UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

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Form 10-Q

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QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED September 30, 2010.

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TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ______________ TO ______________.

Commission file number 1-11900

Integrated Security Systems, Inc.

(Exact name of small business issuer as specified in its charter)

(972) 444-8280

(Issuer’s telephone number)

Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) during the past 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 x    No o

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 o    No o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):  Yes o    No x

Indicate by check mark whether the registrant is a (See definitions in Rule 12b-2 of the Exchange Act:

Large accelerated filer ¨       Accelerated filer ¨       Non-accelerated filer ¨       Smaller reporting company ý

As of October 31, 2010, 558,915,082 shares of the registrant’s common stock were outstanding.

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 INTEGRATED SECURITY SYSTEMS, INC.

INDEX

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The accompanying notes are an integral part of the consolidated financial statements.

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The accompanying notes are an integral part of the consolidated financial statements.

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The accompanying notes are an integral part of the consolidated financial statements.

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INTEGRATED SECURITY SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Three Months Ended September 30, 2010 and 2009

Note 1 – Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information.  Accordingly, they do not include all of the information and footnotes required for complete financial statements. In the opinion of management, all adjustments (all of which are normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the interim period are not necessarily indicative of the results that may be expected for the fiscal year ending June 30, 2011. Prior periods have been reclassified to conform to the current period presentation.

The accompanying financial statements include the accounts of Integrated Security Systems, Inc. (the “Company”) and all of its subsidiaries, with all significant intercompany accounts and transactions eliminated. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s fiscal 2010 Annual Report on Form 10-K filed on September 28, 2010 with the Securities and Exchange Commission.

Note 2 – Stock-based Compensation

The Company accounts for equity instruments issued to employees in accordance with ASC 718 “Compensation – Stock Compensation” (formerly SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”)). Under ASC 718, the cost of employee services received in exchange for an award of equity instruments is based on the grant-date fair value of the award, and that cost is recognized over the vesting period.  Our forfeiture rate is a graded 20% rate, which averages out to an overall forfeiture rate of 48.8%. An expense of $17,461 was recorded in the three months ended September 30, 2010. The known amount of compensation expense to be recognized in future periods through fiscal 2012 is $66,827.

Note 3 – Recent Accounting Pronouncements

In December 2007, the FASB issued ASC 810 “Consolidation” (formerly SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements, an amendment of Accounting Research Bulletin No. 51" ("SFAS No. 160")). ASC 810 requires (a) that noncontrolling (minority) interest be reported as a component of shareholders' equity; (b) that net income attributable to the parent and to the noncontrolling interest be separately identified in the consolidated statement of operations; (c) that changes in a parent's ownership interest while the parent retains its controlling interest be accounted for as equity transactions; (d) that any retained noncontrolling equity investment upon the deconsolidation of the subsidiary be initially measured at fair value; and (e) that sufficient disclosures are provided that clearly identify and distinguish between the interest of the parent and the interests of the noncontrolling owners. ASC 810 is effective for fiscal years beginning after December 15, 2008, and applied to the Company in the quarter ended September 30, 2009. The Company revised its reporting and disclosures regarding noncontrolling interest, but there was no material effect from the adoption of ASC 810.

In June 2009, the FASB issued ASC 105, “Generally Accepted Accounting Principles” (formerly SFAS No. 168, “FASB Accounting Standards Codification^TM and the Hierarchy of Generally Accepted Accounting Principles. SFAS No. 168 replaces SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles).” This statement’s objective is to communicate that the FASB Accounting Standards Codification^TM will become the single official source of authoritative U.S. generally accepted accounting principles (GAAP) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date of this Statement, the Codification will supersede all then-existing non-SEC accounting and reporting standards. All other nongrandfathered non-SEC accounting literature not included in the Codification will become nonauthoritative. This Statement is effective for financial statements issued for interim and annual periods ending after September 15, 2009; and the Company adopted this standard in the first quarter of 2010. The adoption of ASC 105 did not have a material effect on the Company’s financial statements.

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In October 2009, the FASB issued Accounting Standards Update No. 2009-13, “Multiple-Deliverable Revenue Arrangements a consensus of the FASB Emerging Issues Task Force” (“ASU 2009-13”). ASU 2009-13 provides principles for allocation of consideration among its multiple-elements, allowing more flexibility in identifying and accounting for separate deliverables under an arrangement. The ASU introduces an estimated selling price method for valuing the elements of a bundled arrangement if vendor-specific objective evidence or third-party evidence of selling price is not available, and significantly expands related disclosure requirements. This standard is effective on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. Alternatively, adoption may be on a retrospective basis, and early application is permitted. The adoption of this statement did not have a material effect on the Company’s consolidated financial statements or disclosures.

Note 4 – Discontinued Operations

On July 31, 2008 we entered into an Asset Purchase Agreement with the managers and former owners of DoorTek for the sale of substantially all of DoorTek’s assets, including equipment and inventory. On March 25, 2009, we sold substantially all of Intelli-Site, Inc.’s assets, including equipment and intellectual property related to its’ operations. In accordance with generally accepted accounting principles, the operating results for both DoorTek and Intelli-Site have been aggregated and reported as discontinued operations in the Consolidated Statement of Operations and the associated assets and liabilities are classified separately in the balance sheet.

Income from discontinued operations reported in the Consolidated Income Statement for September 30, 2010 is $48,668 from extinguishment of liability.

Selling, general and administrative expense from discontinued operations reported in the Consolidated Income Statement for September 30, 2009 is $1,278.

Liabilities from discontinued operations reported in the Consolidated Balance Sheets for September 30, 2010 and June 30, 2010 consisted of accounts payable of $2,555 and $14,117, respectively.

Note 5 – Accounts Receivable

The majority of our accounts receivable are due from companies in the perimeter security and road and bridge industries. Credit is extended based on evaluation of a customer's financial condition and credit history and, generally, collateral is not required. Accounts receivable are generally due within 30 days and are stated at amounts due from customers net of an allowance for doubtful accounts and sales allowance. Accounts outstanding longer than the contractual payment terms are considered past due. We determine our allowance by considering a number of factors, including the length of time trade accounts receivable are past due, our previous loss history, the customer’s current ability to pay its obligation to us, and the condition of the general economy and the industry as a whole. The Company writes-off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts.  

Note 6 – Inventory

Inventories are stated at the lower of cost or market with cost determined on a first-in, first-out (“FIFO”) method of valuation. The establishment of inventory allowances for excess and obsolete inventories is based on estimated exposure on specific inventory items.

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At September 30, 2010 and June 30, 2010, respectively, inventories were comprised of the following:

Note 7 – Product Warranties

We have one-year, two-year and five-year limited warranties on products we manufacture both internally and externally.  The length of the warranty is generally dictated by competition.  We provide for repair or replacement of components and/or products that contain defects of material or workmanship. When we use other manufacturers’ components and manufacturing services, the warranties of the other manufacturers are passed to the dealers and end users.   In some instances, we absorb the cost of these warranties internally.  To date, the servicing and replacement of defective software components and products have not been material.

We record a liability for an estimate of costs that we expect to incur under our basic limited warranty when product revenue is recognized.  Factors affecting our warranty liability include the number of units sold and historical and anticipated rates of claims and costs per claim.  We periodically assess the adequacy of our warranty liability based on changes in these factors.

Note 8 – Net Income (Loss) per Share

The Company computes basic income (loss) per common share using the weighted average number of common shares outstanding. At September 30, 2010 and 2009 there were 515,000 shares of in-the-money potentially dilutive common shares outstanding. These shares were not included in weighted average shares outstanding for three months ended September 30, 2009 because their effect is antidilutive due to the Company’s reported net loss.

At September 30, 2010 and 2009, we had 670,903,372 and 671,961,909 shares, respectively, of common stock and common stock equivalents outstanding, which comprises all of the Company’s outstanding equity instruments.  

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Note 9 – Debt

As of September 30 and June 30, 2010, our current and long-term debt consisted of the following:

Note 10 – Business Segments

The following table provides financial data by segment for the three months ended September 30, 2010 and 2009:

Note 11 – Comprehensive Loss

The following table provides a summary of total comprehensive loss for the three months ended September 30, 2010 and 2009:

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Note 12 – Noncontrolling interest

Causey Lyon Enterprises (CLE) is the 35% owner of the B&B Roadway joint venture; per the joint venture agreement, CLE manufactures all products for B&B Roadway. CLE is also one of several outsourced fabrication vendors for B&B ARMR.

Changes in noncontrolling interest for the three months ended September 30, 2010 and 2009 were as follows:

Note 13 – Related Party Transactions

During September 30, 2010 and 2009, the Company had the following transactions with Causey Lyon Enterprises (CLE):

Note 14 – Factoring and Security Agreement with Capital Funding Solutions

On August 15, 2008, the Company closed a security agreement with Capital Funding Solutions. The Factoring Agreement provides that the Company will sell to Capital Funding certain of its accounts receivable. Moreover, the factoring agreement requires that we grant to Capital Funding a continuing first priority security interest in all of our now owned and hereafter acquired accounts, chattel paper, deposit accounts, inventory, equipment, instruments, investment property, documents, letter of credit rights, commercial tort claims, general intangibles and supporting obligations. The factoring agreement does not require us to grant a security interest in any of the assets B&B Roadway, Inc. The factoring agreement was initially for a one-year term and was automatically extended by one year on August 15, 2010. The factoring agreement can be terminated at any time by either us or Capital Funding by giving 30 days written notice.

For each account, Capital Funding will pay 80% of the face amount due on such Account at the time of purchase. Upon customer payment of the amount due, Capital Funding will pay 20% of the face amount due less the factoring fee (as defined in the factoring agreement).  The factoring fee is calculated as follows: .35% of the face amount due on an Account at the time of purchase for each 5 day period, computed from the end of the 5 day period following the date on which the purchase price is paid to us for such account and ending when such account is paid by the account debtor.  

The factored balance outstanding under the factoring agreement as of September 30, 2010 and June 30, 2010 was $205,988 and $80,049, respectively.

Note 15 – Concentrations of Credit Risk

The Company maintains cash balances, at times, with financial institutions, which are in excess of amounts insured by the Federal Deposit Insurance Corporation (FDIC). Management monitors the soundness of these institutions and has not experienced any collection losses with these institutions.

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

Forward Looking Statements

This quarterly report on Form 10-Q includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements can be identified by the use of forward-looking terminology such as “may,” “believe,” “expect,” “intend,” “plan,” “seek,” “anticipate,” “estimate,” or “continue” or the negative of those words or other variations or comparable terminology.  

All statements other than statements of historical fact included in this quarterly report on Form 10-Q, including the statements under “Part I. - Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations” and located elsewhere in this quarterly report on Form 10-Q regarding our financial position and liquidity are forward-looking statements. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we can give no assurance that such expectations will prove to have been correct. Important factors regarding forward-looking statements, including certain risks and uncertainties that could cause actual results to differ materially from our expectations, are disclosed in this quarterly report on Form 10-Q. We do not undertake any obligation to publicly revise our forward-looking statements to reflect events or circumstances that arise after the date of this quarterly report on Form 10-Q.

Important factors that could cause actual results to differ materially from those in the forward-looking statements in this quarterly report on Form 10-Q include changes from anticipated levels of operations, customer acceptance of existing and new products, anticipated development schedules of new products, anticipated levels of sales, future national or regional economic and competitive conditions, changes in relationships with our customers, access to capital, casualty to or other disruption of our contracted vendor production facilities and equipment, delays and disruptions in the shipment of our products, government regulations and our ability to meet our stated business goals.  All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by our cautionary statements.

Results of Operations

Three Months Ended September 30, 2010 Compared to Three Months Ended September 30, 2009

Sales. Total sales increased by $0.58 million, or 30.3%, to $2.51 million during the quarter ended September 30, 2010 as compared to $1.92 million during the quarter ended September 30, 2009. Sales in the road and bridge business, B&B Roadway, increased by $0.78 million. In early 2009 the federal government passed a stimulus program that included funds for infrastructure projects such as roads and bridges. During fiscal years 2009 and 2010, state and local agencies had put budgeted projects on hold in anticipation of receiving federal funding. Despite mixed success obtaining federal funds, these state and local projects have begun to be released and sales increased substantially last quarter and again this quarter. In addition, current orders are keeping pace with the shipments; the backlog of orders at October 31, 2010 is approximately $3.6 million with the majority scheduled to ship by June 2011.

Offsetting this increase was a decline in sales at B&B ARMR of $0.20 million due to a major turnover in sales staff in 2009, resulting in a lower level of quote activity. We hired a new Vice President of Sales and have been fully staffed since the end of 2009. Consequently, our quote activity has steadily increased and was above historical levels during the fourth quarter of fiscal 2010 and into the first quarter of fiscal 2011.  Due to the long industry cycle times from quote to order, this reduced quote activity did not impact sales until March 2010; we anticipate an increase in order activity in the latter part of fiscal 2011.

Gross Profit. Gross profit increased by $0.20 million during the quarter ended September 30, 2010 to $0.85 million as compared to the quarter ending September 30, 2009. This increase was due to the increase of sales.

Gross margin increased to 33.9% during the quarter ended September 30, 2010 from 33.5% during the quarter ending September 30, 2009 despite a shift in mix to the lower margin road and bridge product aas gross margin increased at B&B ARMR despite the lower volume in sales.

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Selling, General and Administrative. Selling, general and administrative expenses decreased $0.01 million for the quarter ended September 30, 2010 compared to the quarter ended September 30, 2009 due to head count reduction and lower professional fees.

Interest Expense. Interest expense increased to $0.02 million during the quarter ended September 30, 2010 from $0.01 million compared to the quarter ended September 30, 2009. This increase was primarily due to an increase in notes payable.

Liquidity and Capital Resources

We were profitable during the three months ending September 30, 2010 however we suffered a net loss during fiscal 2010, and we suffered losses from operations during fiscal 2009 and 2008. Management expects that we will continue to be profitable on an operating basis in fiscal 2011; however, this expectation is dependent on the Company’s ability to draw additional funds on its factoring agreement or to obtain additional financing from alternative sources. As the factoring agreement is a demand note and subject to termination with 30 days notice, plus the fact that the Company has been unable to find alternative financing to date, we can give no assurances that funds will be available to settle current liabilities as they become due. Ultimately, failure to obtain additional financing could jeopardize our ability to continue as a going concern.

Our cash position increased $0.1 million during the three months ended September 30, 2010. At September 30, 2009, we had $0.3 million in cash and cash equivalents and $0.2 million outstanding under our factoring agreement with Capital Funding Solutions. The factoring agreement, which is secured by substantially all of our assets, permits us to borrow up to $1.0 million based on eligible invoices.

For the three months ended September 30, 2010, our operating activities used $0.1 million of cash compared to providing $0.3 million of cash during the three months ended September 30, 2009.

Our backlog is calculated as the aggregate sales prices of firm orders received from customers less revenue recognized. At October 31, 2010, the Company’s backlog was $4.5 million. We expect to fill the majority of this backlog by June 30, 2011.

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Item 4. Controls and Procedures.

(a) Evaluation of Disclosure Controls and Procedures.  As indicated in the certifications in Exhibit 31 of this report, our Chief Executive Officer (CEO) and Chief Financial Officer (CFO) have evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2010.  Based on that evaluation, we have concluded that, as of September 30, 2010, our disclosure controls and procedures were not effective to provide reasonable assurance that information required to be disclosed in the Company’s periodic filings under the Securities Exchange Act of 1934 is accumulated and communicated to management, including the officers, to allow timely decisions regarding required disclosure.  

Based upon this assessment, our CEO and CFO concluded that, as of September 30, 2010, there existed a material weakness in our processes, procedures and controls related to the preparation of our quarterly financial statements. We have concluded that our internal control over financial reporting was not effective as of September 30, 2010. Due to this material weakness, in preparing our quarterly financial statements, we performed compensating additional procedures designed to ensure that such financial statements were fairly presented in all material respects in accordance with generally accepted accounting principles.

(b) Changes in Internal Controls. There were no changes to our internal controls over financial reporting during our last completed fiscal quarter that have materially affected or are reasonably likely to materially affect, our internal controls over financial reporting, except as described above. Additionally, we have and will continue to improve both the quality and the quantity of staffing in order to effect significant improvements in our internal control structure.

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PART II.  OTHER INFORMATION

Item 1. Legal Proceedings.

None.

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

None.

Item 3.  Defaults Upon Senior Securities.

None.

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

None.

Item 5.  Other Information.

None.

Item 6.  Exhibits.

31.1+

Officer’s Certificates Pursuant to Section 302

32.1+

Officer’s Certificates Pursuant to Section 906

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+

Filed herewith.

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SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

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EXHIBIT INDEX

31.1+

Officers’ Certificate Pursuant to Section 302

32.1+

Officers’ Certificate Pursuant to Section 906

________________________

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Filed herewith.

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