such shares will represent a smaller percentage of our total shares that will be outstanding after such events.

Sales of common stock issuable on the exercise of outstanding options and warrants, may depress the price of our common stock.

As of July 18, 2005, we had outstanding options granted to our employees, directors and consultants to purchase 2,133,810 shares of our common stock, and had outstanding warrants issued to investors and others to purchase 3,890,153 shares of our common stock. The exercise prices for the options and warrants range from $2.00 to $11.00 per share. In the future we may issue additional convertible securities, options and warrants. The issuance of shares of common stock issuable upon the exercise of convertible securities, options or warrants could cause substantial dilution to holders of common stock, and the sale of those shares in the market could cause the market price of our common stock to decline. The potential dilution from these shares could negatively affect the terms on which we could obtain equity financing.

We may issue preferred stock in the future, and the terms of the preferred stock may reduce the value of your common stock.

We are authorized to issue up to 5,000,000 shares of preferred stock in one or more series. Our board of directors may determine the terms of future preferred stock offerings without further action by our stockholders. If we issue additional preferred stock, it could affect your rights or reduce the value of your common stock. In particular, specific rights granted to future holders of preferred stock could be used to restrict our ability to merge with or sell our assets to a third party. These terms may include voting rights, preferences as to dividends and liquidation, conversion and redemption rights, and sinking fund provisions.

Our stock price is volatile and may continue to be volatile in the future.

Our common stock trades on the NASDAQ SmallCap Market. The market price of our common stock has fluctuated significantly to date. In the future, the market price of our common stock could be subject to significant fluctuations due to general market conditions and in response to quarter-to-quarter variations in:

The stock market in recent years has experienced extreme price and volume fluctuations that have affected the market price of many technology companies, and that have often been unrelated or disproportionate to the operating performance of companies.

37

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

Market risk represents the risk of loss that may impact our financial position, results of operations or cash flows due to adverse changes in market prices, including interest rate risk and other relevant market rate or price risks. We do not use derivative financial instruments in our investment portfolio.

We are exposed to some market risk through interest rates, related to our investment of current cash and cash equivalents of approximately $2.4 million at June 30, 2005. Based on this balance, a change of one percent in interest rate would cause a change in interest income of $24,000. The risk is not considered material and we manage such risk by continuing to evaluate the best investment rates available for short-term high quality investments.

Item 4. Controls and Procedures.

We maintain disclosure controls and procedures designed to ensure that material information related to us, including our consolidated subsidiaries, is recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms.

Limitations. Our management, including our co-principal executive officers and principal financial officer, does not expect that our disclosure control or internal controls over financial reporting will prevent all errors or all instances of fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of control is based in part upon certain assumptions about the likelihood of future events, and any design may not succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitation of a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

38

PART II. OTHER INFORMATION

Item 1.  Legal Proceedings.

Reference is made to Note 13 of our Notes to Interim Financial Statements included in Part I, Item 1 of this report for information regarding Legal Proceedings.

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

None.

Item 3.  Defaults Upon Senior Securities.

Not applicable.

39

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

At the Company’s Annual Meeting of Stockholders held on April 28, 2005, the following individuals, all of the members of the Board of Directors were elected: Elwood G. Norris, Kalani Jones, Richard M. Wagner, David J. Carter and Daniel Hunter. For each elected director, the results of the voting were:

Our stockholders also voted to ratify the selection of BDO Seidman, LLP as our independent auditors for the fiscal year ending September 30, 2005. The results of the voting on this proposal were:

The foregoing proposal was approved and accordingly ratified.

Our stockholders also voted to approve the American Technology Corporation 2005 Equity Incentive Plan. The results of the voting on this proposal were:

The foregoing proposal was approved.

Item 5.  Other Information.

On August 5, 2005, our Compensation Committee approved amendments to our 2005 Equity Incentive Plan and standard forms of Stock Option Agreement and Stock Award Agreement for the 2005 Equity Incentive Plan. The amendments were made in response to comments of the California Department of Corporations in connection with our application for qualification of the 2005 Equity Incentive Plan in California. The amendments included a modification of the definition of Change in Control to narrow the circumstances defined as a Change in Control, and clarifications that any right of repurchase we might reserve in an award agreement and any rights of transferability we might permit in an award agreement, must conform to limitations contained in regulations promulgated by the California Department of Corporations. The amended 2005 Equity Incentive Plan and standard forms of Stock Option Agreement and Stock Award Agreement are attached to this report as Exhibits 10.9, 10.11 and 10.12.

The foregoing disclosure is made in lieu of disclosure under Item 1.01 on Form 8-K.

As disclosed in Note 11 to our financial statements included in this report, as a result of our decision in June 2005 to terminate the Committed Equity Financing Facility with Kingsbridge Capital Limited, we determined that the prepaid transaction costs asset associated with the fair value of the warrant issued to Kingsbridge and the legal, audit and other fees associated with the financing, was impaired at June 30, 2005. Accordingly, we recognized an impairment charge in the total amount of $477,085, $293,826 of which represents legal, audit and associated fees and is recorded as selling, general and administrative expense for the three and nine months ended June 30, 2005, and $183,259 of which represents the excess of the fair value of the warrant over the associated derivative instrument liability and is recorded as a warrant impairment expense for the three and nine months ended June 30, 2005. The remaining asset of $659,846 in prepaid transaction costs will be offset against the derivative instrument liability of the same amount in the quarter ending September 30, 2005, with no net effect on other income or expense.

The foregoing disclosure is made in lieu of disclosure under Item 2.06 on Form 8-K.

40

Item 6.  Exhibits

41

SIGNATURES

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

42

Exhibit Index