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EX-32.1 - EXHIBIT 32.1 - NET TALK.COM, INC.a6388685ex32_1.htm
EX-31.2 - EXHIBIT 31.2 - NET TALK.COM, INC.a6388685ex31_2.htm
EX-32.2 - EXHIBIT 32.2 - NET TALK.COM, INC.a6388685ex32_2.htm
EX-31.1 - EXHIBIT 31.1 - NET TALK.COM, INC.a6388685ex31_1.htm
EX-99.1 - EXHIBIT 99.1 - NET TALK.COM, INC.a6388685ex99_1.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q
(Mark One)

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

 
For the quarter ended June 30, 2010

OR

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

For the transition period from ______ to ______

Commission file number: 000-53668

NET TALK.COM, INC.
(Exact name of Registrant as specified in its charter)
 
Florida
20-4830633
(State or other jurisdiction of incorporation or organization)
(I.R.S. employer identification no.)
 
1100 NW 163 Drive, Miami, FL
33169
(Address of principal executive offices)
(Zip code)
 
Registrant's telephone number, including area code:  (305) 621-1200


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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during  the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [X] No [ ]

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

Large accelerated filer  [ ]       Accelerated Filer  [ ]       Non-accelerated filer   [ ]       Smaller reporting company   [√]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes [  ] No [√]

The Registrant had 13,429,300 shares of Common Stock, par value $0.001 per share, outstanding as of August 13, 2010.
 
 
1

 
 
Net Talk.com, Inc


INDEX
 
 
Page No.
 
         
     
         
 
  3  
         
 
     
 
  4  
         
 
     
 
  5  
         
 
  6  
         
     
 
  19  
         
  30  
         
  30  
         
     
         
  31  
         
  31  
         
  31  
         
  31  
         
  31  
         
  32  
         
  32  
         
    33  
 
 
2

 
 
           
             
Item 1.   Financial statements
           
             
             
Net Talk.com, Inc.
Balance Sheets
             
   
June 30,
   
September 30,
 
   
2010
   
2009
 
   
(unaudited)
   
 
 
Assets
           
Current assets:
           
   Cash and cash equivalents
  $ 2,033,564     $ 1,007,366  
   Restricted cash
    2,026,423       3,332  
   Accounts receivables, net of allowance for bad debts of $13,902 and $1,042
    20,960       37,315  
   Inventory
    306,419       117,712  
   Prepaid expenses
    1,080       5,008  
Total current assets
    4,388,446       1,170,733  
                 
Telecommunication equipment and other property, net
    585,413       665,315  
Intangible assets, net
    425,489       604,987  
Deferred financing costs and other assets
    19,000       298,266  
                 
Total assets
  $ 5,418,348     $ 2,739,301  
                 
                 
Liabilities and Stockholders' Deficit:
               
   Accounts payable
  $ 290,102     $ 264,912  
   Due to officer
    -       56,300  
   Accrued dividends
    126,000       168,774  
   Accrued expenses
    15,570       49,320  
   Current portion of senior secured convertible debentures
    -       1,509,880  
     ($0 and $1,500,000 face value)
               
   Current portion of derivative liabilities
    -       382,200  
Total current liabilities
    431,672       2,431,386  
                 
 
               
Senior secured convertible debentures ($4,998,773 and $2,700,000 face value)
    4,998,773       1,136,875  
Derivative liabilities
    5,458,695       945,072  
                 
Total liabilities
    10,889,140       4,513,333  
                 
Redeemable preferred stock $.001 par value, 10,000,000 shares
               
       authorized, 300 issued and outstanding
    94,868       -  
                 
Stockholders' equity (Deficit):
               
   Common stock, $.001 par value, 300,000,000 shares
               
       authorized, 9,719,800 issued and outstanding, as of
    9,720       9,720  
      June 30, 2010 and September 30, 2009, respectively
               
   Preferred stock to be issued at future date(s)
    2,000,000       -  
   Additional paid in surplus
    3,574,872       3,458,825  
   Dividends paid - Preferred stock
    (91,000 )     -  
   Accumulated deficit
    (11,059,252 )     (5,242,577 )
Total stockholders' deficit
    (5,565,660 )     (1,774,032 )
                 
Total liabilities, redeemable preferred stock and stockholders' deficit
  $ 5,418,348     $ 2,739,301  
                 
 The accompanying notes are an integral part of the financial statements
 
 
3

 
 
Net Talk.com, Inc.
Statements of Operations
                         
                         
 
 
Three Months Ended
   
Nine Months Ended
 
   
June 30,
   
June 30,
 
   
2010
   
2009
   
2010
   
2009
 
   
(unaudited)
   
(unaudited)
   
(unaudited)
   
(unaudited)
 
Revenues
  $ 167,820     $ -     $ 597,649     $ -  
Cost of sales
    363,921       -       1,022,704       -  
Gross margin
    (196,101 )     -       (425,055 )     -  
                                 
Advertising
    59,151       -       223,189       2,500  
Compensation and benefits
    98,750       92,500       292,584       349,099  
Professional fees
    45,435       95,296       187,039       231,721  
Depreciation and amortization
    90,948       134,263       272,156       267,822  
Research and development
    92,053       123,743       216,517       235,740  
General and administrative expenses
    120,987       112,160       374,732       256,376  
Total operating expenses
    507,324       557,962       1,566,217       1,343,258  
                                 
Loss from operations
    (703,425 )     (557,962 )     (1,991,272 )     (1,343,258 )
                                 
Other income (expenses):
                               
   Interest expense
    -       (160,830 )     (1,184,363 )     (326,448 )
   Derivative income (expense)
    7,239,856       (73,944 )     1,892,559       90,970  
   Debt extinguished
    -       -       (3,617,984 )     -  
   Interest income
    5,584       3,002       11,566       8,757  
 
    7,245,440       (231,772 )     (2,898,222 )     (226,721 )
 
                               
Net income (loss)
    6,542,015       (789,734 )     (4,889,494 )     (1,569,979 )
                                 
Reconciliation of net income (loss) to (loss), applicable to common stockholders:
        Preferred stock dividends in arrears
    (91,000 )     -       (126,000 )     -  
        Accretion of preferred stock
    (54,862 )     -       (94,868 )     -  
                                 
Income (loss), applicable to common stockholders
  $ 6,396,153     $ (789,734 )   $ (5,110,362 )   $ (1,569,979 )
                                 
Loss per common shares:
                               
Basic earnings per common share
  $ 0.66     $ (0.09 )   $ (0.53 )   $ (0.18 )
                                 
Diluted earnings per common share
  $ 0.22     $ (0.09 )   $ (0.53 )   $ (0.18 )
                                 
Weighted average shares:
                               
Basic
    9,719,800       8,749,800       9,719,800       8,749,800  
Diluted
    29,714,892       8,749,800       9,719,800       8,749,800  
                                 
                                 
The accompanying notes are an integral part of the financial statements
 
 
4

 
 
Net Talk.com, Inc.
Statements of Cash Flows
             
   
Nine Months Ended June 30,
 
   
2010
   
2009
 
   
(unaudited)
   
(unaudited)
 
             
Cash flow from operating activities:
           
             
Net income (loss)
  $ (4,889,494 )   $ (1,569,979 )
Adjustments to reconcile net loss to cash used in operations:
               
   Depreciation
    92,657       88,738  
   Amortization
    179,499       179,085  
   Amortization of finance costs
    72,341       43,880  
   Amortization of debt discount
    479,404       85,540  
   Bad debt expense
    12,860       -  
  Warrant liability
    3,570       -  
   Derivative fair value adjustments
    (8,215,359 )     (90,970 )
   Day one derivative losses
    6,322,800          
   Extinguishment
    3,617,983          
Changes in assets and liabilities:
               
  Accounts receivables
    3,494       -  
  Prepaid expenses and other assets
    3,927       (240,924 )
  Inventories
    (188,707 )     -  
  Accounts payables
    25,193       250,535  
  Accrued expenses
    592,679       -  
Net cash used in operating activities
    (1,887,153 )     (1,254,095 )
Cash flow used in investing activities:
               
   Restricted cash
    (2,026,423 )     -  
   Acquisition of fixed assets
    (12,755 )     (34,211 )
   Decrease in deposits
    5,497       -  
Net cash used in investing activities
    (2,033,681 )     (34,211 )
Cash flow used in financing activities:
               
   Issuance of Senior Debenture
    -       951,150  
   Issuance of preferred stock and warrants
    5,000,000       -  
   Payment on loans from officers
    (56,300 )     -  
   Loans from officers
    -       100,000  
Net cash used in investing activities
    4,943,700       1,051,150  
Net increase in cash
    1,022,866       (237,156 )
Cash and equivalents, beginning
    1,010,698       342,793  
Cash and equivalents, ending
  $ 2,033,564     $ 105,637  
                 
Supplemtal disclosures:
               
                 
Non - cash changes:
               
                 
Cash paid for interest
  $ -     $ 121,000  
Cash paid for income taxes
  $ -     $ -  
                 
                 
                 
                 
The accompanying notes are an integral part of the financial statements
 
 
5

 
 
NET TALK.COM, INC.

Note 1 – Nature of operations and basis of presentation

Basis of presentation:

The accompanying unaudited condensed financial statements as of and for the three and nine months ended June 30, 2010 have  been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission for Form 10-Q. Accordingly, they do not include all the information and footnotes required for complete financial statements. However, the unaudited condensed consolidated financial information includes all adjustments which are, in the opinion of management, necessary to fairly present the financial position and the results of operations for the interim periods presented. The operations for the three and nine months ended June 30, 2010 and 2009 are not necessarily indicative of the results for the year ending September 30, 2010.
The unaudited condensed financial statements included in this report should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2009, filed with the Securities and Exchange Commission.

Nature of operations:

Net Talk.com, Inc. (“Nettalk” or the “Company”) was incorporated on May 1, 2006 under the laws of the State of Florida.  We are a telephone company, who provides, sells and supplies commercial and residential telecommunication services, including services utilizing voice over internet protocol (“VoIP”) technology, session initiation protocol (“SIP”) technology,  wireless fidelity technology, wireless maximum technology, marine satellite services technology and other similar type technologies. Our main product is the TK 6000, an analog telephone adapter that provides connectivity for analog telephones and faxes to home, home office or corporate local area networks (“LAN”). Our TK 6000 and its related services is a cost effective solution for individuals, small businesses and telecommuters connecting to any analog telephone, fax or private branch exchange (“PBX”).  The TK 6000 provides one USB port, one Ethernet port and one analog telephone port. A full suite of internet protocol features is available to maximize universal connectivity. In addition, analog telephones attached to the TK 6000 are able to use advanced calling features such as call forwarding, caller ID, 3-way calling, call holding, call retrieval and call transfer.

Note 2 - Summary of Significant Accounting Policies:

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires our management to make estimates and assumptions that affect the amounts reported in the financial statements and footnotes. Significant estimates inherent in the preparation of our financial statements include developing fair value measurements upon which to base our accounting for acquisitions of intangible assets and issuances of financial instruments, including our common stock. Our estimates also include developing useful lives for our tangible and intangible assets and cash flow projections upon which we determine the existence of, or the measurements for, impairments. In all instances, estimates are made by competent employees and consultants under the supervision of management, based upon the current circumstances and the best information available. However, actual results could differ from those estimates.

Risk and Uncertainties

Our future results of operations and financial condition will be impacted by the following factors, among others: dependence on the worldwide telecommunication markets characterized by intense competition and rapidly changing technology, on third-party manufacturers and subcontractors, on third-party distributors in certain markets, and on the successful development and marketing of new products in new and existing markets. Generally, we are unable to predict the future status of these areas of risk and uncertainty.
 
Revenue recognition
 
Operating revenue consist of customer equipment sales of our main product TK6000, telecommunication service revenues, and shipping and handling revenues.
 
 
6

 
 
Most all of our operating revenues are generated from the sale of customer equipment of our main product the TK6000. We also derive service revenues from per minute fees for international calls. Our operating revenue is fully recognized at the time of our customer equipment sale which includes credit card acceptance date and shipment date.  The device provides for life time service (over the life of the device/equipment).  Our equipment is able to operate within our network/platform or over any other network/platform.  There is no need for income allocation between our device and life time service provided.  The full intrinsic value of the sale is allocated to the device.  Therefore, we recognized 100% of revenue at time of customer equipment sale and do not allocate any income to the life time service provided. Shipping and handling is also recognized at time of sale.  International calls are billed as earned from our customers.  International calls are prepaid and customers account is debited as minutes are used and earned.
 
Cash and Cash Equivalents

We consider all highly liquid cash balances and debt instruments with an original maturity of three months or less to be cash equivalents. We maintain cash balances only in domestic bank accounts, which at times, may exceed federally insured limits.

Inventory 

Inventories are recorded at cost or market, whichever is lower.
 
 
 
June 30, 2010
   
September 30, 2009
 
Productive material, work in process and supplies
    288,346     $ 43,538  
Finished products
    18,073       74,174  
Total
  $ 306,419     $ 117,712  
 
During the nine months ended June 30, 2010, in accordance with our lower of cost or market analyses we did not record lower of cost or market adjustments to our finished goods inventories.

Telecommunications Equipment and Other Property
 
Property, equipment and telecommunication equipment includes acquired assets which consist of network equipment, computer hardware, furniture and software, more fully described in Note 3. All of our equipment is stated at cost with depreciation calculated using the straight line method over the estimated useful lives of related assets, which ranges from three to five years. The cost associated with  major improvements is capitalized while the cost of maintenance and repairs is charged to operating expenses.
 
Intangible Assets

Our intangible assets includes acquired assets  more fully described in Note 4. The intangible assets were recorded at our acquisition cost, which encompassed estimates of their relative fair values, as well as estimates of the fair value of consideration that we issued. We amortize our intangible assets using the straight-line method over lives that are predicated on contractual terms or over periods we believe the assets will have utility.

Impairments and Disposals

We evaluate our tangible and definite-lived intangible assets for impairment annually or more frequently in the presence of circumstances or trends that may be indicators of impairment. Our evaluation is a two step process. The first step is to compare our undiscounted cash flows, as projected over the remaining useful lives of the assets, to their respective carrying values. In the event, that the carrying values are not recovered by future undiscounted cash flows, as a second step, we compare the carrying values to the related fair values and, if lower, record an impairment adjustment. For purposes of fair value, we generally use replacement costs for tangible fixed assets and discounted cash flows, using risk-adjusted discount rates for intangible assets.

Research and Development and Software Costs

We expense research and development costs, as these costs are incurred. We account for our offering-related software development costs as costs incurred internally in creating a computer software product and are charged to expense when incurred as research and development until technological feasibility has been established for the product. Technological feasibility is established upon completion of a detail program design or, in its absence, completion of a working model. Thereafter, all software production costs shall be capitalized and subsequently reported at the lower of unamortized cost or net realizable value. Capitalized costs are amortized based on current and future revenue for each product with an annual minimum equal to the straight-line amortization over the remaining estimated economic life of the product. At this time our main product TK6000 is being sold in the market place.
 
 
7

 

Therefore, research and development cost reported in our financial statements relates to pre – marketing costs and are expensed accordingly.  Our components of Research and Development cost for three and nine months ended June 30, 2010 and 2009, are as follows:
 
 
 
Three months ended
   
Nine months ended
 
 
 
June 30,
   
June 30,
 
Components of Research and Development:
 
2010
   
2009
   
2010
   
2009
 
Product development and engineering
  $ 52,126     $ 47,175     $ 77,621     $ 114,104  
Payroll and benefits
    39,927       76,568       138,896       121,636  
Total
  $ 92,053     $ 123,743     $ 216,517     $ 235,740  
 
On July 14, 2010 we revealed our newest product the net TALK DUO (“DUO”).
 
The DUO offers our customers free nationwide calls to any landline or mobile phone in the U.S. and Canada from anywhere in the world, as well as low-cost international rates.  It’s also a versatile digital phone service with no monthly fees, no contracts and no computer required.

The DUO is flexible enough to connect directly to your Internet connection through the router/modem, there is also a convenient option with the DUO to connect to your computer. The sleek design is small enough to fit in the palm of your hand, making it a portable device.

The DUO reduces the wear and tear on your home or office computer and reduces energy costs, resulting in money savings. The fax-friendly DUO, offers fax (incoming and outgoing), a unique feature not offered, to our knowledge, by similar digital phone services.

The portability of this small device is also great for international travelers who want to place free nationwide calls to the U.S. and Canada, or who are looking for a low-cost solution for international rates. Calls to other netTALK customers are always free.

We are presently working on other new products and anticipate future deployment the later part of this year and over the next year.

Reclassification

Certain reclassifications have been made to prior years financial statements in order to conform to the current year’s presentation. The reclassification had no impact on net earnings previously reported.

Share based payment arrangements
 
In June 2008, the FASB issued authoritative guidance on the treatment of participating securities in the calculation of earnings per shares (“EPS”). This guidance addresses whether instruments granted in share based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing EPS under the two - class method. This guidance was effective for fiscal years beginning on or after December 15, 2008.  Adoption of this guidance did not have a material impact on our results of operations and financial position, or on basic or diluted EPS.
 
We apply the grant date fair value method to our share based payment arrangements with employees and consultants.  Share based compensation cost to employees is measured at the grant date fair value based on the value of the award and is recognized over the service period.  Share based payments to non – employees are recorded at fair value on the measurement date and reflected in expense over the service period.

Financial Instruments

Financial instruments, as defined in the Accounting Standards Codification (“ASC”) 825 Financial Instruments, consist of cash, evidence of ownership in an entity, and contracts that both (i) impose on one entity a contractual obligation to deliver cash or another financial instrument to a second entity, or to exchange other financial instruments on potentially unfavorable terms with the second entity, and (ii) conveys to that second entity a contractual right (a) to receive cash or another financial instrument from the first entity, or (b) to exchange other financial instruments on potentially favorable terms with the first entity. Accordingly,  our financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities, secured convertible debentures, and derivative financial instruments.
 
 
8

 

We carry cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities at historical costs since their respective estimated fair values approximate carrying values due to their current nature. We also carry convertible debentures  and redeemable preferred stock at historical cost. However, the fair values of debt and akin-to-debt financial instruments are estimated for disclosure purposes. As of June 30, 2010, estimated fair values and respective carrying values of our Secured Convertible Debentures and Series A Convertible Preferred Stock are as follows:

 
Financial Instrument
 
Note
   
Fair
Value
   
Carrying
Value
 
$ 3,146,000 12% Secured Convertible  Debenture
    6     $ 4,147,330     $ 3,146,000  
$ 587,166 12% Secured Convertible  Debenture
    6       999,945       587,166  
$ 1,265,607 12% Secured Convertible  Debenture
    6       1,494,411       1,265,607  
$ 3,000,000 stated value, 12% Series A Convertible
   Preferred Stock
    7       3,966,860       94,868  
     Total
          $ 10,608,546     $ 5,093,641  

The fair values of the Secured Convertible Debentures and Series A Convertible Preferred Stock were determined based upon their respective discounted cash flow, using observable market rates, plus the fair value of the embedded conversion options. Observable market rates ranged from 8.07% for one-year and 8.59% for two years and were derived from publicly available surveys of corporate bond curves for issuers with similar risk characteristics as ours.

Derivative financial instruments, as defined in ASC 815-10-15-83 Derivatives and Hedging, consist of financial instruments or other contracts that contain a notional amount and one or more underlying (e.g. interest rate, security price or other variable), require no initial net investment and permit net settlement. Derivative financial instruments may be free-standing or embedded in other financial instruments. Further, derivative financial instruments are initially, and subsequently, measured at fair value and recorded as liabilities or, in rare instances, assets.

We generally do not use derivative financial instruments to hedge exposures to cash-flow, market or foreign-currency risks. However, we have entered into certain other financial instruments and contracts, such as our secured convertible debenture and warrant financing arrangements that are either (i) not afforded equity classification, (ii) embody risks not clearly and closely related to host contracts, or (iii) may be net-cash settled by the counterparty. As required by ASC 815, these instruments are required to be carried as derivative liabilities, at fair value, in our financial statements. See Note 8 for additional information about derivative financial instruments.

Redeemable Preferred Stock

Redeemable preferred stock (and other redeemable financial instrument we may enter into) is initially evaluated for possible classification as liabilities under Statements of Financial Accounting Standards No. 150 Financial Instruments with Characteristics of Both Liabilities and Equity. Redeemable preferred stock classified as liabilities is recorded and carried at fair value. Redeemable preferred stock that does not, in its entirety, require liability classification is evaluated for embedded features that may require bifurcation and separate classification as derivative liabilities under Statement 133. In all instances, the classification of the redeemable preferred stock host contract that does not require liability classification is evaluated for equity classification or mezzanine classification based upon the nature of the redemption features. Generally, any feature that could require cash redemption for matters not within our control, irrespective of probability of the event occurring, requires classification outside of stockholders’ equity. See Note 7 for further disclosures about our redeemable preferred stock.

Loss per common share

Basic loss per common share represents our loss applicable to common shareholders divided by the weighted average number  of common shares outstanding during the period. Diluted loss per common share gives effect to all potentially dilutive securities. We compute the effects on diluted loss per common share arising from warrants and options using the treasury stock method or, in the case of liability classified warrants, the reverse treasury stock method. We compute the effects on diluted loss per common share arising from convertible securities using the if-converted method. The effects, if anti-dilutive are excluded.
 
 
9

 

Accounting Changes

Effective on October 1, 2009, we adopted Emerging Issues Task Force Consensus No. 07-05 Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock (“EITF 07-05”). EITF 07-05 amended previous guidance related to the determination of whether equity-linked contracts, such as our convertible debentures, meet the exclusion to bifurcation and derivative classification of the respective embedded conversion feature. Under EITF 07-05, the embedded conversion option was no longer exempt from bifurcation and derivative classification because the conversion option was subject to adjustments that are not allowable under the new standard. We have accounted for the change as a change in accounting principle where the cumulative effect, which amounted to $872,320, as a charge to our opening accumulated deficit on October 1, 2009.

Income Taxes

We record our income taxes using the asset and liability method. Under this method, the future tax consequences attributed to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis are reflected as tax assets and liabilities using enacted tax rates expected to apply to taxable income in the years in which those temporary differences reverse. Changes in these deferred tax assets and liabilities are reflected in the provision for income taxes.  However, we are required to evaluate the recoverability of net deferred tax assets. If it is more likely than not that some portion of a net deferred tax asset will not be realized, a valuation allowance is recognized with a charge to the provision for income taxes.
 
Our net income (loss) reflects permanent tax differences which are not deductible for tax purposes.  Therefore, our tax net operating loss would be reduced accordingly.  Our major permanent differences for the period ended June 30, 2010, are as follows:
 
Permanent differences:
 
Three Months Ended
   
Nine Months Ended
 
                 
Derivative income (loss)
  $ 7,239,856     $ 1,892,559  
Debt extinguished (loss)
    -       (3,617,984 )
Total
  $ 7,239,856     $ (1,725,425 )
 
Recent accounting pronouncements
 
In June 2009, the Financial Accounting Standard Board (“FASB”) issued Accounting Standards Update No. 2009-01, Generally Accepted Accounting Principles, which establishes FASB Accounting Standards Codification (“the Codification”) as the official single source of authoritative U. S, GAAP.  All existing accounting standards are superseded.  All other accounting guidance not included in the Codification will be considered non – authoritative.  The Codification also includes all relevant SEC guidance organized using the same topical structure in separate sections within the Codification.
 
In December 2007, the FASB revised the authoritative guidance for business combinations. This guidance establishes principles and requirements for how the acquirer in a business combination recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed  and any non – controlling interest in the acquiree. This guidance changes the accounting for business combinations in a number of areas, including the treatment of contingent consideration, pre - acquisition contingencies, transaction costs and restructuring costs. In addition , under the new guidance, changes in the acquired entity’s deferred tax assets and uncertain tax positions after the measurement period will impact income tax expense. This guidance was effective for fiscal year beginning on or after December 15, 2008 and requires the immediate expensing of acquisition related costs associated with acquisitions completed after December 31, 2008.  Adoption of this guidance on October 1, 2009 had no impact on our results of operations, and financial position.  However, we expect this guidance will affect acquisitions made thereafter, though the impact will depend upon the size and nature of the acquisition.
 
 
10

 

Note 3 - Telecommunications Equipment and Other Property:

Telecommunications equipment and other property consist of the following:
 
 
 
 
   
June 30,
   
September 30,
 
 
 
Life
   
2010
   
2009
 
                   
Telecommunication equipment
  7     $ 652,189     $ 650,804  
Computer equipment
  5       117,434       106,577  
Office equipment and furnishing
  7       23,759       23,760  
Purchased software
  3       10,555       10,041  
Sub – total
            803,937       791,182  
Less: accumulated depreciation
            (218,524 )     (125,867 )
Total
          $ 585,413     $ 665,315  
 
Our telecommunications equipment is deployed in our Network Operations Center (“NOC”) as is most of the computer equipment. Other computer and office equipment and furnishings are deployed at our corporate offices, which we lease under an operating lease.

Depreciation of the above assets was as follows:
 
 
 
Three Months Ended
   
Nine Months Ended
 
 
 
June 30,
   
June 30,
 
 
 
2010
   
2009
   
2010
   
2009
 
                         
Depreciation expense
  $ 31,115     $ 30,193     $ 92,657     $ 88,738  
 
Note 4 - Intangible Assets:

Intangible assets consist of following:
 
 
 
Life
   
March 31, 2010
   
September 30, 2009
 
 
                 
Trademarks National and International
  5     $ 332,708     $ 332,708  
Employment agreements
  3       225,084       225,084  
Knowhow and specialty skills
  3       212,254       212,254  
Workforce
  3       54,000       54,000  
Telephony licenses
  2       9,195       9,195  
Patents
  20       11,024       11,024  
Domain names
  2       7,723       7,723  
 
            851,988       851,988  
Less accumulated amortization
            (426,499 )     (247,001 )
 
          $ 425,489     $ 604,987  

Amortization of the above assets was as follows:
 
 
 
Three months ended
   
Nine months ended
 
 
 
June 30,
   
June 30,
 
 
 
2010
   
2009
   
2010
   
2009
 
                         
Amortization expense
  $ 59,833     $ 104,071     $ 179,499     $ 179,085  
 
The weighted average amortization period for the amortizable intangible assets is 2.4 years.
 
Estimated future amortization of intangible assets is as follows:
 
March, 31,
     
2010
  $ 67,335  
2011
    225,910  
2012
    70,238  
2013
    62,006  
Total
  $ 425,489  
 
 
11

 
 
Note 5 - Secured Convertible Debentures

The carrying values of our 12% secured convertible debentures consist of the following as of June 30, 2010 and September 30, 2009:

   
June 30,
2010
   
September 30,
2009
 
             
$3,146,000 face value convertible debenture, due June 30, 2011
  $ 3,146,000        
$587,166 face value convertible debenture, due July 20, 2011
    587,166        
$1,265,607 face value convertible debenture, due September 30, 2011
    1,265,607        
$1,000,000 face value convertible debenture, due September 10, 2010
    --     $ 1,006,587  
$500,000 face value convertible debenture, due September 10, 2010
    --       503,293  
$600,000 face value convertible debenture, due January 30, 2011
    --       293,726  
$500,000 face value convertible debenture, due January 30, 2011
    --       271,741  
$500,000 face value convertible debenture, due July 20, 2011
    --       179,778  
$1,100,000 face value convertible debenture, due September 25, 2011
    --       391,630  
     Total
  $ 4,998,773     $ 2,646,755  

Our convertible debentures as of June 30, 2010 were issued on February 24, 2010 in connection with an exchange agreement with our creditors that provided for, among other things, the consolidation of our previous secured convertible debt instruments, with maturities listed in the table above, and included the capitalization of $798,773 of accrued interest. The newly issued convertible debentures bear interest at 12%, which is payable at the earlier of the maturity date or the date that the debentures are converted, if ever.  Such interest is payable at the Company’s option in cash or common stock at $0.25 per common share. The principal amount of the debentures is convertible into common stock at $0.25. Accordingly, the convertible debentures are indexed to 19,995,092 shares of our common stock. Each of the principal and debt conversion rates are subject to adjustment for recapitalization events or sales of equity or equity-linked contracts with a price or conversion price less than the contractual conversion price. The convertible debentures are secured by substantially all of our assets and are either callable or subject to a default interest rate, at the creditor’s option, if we default on the debentures. The significant events that could trigger a default include our failure to service the debentures, bankruptcy and the filing  of significant judgments against us. The debentures also preclude merger and similar transactions, incurring additional debt, our payment of dividends on our equity securities and limit the compensation that we may pay to our officers.

Our accounting for the aforementioned exchange transaction required us to consider whether the exchange resulted in a substantial modification to the original convertible debentures based upon either cash flows or the fair value of the embedded conversion feature, wherein substantial is generally defined as a change greater than 10%. In all instances our calculations indicated that the exchange of convertible debentures resulted in changes that were substantial to either cash flows, the embedded conversion option, or both.  As a result, we were required to extinguish the prior debt instruments and reestablish the new convertible debentures, at fair value, with the change reflected in our expenses. The following table reflects the components of our extinguishment calculations on  February 24, 2010:
 
   
Convertible Debenture due
       
   
June 30,
2011
   
July 20,
2011
   
September 30,
2011
   
Total
 
Fair value of new debenture
  $ 7,767,450     $ 1,490,256     $ 3,196,102     $ 12,453,808  
Carrying value of old debentures:
                               
   Debentures
    1,713,125       152,755       267,000       2,132,880  
   Accrued Interest
    546,000       87,166       165,607       798,773  
   Compound embedded derivative
    3,723,200       750,000       1,632,400       6,105,600  
   Deferred finance costs
    (85,372 )     (23,933 )     (92,122 )     (201,427 )
      5,896,952       965,988       1,972,885       8,835,825  
                                 
Extinguishment loss
  $ 1,870,499     $ 524,268     $ 1,223,217     $ 3,617,984  

The fair values of the Secured Convertible Debentures were determined based upon their respective discounted cash flow,  using observable market rates, plus the fair value of the embedded conversion options. Observable market rates ranged from 7.91% for one-year and 8.47% for two years and were derived from publicly available surveys of corporate bond curves for issuers with similar risk characteristics as ours. The fair value of our compound embedded derivatives were determined using the Monte Carlo Simulations model. See Note 8. The compound embedded derivatives were adjusted to fair value on the exchange date, immediately before the exchange transaction, which amount is included in our derivative income (expense).
 
 
12

 
 
The fair value of the new convertible debentures was allocated to the debt balance, the compound embedded derivative and paid-in capital. Paid-in capital arises in this transaction, because the allocation resulted in premiums which, under accounting principles, are considered equity components. The following table summarizes the allocation on the exchange date:

   
Convertible Debenture due
       
   
June 30,
2011
   
July 20,
2011
   
September 30,
2011
   
Total
 
Convertible debentures
  $ 3,146,000     $ 587,166     $ 1,265,607     $ 4,998,773  
Compound embedded derivative
    4,505,072       880,749       1,878,161       7,263,982  
Paid-in capital
    116,378       22,341       52,334       191,053  
    $ 7,767,450     $ 1,490,256     $ 3,196,102     $ 12,453,808  

Our accounting for the original debenture financings is as follows:

2008 Convertible Debenture Financing

On September 10, 2008, we issued a $1,000,000 face value, 12% secured convertible debenture (T-1), due September 10, 2010 and Series B warrants indexed to 4,000,000 shares of our common stock in exchange for the Interlink Asset Group. Also on September 30, 2008, we issued a $500,000 face value 12% secured convertible debenture (T-2), due September 10, 2010 and Series B warrants indexed to 2,000,000 shares of our common stock for net cash proceeds of $472,800. The warrants have a term of five years. These financial instruments were issued to the same creditor under contracts that are substantially similar, unless otherwise mentioned in the following discussion.

The principal amount of the debentures is payable on September 10, 2010 and the interest is payable quarterly, on a calendar quarter basis. While the debenture is outstanding, the investor has the option to convert the principal balance, and not the interest, into shares of our common stock at a conversion price of $0.25 per common share.  The terms of the conversion option provide for anti-dilution protections for traditional restructurings of our equity, such as stock-splits and reorganizations, if any, and for sales of our common stock, or issuances of common-indexed financial instruments, at amounts below the otherwise fixed conversion price. Further, the terms of the convertible debenture provide for certain redemption features. If, in the event of certain defaults on the terms of the debentures, some of which are indexed to equity risks, we are required at the investors option to pay the higher of (i) 110% of the principal balance, plus accrued interest or (ii) the if-converted value of the underlying common stock, using the 110% default amount, plus accrued interest. If this default redemption is not exercised by the investor, we would incur a default interest rate of 18% and the investor would have rights to our assets under the related Security Agreement. We may redeem the convertible debentures at anytime at 110% of the principal amount, plus accrued interest.

Because the two hybrid debt contracts were issued as compensation for the Interlink Asset Group we concluded that they should be combined for accounting purposes, the accounting resulted in no beneficial conversion feature.

2009 Convertible Debenture Financings

We entered into several Securities Purchase Agreements with Debt Opportunity Fund, LLP (“DOF”) during the year ended  September 30, 2009.

 
-
On January 30, 2009 we issued (a) 12% Senior Secured Convertible Debentures in the aggregate principal amount of $600,000 with a maturity date of January 30, 2011, convertible into shares of common stock at a conversion price of $0.25; and (b) Series C Warrants to purchase 2,400,000 shares of our common stock at an exercise price of $0.50 for net cash proceeds of $507,900. The warrants have a term of five years.

 
-
On February 6, 2009 we issued (a) 12% Senior Secured Convertible Debentures in the aggregate principal amount of $500,000 with a maturity date of January 30, 2011, convertible into shares of common stock at a conversion price of $0.25; and (b) Series C Warrants to purchase 2,000,000 shares of our common stock at an exercise price of $0.50 for net cash proceeds of $443,250. The warrants have a term of five years.  n July 20, 2009, we issued (a) 12% Senior Secured Convertible Debentures in the aggregate principal amount of $500,000 with a maturity date of July 20, 2011, convertible into shares of common stock at a conversion price of $0.25; and (b) Series C Warrants to purchase 2,000,000 shares of our common stock at an exercise price of $0.50 for net cash proceeds of $446,250.    The warrants have a term of five years.
 
 
13

 
 
 
-
On September 25, 2009, we issued (a) 12% Senior Secured Convertible Debentures in the aggregate principal amount of $1,100,000 with a maturity date of July 20, 2011, convertible into shares of common stock at a conversion price of $0.25; and (b) Series C Warrants to purchase 4,400,000 shares of our common stock at an exercise price of $0.25 for net cash proceeds of $1,000,000.  The warrants have a term of five years.

Each debenture bears interest at a rate of 12% per annum from the date of issuance until paid in full. Interest is calculated on the basis of a 360-day year and paid for the actual number of days elapsed, and accrues and is payable quarterly or upon conversion  (as to the principal amount then being converted). The debentures convert into shares of our common stock at the option of the holder at $0.25 per share (which conversion price is subject to adjustment under certain circumstances). The debentures are secured by a lien in all of the assets of the Company. Further, the terms of the convertible debentures provide for default redemption features similar to those described above.

Midtown Partners & Co., LLC (“Midtown Partners”), an NASD registered broker dealer, acted as the placement agent for the Company in connection with the January 30, July 20, and September 25, 2009 Convertible Debt Offerings (“2009 Convertible Debt Offerings”). We paid Midtown Partners cash commissions equal to $198,000 and we issued Series BD Common Stock Purchase Warrants to Midtown Partners entitling Midtown Partners to purchase 1,720,000 shares of the Company’s common stock at an initial exercise price of $0.50 per share and 440,000 shares of the Company’s common stock at an initial exercise price $0.25 per share. Since the Series BD warrants offered full ratchet anti-dilution protection, any previously issued and outstanding warrants with a conversion price greater than $0.25 automatically had their conversion price ratchet down to $0.25 as subsequent issuances were made with a conversion price of $0.25.

On September 22, 2009 we voided and reissued warrants in connection with our financing transactions. The cancellation and reissuance of warrants was treated as a modification under ASC 470-50 Modifications and Extinguishments although the change in cash flow was <10% so extinguishment accounting was not applicable.
 
Cancelled and re-issued warrants were as follows:
 
 
Original Warrants
 
Indexed
Shares
   
Strike
Price
 
Reissued
Warrants
 
Indexed
Shares
   
Strike
 Price
 
C-1 warrants
    2,400,000     $ 0.50  
C-3 warrants
    2,400,000     $ 0.50  
C-2 warrants
    2,000,000     $ 0.50  
C-4 warrants
    2,000,000     $ 0.50  
BD-1 warrants
    480,000     $ 0.50  
BD-4 warrants
    240,000     $ 0.25  
                 
BD-5 warrants
    240,000     $ 0.50  
BD-2 warrants
    400,000     $ 0.50  
BD-6 warrants
    200,000     $ 0.25  
                 
BD-7 warrants
    200,000     $ 0.50  
BD-3 warrants
    200,000     $ 0.50  
BD-8 warrants
    200,000     $ 0.25  
BD-4 warrants
    200,000     $ 0.50  
BD-9 warrants
    200,000     $ 0.50  
 
Accounting for the Financing Arrangements:

We have evaluated the terms and conditions of the secured convertible debentures under the guidance of ASC 815,  Derivatives and Hedging. We have determined that, while the anti-dilution protections preclude treatment of the embedded conversion option as conventional, the conversion option is exempt from classification as a derivative because it otherwise achieves the conditions for equity classification (if freestanding) provided in ASC 815. We have further determined that the default redemption features described above are not exempt for treatment as derivative financial instruments, because they are not clearly and closely related in terms of risk to the host debt agreement. On the inception date of the arrangements through June 30, 2010, we determined that the fair value of these compound derivatives is de minus. However, we are required to re-evaluate this value at each reporting date and record changes in its fair value, if any, in income. For purposes of determining the fair value of the compound derivative, we have evaluated multiple, probability-weighted cash flow scenarios. These cash flow scenarios include, and will continue to include fair value information about our common stock. Accordingly, fluctuations in our common stock value will significantly influence the future outcomes from applying this technique.

Since, as discussed above, the embedded conversion options did not require treatment as derivative financial instruments; however, we were required to evaluate the feature as embodying a beneficial conversion feature under ASC 470-20, Debt with Conversion and Other Options. A beneficial conversion feature (“BCF”) is present when the fair value of the underlying common share exceeds the effective conversion price of the conversion option. The effective conversion price is calculated as the basis in the financing arrangement allocated to the hybrid convertible debt agreement, divided by the number of shares into which the instrument is indexed.
 
 
14

 

Because the two hybrid debt contracts dated September 10, 2008 were issued as compensation for the Interlink Asset Group we concluded that they should be combined for accounting purposes and the accounting resulted in no beneficial conversion feature. The financings issued in 2009 were found to have a BCF which gives effect to the (i) the trading market price on the contract dates and (ii) the effective conversion price of each issuance after allocation of proceeds to all financial instruments sold based upon their relative fair values. Notwithstanding, the BCF was limited to the value ascribed to the remaining hybrid contract (using the relative fair value approach). Accordingly, the BCF allocated to paid-in capital from the 2009 financings amounted to $872,320 for the year ended September 30, 2009.

We evaluated the terms and conditions of the Series B, Series C and Series BD warrants under the guidance of ASC 480, Distinguishing Liabilities from Equity (“ASC 480”). The warrants embody a fundamental change-in-control redemption privilege wherein the holder may redeem the warrants in the event of a change in control for a share of assets or consideration received in such a contingent event. This redemption feature places the warrants within the scope of ASC 480-10, as put warrants and, accordingly, they are classified in liabilities and measured at inception and on an ongoing basis at fair value. Fair value of the warrants was measured using the Black-Scholes-Merton valuation technique and in applying this technique we were required to develop certain subjective assumptions which are listed in more detail below.

Premiums on the secured convertible debentures arose from initial recognition at fair value, which is higher than face value. Discounts arose from initial recognition at fair value, which is lower than face value. Premiums and discounts are amortized through credits and debits to interest expense over the term of the debt agreement. Amortization of debt (discount) premiums amounts to $479,403 and $2,640 for the nine months ended June 30, 2010 and 2009, respectively.

Direct financing costs were allocated to the financial instruments issued (hybrid debt and warrants) based upon their relative fair values. Amounts related to the hybrid debt are recorded as deferred finance costs and amortized through charges to interest expense over the term of the arrangement using the effective interest method. Amounts related to the warrants were charged directly to income because the warrants were classified in liabilities, rather than equity, as described above. Direct financing costs are amortized through charges to interest expense over the term of the debt agreement.

On September 24, 2009, we obtained an extension of the interest payments due June 30, 2009 and September 30, 2009 to June 30, 2010 and September 30, 2010, respectively. The change in cash flow from this modification was analyzed to determine if it was greater than 10% which would give rise to extinguishment accounting. In each case, the change in cash flows was less than 10% so extinguishment accounting was not applicable.

On February 24, 2010, we exchanged the convertible debentures for newly issued convertible debentures as discussed in the beginning of this footnote.

Note 6 – Redeemable Preferred Stock

On February 24, 2010, we designated 500 shares of our authorized preferred stock as Series A Convertible Preferred Stock;  par value $0.001 per share, stated value $10,000 per share (“Preferred Stock”). The Preferred Stock is redeemable for cash on June 30, 2011at the stated value, plus accrued and unpaid dividends. Dividends accrue, whether or not declared, at a rate of 12% of the stated value. The Preferred Stock is convertible into common stock at the holder’s option at $0.25 based upon the stated value. Such conversion rate is subject to adjustment for traditional reorganizations and recapitalization and in the event that we sell common stock or other equity-linked instruments below the conversion price. Holders of the Preferred Stock are entitled to a preference equal to the stated value, plus accrued and unpaid dividends. While the Preferred Stock is outstanding, holders vote the number of indexed common shares.

Our accounting for the Preferred Stock and warrant financing transaction required us to evaluate the classification of the embedded conversion feature and the warrants. As a prerequisite to establishing the classification of the embedded conversion option, we were required to determine the nature of the hybrid Preferred Stock contract based upon its risks as either a debt-type or equity-type contract. The presence of the mandatory cash redemption and the requirement to accrue dividends were persuasive evidence that the Preferred Stock was more akin to a debt than an equity contract, with insufficient evidence to the contrary (e.g. voting privilege). Given that the embedded conversion feature, when evaluated as embodied in a debt-type contract, did not meet the definition for an instrument indexed to a company’s own stock, the embedded conversion feature required bifurcation and classification in liabilities,at fair value. Similarly, the warrants did not meet the definition for an instrument indexed to a company’s own stock, resulting in their classification in liabilities, at fair value.
 
 
15

 

The following table reflects the allocation of the purchase price on the financing date:

Allocation:
 
Amount
 
   Preferred Stock
  $ --  
   Warrants
    5,062,800  
   Compound embedded derivative
    4,260,000  
   Derivative loss, included in derivative income (expense)
    (6,322,800 )
    $ 3,000,000  

Warrants were valued using the Black-Scholes-Merton valuation technique. Significant assumptions were as follows: Market value of underlying, using the trading market of $0.58; expected term, using the contractual term of 5.0 years; market volatility, using a peer group of 90.20%; and, risk free rate, using the yield on zero coupon government instruments of 2.40%.

The compound embedded derivative was valued using the Monte Carlo Simulations (“MCS”) technique. The MSC technique is  a generally accepted valuation technique for valuing embedded conversion features in hybrid convertible notes, because it is an open-ended valuation model that embodies all significant assumption types, and ranges of assumption inputs that management of the Company believe would likely be considered in connection with the arms-length negotiation related to the transference of the instrument by market participants. However, there may be other circumstances or considerations, other than those addressed herein, that relate to both internal and external factors that would be considered by market participants as it relates specifically to the Company and the subject financial instruments.

Given its redeemable nature, we are required to classify our Preferred Stock outside of stockholders’ equity. Further, the inception date carrying value is subject to accretion to its ultimate redemption value over the term to redemption, using the effective method. During the period from its issuance to June 30, 2010, we accreted $94,868, which was reflected as a charge to paid-in capital in the absence of accumulated earnings. We also accrued $126,000 during the same period which amount represents the cumulative dividends that we are required to pay whether or not declared.

Note 7 – Derivative Financial Instruments

The components of our derivative liabilities consisted of the following at June 30, 2010 and September 30, 2009:
 
   
June 30, 2010
       
Derivative Financial Instrument
 
Indexed
Shares
   
Fair
Value
   
September 30,
2009
 
Compound Derivative Financial Instruments:
                 
February 24, 2010 Secured Convertible
   Debentures
    19,995,092     $ 1,402,515     $ --  
February 24, 2010 Series A Convertible Preferred
   Stock
    12,000,000       828,000       --  
Warrants (dates correspond to financing):
                       
February 24, 2010 Series D warrants, issued
   with the preferred financing (Note 6)
    12,000,000       1,246,800       --  
February 24, 2010 Series D warrants, issued
   with the exchange (Note 7)
    16,800,000       1,745,520       --  
September 10, 2008 Series B warrants
    --       --       382,200  
January 30, 2009 Series C warrants
    --       --       167,040  
February 6, 2009 Series C warrants
    --       --       139,400  
July 20, 2009 Series C warrants
    --       --       146,600  
September 25, 2009 Series C warrants
    --       --       335,720  
Financing warrants issued to brokers
    2,160,000       235,860       156,312  
                         
        Total
    62,955,092     $ 5,458,695     $ 1,327,272  

 
16

 

The following table reflects the activity in our derivative liability balances from September 30, 2009 to June 30, 2010:

   
Compound
   
Warrants
   
Total
 
Balances at September 30, 2009
  $ --     $ 1,327,272     $ 1,327,272  
Change in accounting
    1,865,600       --       1,865,600  
Effect of the exchange transaction
    1,158,382       --       1,158,382  
Issued in the Preferred Stock and Warrant
    financing Transaction
    4,260,000       5,062,800       9,322,800  
Unrealized derivative (gains) losses
    (5,053,467 )     (3,161,892 )     (8,215,359 )
Balances at June 30, 2010
  $ 2,230,515     $ 3,228,180     $ 5,458,695  

The following table summarizes the effects on our income (loss) associated with changes in the fair values of our derivative financial instruments:
 
   
Three months ended
 
   
June 30,
2010
   
June 30,
2009
 
Compound Derivative Financial Instruments:
           
February 24, 2010 Secured Convertible
   Debentures
  $ 2,054,100     $ --  
February 24, 2010 Series A Convertible Preferred
   Stock
    1,248,000       --  
Warrants (dates correspond to financing):
               
February 24, 2010 Series D warrants, issued
   with the preferred financing (Note 6)
    1,513,200       --  
February 24, 2010 Series D warrants, issued
   with the exchange (Note 7)
    2,118,400       --  
Other warrants
    306,156       (73,944 )
    $ 7,239,856     $ (73,944 )
 
   
Nine months ended
 
   
June 30,
2010
   
June 30,
2009
 
Compound Derivative Financial Instruments:
           
February 24, 2010 Secured Convertible
  Debentures
  $ 5,861,467     $ --  
Pre-exchange Secured Convertible Debentures (amount through
  the exchange date of February 24, 2010)
    (4,240,000 )     --  
February 24, 2010 Series A Convertible Preferred
  Stock
    3,432,000       --  
Warrants (dates correspond to financing):
               
February 24, 2010 Series D warrants, issued
  with the preferred financing (Note 6)
    3,816,000       --  
February 24, 2010 Series D warrants, issued
  with the exchange (Note 7)
    467,760       --  
Other warrants
    (1,121,868 )     (90,970 )
Total fair value adjustments
    8,215,359       (90,970 )
Day-one derivative expense, resulting from the
  Series A Preferred Stock Financing (Note 6)
    (6,322,800 )     --  
Day-one derivative expense from prior financings
    --       --  
    $ 1,892,559     $ (90,970 )
 
Fair Value Considerations

We adopted the provisions of ASC 820 Fair Value Measurements and Disclosures (“ASC 820”) with respect to our financial instruments. As required by of ASC 820, assets and liabilities measured at fair value are classified in their entirety based on the lowest level of input that is significant to their fair value measurement. Our derivative financial instruments which are required to be measured at fair value on a recurring basis under of ASC 815 as of June 30, 2010 are all measured at fair value using Level 3 inputs. Level 3 inputs are unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
 
 
17

 

The warrants are valued using the Black-Scholes-Merton (“BSM”) valuation methodology because that model embodies all of the relevant assumptions that address the features underlying these instruments. Significant assumptions were as follows as of June 30, 2010:
 
 
June 30, 2010
 
Series
D
Warrants
   
BD
Warrants
   
BD
Warrants
 
  Adjusted Strike price
  $ 0.50     $ 0.25     $ 0.50  
  Volatility
    96.86 %     99.5%--105.2 %     99.50%--105.2 %
  Expected term (years)
    4.65       3.59—4.25       3.59—4.25  
  Risk-free rate
    1.79 %     1.40 %     1.40 %
  Dividends
    --       --       --  

Assumptions at September 30, 2009 related to warrants by class were as follows:

 
 
September 30, 2009
 
Series
B
Warrants
   
Series
C-3
Warrants
   
Series
C-4
Warrants
   
Series
C-5
Warrants
   
Series
C-6
Warrants
   
Series
BD
Warrants
 
  Adjusted Strike price
  $ 0.25     $ 0.25     $ 0.25     $ 0.25     $ 0.25     $ 0.25  
  Volatility
    93 %     92 %     92 %     89 %     89 %     89%-93 %
  Expected term (years)
    3.95       4.34       4.36       4.81       5.00       3.95-5.00  
  Risk-free rate
    2.31 %     2.31 %     2.31 %     2.31 %     2.31 %     2.31 %
  Dividends
    --       --       --       --       --       --  

We did not have a historical trading history sufficient to develop an internal volatility rate for use in BSM. As a result, we have used a peer approach wherein the historical trading volatilities of certain companies with similar characteristics as ours and who had a sufficient trading history were used as an estimate of our volatility. In developing this model, no one company was weighted more heavily.
 
The effect of changes in our trading market price on the fair values of our derivative liabilities is significant because all techniques that we employ consider the intrinsic values of the equity-linked contracts. Accordingly, increases in our trading market price will have the effect of increasing the derivative value and decreases will have the effect of decreasing the derivative value. However, the techniques embody other assumptions that may have an incremental or an offsetting effect. Since changes in the fair value of derivative financial instruments are recorded in income, our operations will reflect the expense or income over all periods that the contracts are outstanding. These effects could be material.

Note 8 - Commitment and Contingencies:

Leases

We lease our principal office space under an arrangement that is an operating lease. Rent and associated occupancy expenses for the three and six months ended June 30, 2010 and 2009 were as follows:
 
 
 
Three months ended
   
Nine months ended
 
 
 
June 30,
   
June 30,
 
 
 
2010
   
2009
   
2010
   
2009
 
                         
Occupancy expense
  $ 43,384     $ 41,760     $ 129,774     $ 124,279  
 
Minimum non-cancellable future lease payments as of June 30, 2010, were as follows: 2010 - $44,875.

Employment arrangements

We have entered into an employment agreement with our Chief Executive Officer, Anastasios Kyriakides and in  consideration of his services to us, we have agreed to pay him a base salary of $150,000 plus certain bonuses and awards if the Company achieves certain profitability levels and adopts certain incentive compensation plans. As of March 31, 2010, none of these incentive arrangements and plans had been realized. The agreement is effective through September 30, 2013.
 
 
18

 

Item 2 – Management Discussion and Analysis of Financial Conditions and Results of Operations
 
Our Management’s Discussion and Analysis should be read in conjunction with our financial statements included in this report.
 
Forward Looking Statements
 
Certain statements contained in this report on Form 10-Q and other written material and oral statements made from time to time by us do not relate to historical or current facts.  As such, they are referred to as “forward-looking statements,” which are intended to convey our expectations or predictions regarding the occurrence of possible future events or the existence of trends and factors that may impact our future plans and operating results. These forward-looking statements are derived, in part, from various assumptions and analyses we have made in the context of our current business plan and information currently available to us and in light of our experience and perceptions of historical trends, current conditions and expected future developments and other factors we believe to be appropriate in the circumstances. You can generally identify forward-looking statements through words and phrases such as “ seek, ” “ anticipate, ” “ believe, ” “ estimate, ” “ expect, ” “ intend, ” “ plan, ” “ budget, ” “ project, ” “ may be, ” “ may continue, ” “ may likely result, ” and similar expressions. When reading any forward looking statement, you should remain mindful that actual results or developments may vary substantially from those expected as expressed in or implied by that statement for a number of reasons or factors, such as those relating to:
 
 
·
whether or not a market for our products and services develop and, if a market develops, the pace at which it develops;
 
·
our ability to successfully sell our products and services if a market develops;
 
·
our ability to attract the qualified personnel to implement our growth strategies;
 
·
our ability to develop sales and marketing capabilities;
 
·
the accuracy of our estimates and projections;
 
·
our ability to fund our short-term and long-term financing needs;
 
·
changes in our business plan and corporate strategies; and other risks and uncertainties discussed in greater detail in the sections of this prospectus, including the section captioned “Plan of Operation”.
 
Each forward-looking statement should be read in context with, and with an understanding of, the various other disclosures concerning our Company and our business made elsewhere in this prospectus, as well as other public reports filed with the SEC. You should not place undue reliance on any forward-looking statement as a prediction of actual results or developments. We are not obligated to update or revise any forward-looking statement contained in this report to reflect new events or circumstances unless and to the extent required by applicable law.
 
Background
 
Company and Business
 
We are a telephone company, who provides, sells and supplies commercial and residential telecommunication services,  including services utilizing voice over internet protocol (“VoIP”) technology, session initiation protocol (“SIP”) technology,  wireless fidelity technology, wireless maximum technology, marine satellite services technology and other similar type technologies. Our main product is the TK 6000, an analog telephone adapter that provides connectivity for analog telephones and faxes to home, home office or corporate local area networks (“LAN”).
 
Our TK 6000 and its related services is a cost effective solution for individuals, small businesses and telecommuters connecting to any analog telephone, fax or private branch exchange (“PBX”).  The TK 6000 provides one USB port, one Ethernet port and one analog telephone port. A full suite of internet protocol features is available to maximize universal connectivity. In addition, analog telephones attached to the TK 6000 are able to use advanced calling features such as call forwarding, caller ID, 3-way calling, call holding, call retrieval and call transfer.

On July 14, 2010 we revealed our newest product the netTALK DUO (“DUO”).
 
The DUO offers our customers free nationwide calls to any landline or mobile phone in the U.S. and Canada from anywhere in the world, as well as low-cost international rates.  It’s also a versatile digital phone service with no monthly fees, no contracts and no computer required.

We are presently working on other new products and anticipate future deployment over the next year.
 
 
19

 
 
History and Overview
 
We are a Florida corporation, incorporated on May 1, 2006 under the name Discover Screens, Inc. (“Discover Screens”).
 
Prior to September 10, 2008, we were known as Discover Screens, a development-stage company, dedicated to providing advertising through interactive, audiovisual, information and advertising portals located in high-traffic indoor venues. Our name and business operations changed in a series of transactions beginning in December of 2007. Pursuant to an asset purchase agreement dated December 30, 2007, we sold all of the assets associated with the advertising business as a going concern to Robert H. Blank,  who was then our President and Chief Operating Officer. Following that transaction, we ceased all existing operations, and from December 30, 2007 to September 9, 2008, we owned nominal assets and generated no revenue. In February of 2008,  Mr. Blank resigned as officer and director.
 
On September 9, 2008, Robin C. Hoover, our sole remaining officer and director, appointed four new members to the Board of Directors, Anastasios Kyriakides, Kenneth Hosfeld, Guillermo Rodriguez and Leo Manzewitsch. Mr. Hoover then resigned as an officer and director. Mr. Richard Diamond was appointed by the Board of Directors to fill the vacancy left by Mr. Hoover’s resignation.  Mr. Diamond resigned as a director of the Company, effective November 23, 2009.
 
On September 10, 2008, we changed our name from Discover Screens, Inc. to Net Talk.com, Inc. On September 10, 2008, we entered into a Contribution Agreement with Vicis Capital Master Fund (“Vicis”) by which Vicis contributed certain operating assets to the Company in exchange for (a) a 12% Senior Secured Convertible Debenture in the principal amount of $1,000,000; and (b) a Series B Warrant to purchase 4,000,000 shares of common stock of the Company. Also on September 10, 2008, the Company entered into a Securities Purchase Agreement with Debt Opportunity Fund, LLP (“DOF”) by which DOF purchased (a) a 12% Senior Secured Convertible Debenture in the principal amount of $500,000; and (b) a Series B Warrant to purchase 2,000,000 shares of Common Stock of the Company.
 
On September 10, 2008, we acquired certain tangible and intangible assets, formerly owned by Interlink Global Corporation (“Interlink”), (the “Interlink Asset Group”) directly from Interlink’s creditor who had seized the assets pursuant to a Security and Collateral Agreement. Our purpose in acquiring these assets, which included employment rights to the executive management team  of Interlink who now currently serve as our officers, was to advance the TK 6000 VoIP Technology Program, which Interlink launched in July 2008. Accordingly, these assets substantially comprise our current business assets and the infrastructure for our future operations. Contemporaneously with this purchase, we executed an assignment and intellectual property agreement with Interlink that served to perfect our ownership rights to the assets.
 
Consideration for the acquisition consisted of a face value $1,000,000 convertible debenture, plus warrants to purchase 4,000,000 shares of our common stock. On the date of the Interlink Asset Group acquisition, we also entered into a financing agreement with DOF (as described above) that provided for the issuance of a face value $500,000 convertible debenture, plus warrants to purchase 2,000,000 shares of our common stock for net cash consideration of $448,300.  In connection with this acquisition, we issued 6,000,000 shares of common stock to our new management team in connection with the Interlink Asset Group acquisition.
 
We continue to improve and enhance the following factors in building and expanding our customer base:
 
 
·
Deployment and distribution of our main product TK 6000 device.
 
 
·
Attractive and innovative value proposition.  We offer our customers an attractive and innovative value proposition: a portable telephone replacement with multiple and unique features that differentiates our services from the competition.
 
 
·
Innovative, high technology and low cost technology platform.  We believe our innovative software and network technology platform provides us with a competitive advantage over our competition and allows us to maintain a low cost infrastructure relative to our competitors.

On July 14, 2010 we revealed our newest creation the netTALK DUO (“DUO”).
 
The DUO offers our customers free nationwide calls to any landline or mobile phone in the U.S. and Canada from anywhere in the world, as well as low-cost international rates.  It’s also a versatile digital phone service with no monthly fees, no contracts and no computer required.

We are presently working on other new products and anticipate future deployment over the next year.
 
 
20

 
 
Plan of Operation
 
We provide, sell and supply commercial and residential telecommunication services, including services utilizing voice over internet protocol (“VoIP”) technology, session initiation protocol (“SIP”) technology, wireless fidelity technology, wireless maximum technology, marine satellite services technology and other similar type technologies. We are developing our business infrastructure and new products and services.
 
Our Product
 
At this time, our main product is the “TK 6000”. The TK 6000 is designed to provide specifications unique to each customer’s existing equipment. It allows the customer full mobile flexibility by being able to take internet interface anywhere the customer has    an internet connection. The TK 6000 has the following features:

     
A Universal Serial Bus (“USB”) connection allowing the interconnection of the TK 6000 to any computer. The USB connection results in shared power between the TK 6000 and the host computer.
 
         
  
   
In addition to the USB power source option, the TK 6000 will also have an external power supply allowing the phone to independently power itself when not connected to a host computer;
 
         
     
Unlike most VoIP telephone systems, the TK 6000 has a standalone feature allowing it to be plugged directly into a standard internet connection without the need of a computer.
 
     
The TK 6000 is a compact, space-efficient product.
 
The TK 6000 has an interface component so that the customer can purchase multiple units that can communicate with each other allowing simultaneous ringing from multiple locations.
 
Our product is portable and allows our customers to make and receive phone calls with a telephone anywhere broadband internet connection is available.  We transmit the calls using Voice over Internet Protocol “VOIP” technology, which converts voice signals into digital data transmissions over the internet.

On July 14, 2010 we revealed our newest creation the netTALK DUO (“DUO”).
The DUO offers our customers free nationwide calls to any landline or mobile phone in the U.S. and Canada from anywhere in the world, as well as low-cost international rates.  It’s also a versatile digital phone service with no monthly fees, no contracts and no computer required.

The DUO is flexible enough to connect directly to your Internet connection through the router/modem, there is also a convenient option with the DUO to connect to your computer. The sleek design is small enough to fit in the palm of your hand, making it a portable device.

The DUO reduces the wear and tear on your home or office computer and reduces energy costs, resulting in money savings.  The fax-friendly DUO, offers fax (incoming and outgoing), a unique feature not offered by similar digital phone services.

The portability of this small device is also great for international travelers who want to place free nationwide calls to the U.S. and Canada, or who are looking for a low-cost solution for international rates. Calls to other netTALK customers are always free.

We are presently working on other new products and anticipate future deployment the later part of this year and over the next year.
 
Our Services
 
Our business is to provide products and services that utilize Voice Over Internet Protocol, which we refer to as “VoIP.”  VoIP is a technology that allows the consumer to make telephone calls over a broadband internet connection instead of using a regular (or analog) telephone line. VoIP works by converting the user’s voice into a digital signal that travels over the internet until it reaches its destination. If the user is calling a regular telephone line number, the signal is converted back into a voice signal once it reaches the end user. Our business model is to develop and commercialize software technology solutions for cost effective, real-time communications over the internet and related services.
 
Patents – Domestic and International:
 
Our products are currently under US patent pending as well as International patent pending in over 123 countries.
 
 
21

 
 
Results of Operations
 
Three months ended June 30, 2010 compared to three months ended June  30, 2009
 
Revenues: Our revenues amounted to $167,820 and $0 for the three months ended June 30, 2010, and 2009, respectively. The increase in revenues relates to establishing our operating architecture and commencing revenue producing activities.
 
Cost of sales: Our cost of sales amounted to $363,921 and $0 for the three months ended June 30, 2010, and 2009, respectively.  The increase in cost of sales relates to establishing our operating architectural and commencing revenue producing activities.
 
Gross margin: Our gross margin and new allocations amounted to $(196,101) and $0 for the three months ended June 30, 2010 and 2009, respectively. This is due to allocating additional expenses to technical support and telecommunication expenses.
 
Advertising:  Our advertising expenses amounted to $59,151 and $0 for the three months ended June 30, 2010 and 2009, respectively.  The breakdown of our advertising expense is as follows:
 
 
 
June 30,
 
   
2010
   
2009
 
Infomercial/production time
  $ -     $ -  
Media and others
    59,151       -  
Total
  $ 59,151     $ -  
 
Compensation and Benefits: Our compensation and benefits expense amounted to $98,750 and $92,500 for the three months ended June 30, 2010 and 2009, respectively. This amount represents normal salaries and wages paid to management members and employees including marketing and administrative functions.
 
Professional Fees: Our professional fees amounted to $45,435 and $95,296 for the three months ended June 30, 2010 and 2009, respectively. This amount includes normal payments and accruals for legal, accounting and other professional services. Our costs associated with legal and accounting fees will remain higher than historical amounts because, as a reporting company,  we are required to comply with the reporting requirements of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”). This involves the preparation and filing of the quarterly and annual reports required under the Exchange Act as well as other reporting requirements under the Exchange Act.
 
We will also incur additional expenses associated with the services provided by our transfer agent. In addition, to the work we are presently doing, we will need to focus our time and energy to complying with the Exchange Act. This will detract from our ability and efforts to develop and market our products and services. We anticipate incurring these additional expenses related to being a public company without receiving a substantial increase in revenues associated with this undertaking.
 
Depreciation and Amortization: Depreciation and amortization amounted to $90,948 and $134,263 for the three months ended June 30, 2010 and 2009, respectively. These amounts represent amortization of our long-lived tangible and intangible assets using straight-line methods and lives commensurate with the assets’ remaining utility. Decrease of $43,315 relates to assets being fully depreciated over their useful lives. Our long-lived assets, both tangible and intangible, are subject to annual impairment review, or more frequently if circumstances so warrant. During the three months ended June 30, 2010, we did not calculate or record impairment charges. However, negative trends in our business and our inability to meet our projected future results could give rise to impairment charges in future periods.
 
Research and Development and Software Costs

We expense research and development expenses, as these costs are incurred. We account for our offering-related software development costs as costs incurred internally in creating a computer software product and are charged to expense when incurred as research and development until technological feasibility has been established for the product. Technological feasibility is established upon completion of a detail program design or, in its absence, completion of a working model.  At this time our main product TK6000 is being sold in the market place.  Therefore, research and development cost reported in our financial statements relates to pre – marketing cost and are expensed accordingly.
 
 
22

 
 
             
             
Components of research and development:
 
June 30,
 
 
 
2010
   
2009
 
Product development and engineering
  $ 52,126     $ 47,175  
Payroll and benefits
    39,927       76,568  
Total
  $ 92,053     $ 123,743  
 
General and Administrative Expenses: General and administrative expenses amounted to $120,987 and $112,160 for the three   months ended June  30,2010 and 2009, respectively, and consisted of general corporate expenses and certain other start up expenses. General corporate expenses included $43,384 in occupancy costs for the three months ended June 30, 2010 and $43,156 for comparable period ended June 30, 2009.  Our increased costs are associated with our efforts of being a public company.
 
Our general and administrative expenses are made up of the following accounts:
 
 
 
June 30,
 
 
 
2010
   
2009
 
Bad debt expense
  $ 2,628       -  
Rent and occupancy
    43,384       41,760  
Insurance
    16,803       12,557  
Software
    638       1,276  
Taxes and licenses
    18,288       31,831  
Telephone
    4,739       3,388  
Travel
    7,488       4,689  
Other
    27,019       16,659  
Total
  $ 120,987     $ 112,160  
 
Interest Expense: Interest expense amounted to $0 and $160,830 for the three months ended June 30, 2010 and 2009 respectively.  Such amount represented (i) stipulated interest under our aggregate $4,200,000 face value convertible debentures,  (ii) the related amortization of premiums and discounts (iii) the amortization of deferred finance costs. Aggregate premiums continue to be credited to interest expense over the term of the debentures using the effective interest method. During first and second quarter of 2009,  we added $2,700,000 of new debentures at interest rate of 12%. This contributed to an increase of interest expense.
 
In addition, our convertible debentures as of June 30, 2010 were issued on February 24, 2010 in connection with an exchange agreement with our creditors that provided for, among other things, the consolidation of our previous secured convertible debt instruments, and included the capitalization of $798,773 of accrued interest. The capitalization of accrued interest was to include interest up to December 31, 2010.  Therefore, during quarter ended June 30, 2010 we recorded no interest expense.
 
Derivative Income : Derivative income (expense) amounted to $7,239,856 and $(73,944) for the three months ended June 30, 2010  and 2009, respectively.  Such amount represents the change in fair value of liability-classified warrants. Derivative financial instruments are carried as liabilities, at fair value, in our financial statements with changes reflected in income.  In addition to the liability-classified warrants, we also have certain compound derivative financial instruments related to our $4,200,000 face value convertible debentures that had de minimus values. We are required to adjust our warrant and compound derivatives to fair value at each reporting period. The fair value of our warrant derivative is largely based upon fluctuations in the fair value of our common stock. The fair value of our compound derivative is largely based upon estimates of cash flow arising from the derivative and credit-risk adjusted interest rates. Accordingly, the volatility in these underlying valuation assumptions will have future effects on our earnings.
 
 
23

 
 
Our convertible debentures as of June 30, 2010 were issued on February 24, 2010 in connection with an exchange agreement with our creditors that provided for, among other things, the consolidation of our previous secured convertible debt instruments, with maturities listed in the table above, and included the capitalization of $798,773 of accrued interest. The newly issued convertible debentures bear interest at 12%, which is payable at the earlier of the maturity date or the date that the debentures are converted, if ever. Such interest is payable at the Company’s option in cash or common stock at $0.25 per common share. The principal amount of the debentures is convertible into common stock at $0.25. Accordingly, the convertible debentures are indexed to 19,995,092 shares of our common stock. Each of the principal and debt conversion rates are subject to adjustment for recapitalization events or sales of equity or  equity-linked contracts with a price or conversion price less than the contractual conversion price. The convertible debentures are secured by substantially all of our assets and are either callable or subject to a default interest rate, at the creditor’s option, if we default on the debentures. The significant events that could trigger a default include our failure to service the debentures, bankruptcy and the filing of significant judgments against us. The debentures also preclude merger and similar transactions, incurring additional debt, our payment of dividends on our equity securities and limit the compensation that we may pay to our officers.

The following table summarizes the effects on our income (loss) associated with changes in the fair values of our derivative financial instruments:
 
   
Three months ended
 
   
June 30,
2010
   
June 30,
2009
 
Compound Derivative Financial Instruments:
           
February 24, 2010 Secured Convertible
   Debentures
  $ 2,054,100     $ --  
February 24, 2010 Series A Convertible Preferred
   Stock
    1,248,000       --  
Warrants (dates correspond to financing):
               
February 24, 2010 Series D warrants, issued
    with the preferred financing (Note 6)
    1,513,200       --  
February 24, 2010 Series D warrants, issued
    with the exchange (Note 7)
    2,118,400       --  
Other warrants
    306,156       (73,944 )
    $ 7,239,856     $ (73,944 )
 
Debt extinguished: Debt extinguished amounted to $0 and $0 for the three months ended June 30, 2010 and 2009, respectively.

Our accounting for the exchange transaction required us to consider whether the exchange resulted in a substantial modification to the original convertible debentures based upon either cash flows or the fair value of the embedded conversion feature, wherein substantial is generally defined as a change greater than 10%. In all instances our calculations indicated that the exchange of convertible debentures resulted in changes that were substantial to either cash flows, the embedded conversion option, or both. As a result, we were required to extinguish the prior debt instruments and reestablish the new convertible debentures, at fair value, with the change reflected in our expenses. The following table reflects the components of our extinguishment calculations on February 24, 2010:

   
Convertible Debenture due
       
   
June 30,
2011
   
July 20,
2011
   
September 30,
2011
   
Total
 
Fair value of new debenture
  $ 7,767,450     $ 1,490,256     $ 3,196,102     $ 12,453,808  
Carrying value of old debentures:
                               
   Debentures
    1,713,124       152,755       267,000       2,132,879  
   Accrued Interest
    546,000       87,166       165,607       798,773  
   Compound embedded derivative
    3,723,200       750,000       1,632,400       6,105,600  
   Deferred finance costs
    (85,372 )     (23,933 )     (92,122 )     (201,427 )
      5,896,952       965,988       1,972,885       8,835,825  
                                 
Extinguishment loss
  $ 1,870,498     $ 524,268     $ 1,223,217     $ 3,617,983  

Net income (loss): The net income (loss) amounted to $6,542,015 and $(789,734) for the three months ended June 30, 2010 and 2009, respectively.  The net income (loss) includes derivative income (loss) associated with valuation of debentures and warrants, negative gross margin and increase in travel expenses.
 
 
24

 
 
Net income (loss) applicable to common stockholders: The net income (loss) applicable to common stockholders amounted to $6,396,153 and $(789,734) for the three months ended June 30, 2010 and 2009, respectively.  The net income (loss) includes derivative income (expense) associated with valuation of debentures and warrants, negative gross margin and increase in travel expenses.

Income (loss) per common share

Basic loss per common share represents our loss applicable to common shareholders divided by the weighted average number  of common shares outstanding during the period. Diluted loss per common share gives effect to all potentially dilutive securities. We compute the effects on diluted loss per common share arising from warrants and options using the treasury stock method or, in the case of liability classified warrants, the reverse treasury stock method. We compute the effects on diluted loss per common share arising from convertible securities using the if-converted method. The effects, if anti-dilutive are excluded.
 
Results of Operations
 
Nine months ended June 30, 2010 compared to nine months ended June 30, 2009
 
Revenues: Our revenues amounted to $597,649 and $0 for the nine months ended June 30, 2010, and 2009, respectively. The increase in revenues relates to establishing our operating architecture and commencing revenue producing activities.
 
Cost of sales: Our cost of sales amounted to $1,022,704 and $0 for the nine months ended March 31, 2010, and 2009, respectively. The increase in cost of sales relates to establishing our operating architectural and commencing revenue producing activities.
 
Gross margin: Our gross margin and new allocations amounted to $(425,055) and $0 for the nine months ended June 30, 2010 and 2009, respectively. This is due to allocating additional expenses to technical support and telecommunication expenses.
 
Advertising:  Our advertising expenses amounted to $223,189 and $2,500 for the nine months ended June 30, 2010 and 2009, respectively. The breakdown of our advertising expense is as follows:
 
 
 
March 31,
 
   
2010
   
2009
 
Infomercial/production time
  $ 18,400     $ -  
Media and others
    204,789       2,500  
Total
  $ 223,189     $ 2,500  
 
Compensation and Benefits: Our compensation and benefits expense amounted to $292,584 and $349,099 for the nine months ended June 30, 2010 and 2009, respectively. This amount represents normal salaries and wages paid to management members and employees including marketing and administrative functions.  The decrease in expenses is due to allocation of compensations and benefits to Cost of sales.
 
Professional Fees: Our professional fees amounted to $187,039 and $231,721 for the nine  months ended June 30, 2010 and 2009, respectively. This amount includes normal payments and accruals for legal, accounting and other professional services.  Our costs associated with legal and accounting fees will remain higher than historical amounts because, as a reporting company,  we are required to comply with the reporting requirements of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”). This involves the preparation and filing of the quarterly and annual reports required under the Exchange Act as well as other reporting requirements under the Exchange Act.
 
We will also incur additional expenses associated with the services provided by our transfer agent. In addition, to the work we are presently doing, we will need to focus our time and energy to complying with the Exchange Act. This will detract from our ability and efforts to develop and market our products and services. We anticipate incurring these additional expenses related to being a public company without receiving a substantial increase in revenues associated with this undertaking.
 
Depreciation and Amortization: Depreciation and amortization amounted to $272,156 and $267,822 for the nine months ended June 30, 2010 and 2009, respectively. These amounts represent amortization of our long-lived tangible and intangible assets using straight-line methods and lives commensurate with the assets’ remaining utility. Our long-lived assets, both tangible and intangible, are subject to annual impairment review, or more frequently if circumstances so warrant. During the nine months ended  June 30, 2010, we did not calculate or record impairment charges. However, negative trends in our business and our inability to meet our projected future results could give rise to impairment charges in future periods.
 
 
25

 
 
Research and Development and Software Costs

We expense research and development expenses, as these costs are incurred. We account for our offering-related software development costs as costs incurred internally in creating a computer software product and are charged to expense when incurred as research and development until technological feasibility has been established for the product. Technological feasibility is established upon completion of a detail program design or, in its absence, completion of a working model.  At this time our main product TK6000 is being sold in the market place.  Therefore, research and development cost reported in our financial statements relates to pre – marketing cost and  are expensed accordingly.
 
Components of research and development:
 
June 30,
 
 
 
2010
   
2009
 
Product development and engineering
  $ 77,621     $ 114,104  
Payroll and benefits
    138,896       121,636  
Total
  $ 216,517     $ 235,740  
 
General and Administrative Expenses: General and administrative expenses amounted to $374,732 and $256,376 for the nine  months ended June 30, 2010 and 2009, respectively, and consisted of general corporate expenses and certain other start up expenses. General corporate expenses included $129,774 in occupancy costs for the nine months ended June 30, 2010 and $124,280 for comparable period ended June 30, 2009.  Our increase costs are associated with our efforts of being a public company.
 
Our general and administrative expenses are made up of the following items:
 
 
 
June 30, 2010
   
June 30, 2009
 
Rent and occupancy
  $ 129,774     $ 124,280  
Insurance
    52,435       17,902  
Taxes and licenses
    28,329       52,327  
Telephone
    12,850       10,259  
Travel
    62,207       9,875  
Bad debt expense
    12,860       -  
Software
    5,587       1,861  
Other
    70,690       39,872  
Total
  $ 374,732     $ 256,376  
 
Interest Expense: Interest expense amounted to $1,184,363 and $326,448 for the nine months ended June 30, 2010 and 2009 respectively.  Such amount represented (i) stipulated interest under our aggregate $4,200,000 face value convertible debentures, (ii) the related amortization of premiums and discounts (iii) the amortization of deferred finance costs.  Aggregate premiums continue to be credited to interest expense over the term of the debentures using the effective interest method. During first and second quarter of 2009, we added $2,700,000 of new debentures at interest rate of 12%.  This contributed to an increase of interest expense.
 
In addition, our convertible debentures as of June 30, 2010 were issued on February 24, 2010 in connection with an exchange agreement with our creditors that provided for, among other things, the consolidation of our previous secured convertible debt instruments, and included the capitalization of $798,773 of accrued interest.  The capitalization of accrued interest was to include interest up to December 31, 2010.  Therefore, we recorded additional interest expense in the amount of $378,000.
 
Derivative Income: Derivative income (expense) amounted to $1,892,559 and $(90,970) for the nine months ended June 30, 2010 and 2009, respectively.  Such amount represents the change in fair value of liability-classified warrants.  Derivative financial instruments are carried as liabilities, at fair value, in our financial statements with changes reflected in income. In addition to the liability-classified warrants, we also have certain compound derivative financial instruments related to our $4,200,000 face value convertible debentures that had de minimus values. We are required to adjust our warrant and compound derivatives to fair value at each reporting period. The fair value of our warrant derivative is largely based upon fluctuations in the fair value of our common stock. The fair value of our compound derivative is largely based upon estimates of cash flow arising from the derivative and credit-risk adjusted interest rates. Accordingly, the volatility in these underlying valuation assumptions will have future effects on our earnings.
 
 
26

 
 
The following table summarizes the effects on our income (loss) associated with changes in the fair values of our derivative financial instruments:
 
   
Nine months ended
 
   
June 30,
2010
   
June 30,
2009
 
Compound Derivative Financial Instruments:
           
February 24, 2010 Secured Convertible
  Debentures
  $ 5,861,467     $ --  
Pre-exchange Secured Convertible Debentures (amount through
the exchange date of February 24, 2010)
    (4,240,000 )     --  
February 24, 2010 Series A Convertible Preferred
   Stock
    3,432,000       --  
Warrants (dates correspond to financing):
               
February 24, 2010 Series D warrants, issued
  with the preferred financing (Note 6)
    3,816,000       --  
February 24, 2010 Series D warrants, issued
  with the exchange (Note 7)
    467,760       --  
Other warrants
    (1,121,868 )     (90,970 )
Total fair value adjustments
    8,215,359       (90,970 )
Day-one derivative expense, resulting from the
  Series A Preferred Stock Financing (Note 6)
    (6,322,800 )     --  
Day-one derivative expense from prior financings
    --       --  
    $ 1,892,559     $ (90,970 )
 
Debt extinguished: Debt extinguished amount to $3,617,984 and $0 for the nine months ended June 30, 2010 and 2009, respectively.  Such amount is related to the financing agreement executed on February 24, 2010, whereby, we received $5,000,000 additional working capital and our existing debentures were extended and renegotiated.
 
Our accounting for the exchange transaction required us to consider whether the exchange resulted in a substantial modification to the original convertible debentures based upon either cash flows or the fair value of the embedded conversion feature, wherein substantial is generally defined as a change greater than 10%. In all instances our calculations indicated that the exchange of convertible debentures resulted in changes that were substantial to either cash flows, the embedded conversion option, or both. As a result, we were required to extinguish the prior debt instruments and reestablish the new convertible debentures, at fair value, with the change reflected in our expenses. The following table reflects the components of our extinguishment calculations on February 24, 2010:

The following table reflects the components of our extinguishment calculations on February 24, 2010:

   
Convertible Debenture due
       
   
June 30,
2011
   
July 20,
2011
   
September 30,
2011
   
Total
 
Fair value of new debenture
  $ 7,767,450     $ 1,490,256     $ 3,196,102     $ 12,453,808  
Carrying value of old debentures:
                               
   Debentures
    1,713,124       152,755       267,000       2,132,879  
   Accrued Interest
    546,000       87,166       165,607       798,773