AMERICAN DEFENSE SYSTEMS INC - FORM 10-K/A

Attached files

file	filename
EX-32.1 - EX-32.1 - AMERICAN DEFENSE SYSTEMS INC	v245614_ex32-1.htm
EX-31.1 - EX-31.1 - AMERICAN DEFENSE SYSTEMS INC	v245614_ex31-1.htm
EX-23.1 - EX-23.1 - AMERICAN DEFENSE SYSTEMS INC	v245614_ex23-1.htm
EX-31.2 - EX-31.2 - AMERICAN DEFENSE SYSTEMS INC	v245614_ex31-2.htm
EX-21.1 - EX-21.1 - AMERICAN DEFENSE SYSTEMS INC	v245614_ex21-1.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K/A

(Amendment no. 1)

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2010

Commission File Number 001-33888

AMERICAN DEFENSE SYSTEMS, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware		83-0357690
(State or Other Jurisdiction of		(I.R.S. Employer
Incorporation or Organization)		Identification No.)

420 McKinney Parkway

Lillington, North Carolina 27546

(910) 514-9701

(Address including zip code, and telephone number, including area code, of principal executive offices)

Securities registered pursuant to Section 12(g) of the Act:

None

Securities registered pursuant to Section 12(b) of the Act:

Common stock, par value $.001 per share

(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x

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 (the "Exchange Act") 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 x No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is a large accelerated filer, an 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 o		Accelerated filer o		Non-accelerated filer o		Smaller reporting company x
				(Do not check if a smaller reporting company)

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

The aggregate market value of the common stock held by nonaffiliates of the registrant (47,902,454 shares) based on the $0.24 closing price of the registrant's common stock as reported on the NYSE Amex on June 30, 2010, was approximately $11,496,589. For purposes of this computation, all officers, directors and 10% beneficial owners of the registrant are deemed to be affiliates. Such determination should not be deemed to be an admission that such officers, directors or 10% beneficial owners are, in fact, affiliates of the registrant.

As of April 12, 2011, there were 54,341,685 outstanding shares of the registrant's common stock.

Documents Incorporated by Reference

Portions of American Defense Systems, Inc.’s Proxy Statement related to the 2011 Meeting of Stockholders, which was filed with the Securities and Exchange Commission on December 9, 2011, are incorporated by reference into Part III of this annual report.

TABLE OF CONTENTS

	Page

Explanatory Note	4

PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	5
Item 6. Selected Financial Data	6
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations	6
Item 7A. Quantitative and Qualitative Disclosures about Market Risk	13
Item 8. Financial Statements and Supplementary Data	13
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	13
Items 9A. Controls and Procedures	13
Item 9B. Other Information	15

PART III
Item 10. Directors, Executive Officers and Corporate Governance	16
Item 11. Executive Compensation	16
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	16
Item 13. Certain Relationships and Related Transactions, and Director Independence	16
Item 14. Principal Accounting Fees and Services	16

PART IV
Item 15. Exhibits and Financial Statement Schedules	17

CAUTIONARY NOTES REGARDING FORWARD-LOOKING STATEMENTS

We believe that some of the information contained in this report on Form 10-K constitutes forward-looking statements within the definition of the Private Securities Litigation Reform Act of 1995. You can indentify these statements by forward-looking words such as "may," "expect," "project," "anticipate," "contemplate," "believe," "estimate," "intend," "plan," and "continue" or similar words. You should read statements that contain these words carefully because they:

• discuss future expectations;

• contain projections of future results of operations or financial condition; or

• state other “forward-looking” information.

We believe it is important to communicate our expectations to our stockholders. However, there may be events in the future that we are not able to accurately predict or over which we have no control. The risk factors and cautionary language discussed in this report provide examples of risks, uncertainties and events that may cause actual results to differ materially from the expectations described by us in our forward-looking statements, including among other things:

• our ability to continue as a going concern;

• our reliance on the U.S. government for a substantial amount of our sales and growth;

• decreases in U.S. government defense spending;

• our ability to enter into contracts with the U.S. Department of Defense;

• our ability to comply with complex procurement laws and regulations;

• competition and other risks associated with the U.S. government bidding process;

• changes in the U.S. government's procurement practices;

• our ability to obtain and maintain required security clearances;

• our ability to realize the full amount of revenues reflected in our backlog;

• our reliance on certain suppliers;

•

intense competition and other risks associated with the defense industry in general and the security-related defense sector in particular; and

•

other matters discussed in Item 1A. Risk Factors.

You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual future results to differ materially from those projected or contemplated in the forward-looking statements.

All forward-looking statements included herein attributable to us or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section and elsewhere in this report. Except to the extent required by applicable laws and regulations, we undertake no obligation to update these forward-looking statements to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events. You should be aware that the occurrence of the events described in other matters discussed in Item 1A. Risk Factors and elsewhere in this report could have a material adverse effect on us.

Explanatory Note

This amendment to the Form 10-K annual report of American Defense Systems, Inc. for the fiscal year ended December 31, 2010 (the “Original Form 10-K”) is being filed to update its disclosures and include information based upon the comments received from the U.S. Securities and Exchange Commission regarding its Original Form 10-K. Changes were made to Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, Liquidity and Capital Resources section, Part III, and Part IV, Item 15, Exhibits and Financial Statement Schedules, Notes to Consolidated Financial Statements, Footnotes #1, 5, 10, 11, and 12.

PART II

Item 5.

Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market for Common Stock

Our common stock has been traded on the NYSE Amex (formerly known as the American Stock Exchange) under the symbol "EAG" since May 30, 2008. The following table sets forth, for the calendar quarter indicated, the quarterly high and low closing sale prices of our common stock, as reported on the NYSE Amex.

	High		Low
Fiscal Year Ended December 31, 2010
First quarter	$	0.43	$	0.34
Second quarter	$	0.37	$	0.23
Third quarter	$	0.28	$	0.15
Fourth quarter	$	0.23	$	0.12

Fiscal Year Ended December 31, 2009
First quarter	$	1.00	$	0.44
Second quarter	$	0.73	$	0.49
Third quarter	$	0.60	$	0.43
Fourth quarter	$	0.52	$	0.31

As of April 12, 2011, there were approximately 253 record holders of our common stock. This figure does not reflect persons or entities that hold their stock in nominee or "street" name through various brokerage firms.

Dividends

We have not paid any dividends on our common stock to date and do not anticipate paying any dividends in the foreseeable future. We intend to retain future earnings, if any, in the operation and expansion of our business. Any future determination to pay cash dividends will be made at the discretion of our board of directors and will depend on our financial condition, results of operations, capital requirements and other factors that our board of directors deemed relevant. Investors should not purchase our common stock with the expectation of receiving cash dividends.

Equity Compensation Plan Information

As of December 31, 2010, the following equity securities of our company are authorized for issuance, aggregated as follows, pursuant to our compensation plans (including individual compensation arrangements):

Plan Category	Number of securities to be issued upon exercise of outstanding options, warrants and rights		Weighted-average exercise price of outstanding options, warrants and rights		Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column(a)
Equity compensation plans approved by security holders		2,505,000	$	1.65		2,495,000
Equity compensation plans not approved by security holders		—		—		—

Recent Sales of Unregistered Securities

For the year ended December 31, 2010, we issued an aggregate of 7,380,000 shares of our common stock to the holders of our Series A Convertible Preferred Stock as dividends for 2010 pursuant to the Certificate of Designations, Preferences and Rights of Series A Convertible Preferred Stock. We relied on the exemption provided by Section 4(2) of the Securities Act of 1933 and Regulation D promulgated thereunder.

Item 6.

Selected Financial Data

We are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide the information required under this Item 6.

Item 7.

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes that appear elsewhere in this annual report. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this annual report, particularly in "Risk Factors" in Item 1A.

Overview

We are a defense and security products company engaged in three business areas: customized transparent and opaque armor solutions for construction equipment and tactical and non-tactical transport vehicles used by the military; architectural hardening and perimeter defense, such as bullet and blast resistant transparent armor, walls and doors; and tactical training products and services consisting of our live-fire interactive T2 Tactical Training System and our American Institute for Defense and Tactical Studies. The portion of our business related to vehicle anti-ram barriers such as bollards, steel gates and steel wedges that deploy out of the ground was sold as of March 22, 2011.

We primarily serve the defense market and our sales are highly concentrated within the U.S. government. Our customers include various branches of the U.S. military through the U.S. Department of Defense and to a much lesser extent other U.S. government, law enforcement and correctional agencies as well as private sector customers.

Our recent historical revenues have been generated primarily from a limited number of large contracts and a series of purchase orders from a single customer. To continue expanding our business, we are seeking to broaden our customer base and to diversify our product and service offerings. Our strategy to increase our revenue, grow our company and increase stockholder value involves the following key elements:

increase exposure to military platforms in the U.S. and internationally;

develop strategic alliances and form strategic partnerships with original equipment manufacturers (OEMs);

focus on an advanced research and development program to capitalize on increased demand for new armor materials; and

We are pursuing each of these growth strategies simultaneously.

Sources of Revenues

We derive our revenues by fulfilling orders under master contracts awarded by branches of the United States military, law enforcement and corrections agencies and private companies involved in the defense market and other customer purchase orders. Under these contracts and purchase orders, we provide customized transparent and opaque armor products for transport and construction vehicles used by the military, group protection kits and spare parts. We also derive revenues from sales of our architectural hardening and perimeter defense products, which we sometimes refer to as physical security products. To date, we have generated nominal revenues from our T2 and other training solutions and we are evaluating the continued offering of such training products and services and expect to continue that process over the next several months.

As noted in the section entitled "Business Backlog," of our $16 million of contract backlog as of December 31, 2010, we estimate that it will all be filled in 2011. Accordingly, in order to maintain our current revenue levels and to generate revenue growth, we will need to win more contracts with the U.S. government and other commercial entities, achieve significant penetration into critical infrastructure and public safety protection markets, and successfully further develop our relationships with OEM's and strategic partners. Notwithstanding the possible significant troop reductions in Afghanistan and Iraq, we expect that demand in those countries for armored military construction vehicles will continue in order to repair significant war damage and for nation-building purposes. In addition, we are exploring interest in armored construction equipment in other countries with mine-infested regions.

We continue to aggressively bid on projects and are in preliminary talks with a number of international firms to pursue long-term government and commercial contracts, including with respect to Homeland Security. While no assurances can be given that we will obtain a sufficient number of contracts or that any contracts we do obtain will be of significant value or duration, we are confident that we will continue to have the opportunity to bid and win contracts as we have in 2010.

Cost of Revenues and Operating Expenses

Cost of Revenues. Cost of revenues consists of parts, direct labor and overhead expenses incurred for the fulfillment of orders under contract. These costs are charged to expense upon completion and acceptance of an order. Costs of revenue also includes the costs of prototyping and engineering, which are expensed upon completion of an order as well. These costs are included as costs of revenue because they are incurred to modify products based upon government specifications and are reimbursable costs within the contract. These costs for the production of goods under contract are expensed when they are complete. We allocate overhead expenses such as employee benefits, computer supplies, depreciation for computer equipment and office supplies based on personnel assigned to the job. As a result, indirect overhead expenses are included in cost of revenues and each operating expense category.

Sales and Marketing. Expenses related to sales and marketing consist primarily of compensation for our sales and marketing personnel, sales commissions and incentives, trade shows and related travel. Sales and marketing costs are charged to expense as incurred. As we have implemented various cost cutting measures, we expect that in 2011, sales and marketing expenses will decrease.

Research and Development. Research and development expenses are incurred as we perform ongoing evaluations of materials and processes for existing products, as well as the development of new products and processes. We expect that in 2011, research and development expenses will remain consistent with or decrease from 2010 levels. Research and development costs are charged to expense as incurred.

General and Administrative. General and administrative expenses consist of compensation and related expenses for finance, accounting, administrative, legal, professional fees, other corporate expenses and allocated overhead. We expect that in 2011, general and administrative expenses will decrease in absolute dollars and decrease as a percentage of revenues due to cost cutting measures implemented in 2010 and in the first quarter of 2011.

General and Administrative Salaries. General and administrative salaries expenses consist of compensation for the officers, and IT, design and engineering personnel. We expect that in 2011, general and administrative salaries expenses will decrease in absolute dollars and decrease as a percentage of revenues due to the cost cutting measures, which include reduction in labor costs, implemented in 2010.

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates under different assumptions or conditions.

We believe that of our significant accounting policies, which are described in Note 1 to the consolidated financial statements, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations.

Revenue and Cost Recognition. We recognize revenue in accordance with Accounting Standards Codification (ASC) 605, "Revenue Recognition", which states that revenue is realized and earned when all of the following criteria are met: (a) persuasive evidence of the arrangement exists, (b) delivery has occurred or services have been rendered, (c) the seller's price to the buyer is fixed and determinable and (d) collectability is reasonably assured. Under this provision, revenue is recognized upon delivery and acceptance of the order.

We recognize revenue and report profits from purchases orders filled under master contracts when an order is complete, as defined below. Purchase orders received under master contracts may extend for periods in excess of one year. Purchase order costs are accumulated as deferred assets and billings and/or cash received are charged to a deferred revenue account during the periods of construction. However, no revenues, costs or profits are recognized in operations until the period upon completion of the order. An order is considered complete when all costs, except insignificant items, have been incurred and, the installation or product is operating according to specification or the shipment has been accepted by the customer. Provisions for estimated contract losses are made in the period that such losses are determined. As of December 31, 2010, there were no such provisions made.

All costs associated with uncompleted purchase orders under contract are recorded on the balance sheet as a deferred asset called "Costs in Excess of Billings on Uncompleted Contracts." Upon completion of a purchase order, such associated costs are then reclassified from the balance sheet to the statement of operations as costs of revenue.

Stock-Based Compensation. Stock based compensation consists of stock or options issued to employees, directors, consultants and contractors for services rendered. We account for the stock issued using the estimated current market price per share at the date of issuance. Such cost is recorded as compensation in our statement of operations at the date of issuance.

In December 2007, we adopted our 2007 Incentive Compensation Plan pursuant to which we have issued and intend to issue stock-based compensation from time to time, in the form of stock, stock options and other equity based awards. Our policy for accounting for such compensation in the form of stock options is as follows:

We have adopted the provisions of ASC 718 “Compensation–Stock Compensation”. In accordance with ASC 718, we use the Black-Scholes option pricing model to measure the fair value of our option awards. The Black-Scholes model requires the input of highly subjective assumptions including volatility, expected term, risk-free interest rate and dividend yield. In 2005, the SEC issued Staff Accounting Bulletin (SAB) No. 107, as codified in ASC 718-10-599, which provides supplemental implementation guidance for ASC 718.

Stock-based compensation expense recognized will be based on the estimated portion of the awards that are expected to vest. We will apply estimated forfeiture rates based on analyses of historical data, including termination patterns and other factors.

We recognized $248,137 and $261,362 in stock compensation expense for the years ended December 31, 2010 and 2009, respectively.

Fair Value Measurements. We have adopted the provisions of ASC 820, “Fair Value Measurements and Disclosures” (ASC 820). ASC 820 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value investments.

Fair value, as defined in ASC 820, is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value of an asset should reflect its highest and best use by market participants, whether using an in-use or an in-exchange valuation premise. The fair value of a liability should reflect the risk of nonperformance, which includes, among other things, the company’s credit risk.

Valuation techniques are generally classified into three categories: the market approach; the income approach; and the cost approach. The selection and application of one or more of the techniques requires significant judgment and are primarily dependent upon the characteristics of the asset or liability, the principal (or most advantageous) market in which participants would transact for the asset or liability and the quality and availability of inputs. Inputs to valuation techniques are classified as either observable or unobservable within the following hierarchy:

Level 1 Inputs: These inputs come from quoted prices (unadjusted) in active markets for identical assets or liabilities.

Level 2 Inputs: These inputs are other than quoted prices that are observable, for an asset or liability. This includes: quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from or corroborated by observable market data by correlation or other means.

Level 3 Inputs: These are unobservable inputs for the asset or liability which require the company’s own assumptions.

Series A Convertible Preferred Stock. The Series A Convertible Preferred Stock (or Series A Preferred) was mandatorily redeemable on October 1, 2011 and was convertible into shares of common stock at $0.50 per share subject to adjustment should we issue future common stock at a lesser price. As a result we elected to record the hybrid instrument, preferred stock and conversion option together, at fair value. Subsequent reporting period changes in fair value are to be reported in the statement of operations. Pursuant to the Redemption Agreement, all outstanding shares of Series A Convertible Preferred Stock were redeemed on March 22, 2011.

The proceeds from the issuance of the Series A Preferred and accompanying common stock warrants, net of direct costs including the fair value of warrants issued to the Placement Agent in connection with the transaction, must be allocated to the instruments based upon relative fair value upon issuance as they must be measured initially at fair value. Therefore, after the initial recording of the Series A Preferred based upon net proceeds received, the carrying value of the Series A Preferred must be adjusted to the fair value at the date of issuance, with the difference recorded as a gain or loss. On March 7, 2008, the date of initial issuance, we recorded a derivative liability of $9.8 million. On April 4, 2008, the date of the second issuance, we recorded a derivative liability of $3.6 million. These liabilities were subsequently adjusted to fair value as of December 31, 2010 and 2009, which resulted in a loss of $0.8 million and $0.3 million for the years ended December 31, 2010 and 2009, respectively. As of December 31, 2010 and 2009, the Series A Preferred liability was $14.0 million and $12.4 million, respectively.

Debt Extinguishment. We accounted for the effects of the May 22, 2009 settlement agreement (see Note 1) of the accompanying consolidated financial statements) in accordance with the guidelines enumerated in EITF Issue No. 96-19 “ Debtor’s Accounting for a Modification of Exchange of Debt Instruments” as codified in ASC 470-50. ASC 470-50 provides that a substantial modification of terms in an existing debt instrument should be accounted for like, and reported in the same manner as, an extinguishment of debt. ASC 470-50 further provides that the modification of a debt instrument by a debtor and a creditor in a non-troubled debt situation is deemed to have been accomplished with debt instruments that are substantially different if the present value of cash flows under the terms of the new debt instrument is at least ten percent different from the present value of the remaining cash flows under the terms of the original instrument at the date of the modifications.

We evaluated the modification of the payment terms and the related adjustment to financial instruments to determine whether these modifications resulted in the issuance of a substantially different instrument. We determined after giving effect to the changes in the due dates of payments and the consideration paid to the debt holders, in the form of reduced conversion and exercise prices that we had issued substantially different debt instruments, which resulted in a constructive extinguishment of the original debt instrument. Accordingly, we recorded a loss on the extinguishment of debt in the amount of $2,613,630 which represented the difference in the carrying value of the old debt and fair value of the new debt. The debt instrument charge is included in the accompanying statement of operations for the year ended December 31, 2009.

Consolidated Results of Operations

The following discussion should be read in conjunction with the information set forth in the consolidated financial statements and the related notes thereto appearing elsewhere in this report.

Comparison of Years Ended December 31, 2010 and 2009

Revenues. Revenues for 2010 from continuing operations were $39.5 million, a decrease of $6.4 million or 13.9%, from revenues of $45.9 million for 2009. The decrease in revenues from 2009 to 2010 was due primarily to cut backs in federal government spending.

Cost of Revenues. Cost of revenues from continuing operations for the year ended December 31, 2010 was $27.4 million, a decrease of $6.6 million, or 19.4%, over cost of revenues of $34.0 million for the year ended December 31, 2009. The decrease was primarily a decline in revenue and better product mix for 2010 from spare parts and field service representatives (“FSRs”).

Gross Profit Margin. The gross profit margin from continuing operations for the year ended December 31, 2010 was $12.1 million, or 30.6% of revenue, as compared to $12.0 million, or 26.1% of revenue, for the year ended December 31, 2009. The increase in gross profit margin percentage from continuing operations from the year ended December 31, 2009 to the year ended December 31, 2010 was due primarily to better product mix for 2010 from spare parts and FSRs.

Sales and Marketing Expenses. Sales and marketing expenses for the year ended December 31, 2010 decreased $0.8 million, or 29.6% from $2.7 million in 2009 to $1.9 million in 2010 due to cutting of staff and reduction of some trade shows.

Research and Development Expenses. Research and development expenses for the year ended December 31, 2010 was $745,000, consistent with 2009 expenses of $740,000.

General and Administrative Expenses. General and administrative expenses for the year ended December 31, 2010 were $6.6 million, a decrease of $0.6 million, or 8.3%, over general and administrative expenses of $7.2 million for the year ended December 31, 2009. The decrease was primarily due to cost cutting in all areas of general and administrative expenses during 2010.

General and Administrative Salaries Expense. General and administrative salaries expense for the years ended December 31, 2010 and 2009 were $3.5 million and $4.1 million, respectively, a decrease of $0.6 million or 14.6%. As of December 31, 2010, there were 31 employees that were classified as general and administrative personnel, versus 43 employees as of December 31, 2009.

Depreciation Expense. Depreciation expense was approximately $1.4 million and $1.1 million for the years ended December 31, 2010 and 2009, respectively.

Professional Fees. Professional fees for the years ended December 31, 2010 and 2009 were $1.6 million and $2.7 million, respectively, a decrease of $1.1 million or 40.7% primarily due to a decrease in legal and outside consulting fees.

Other (Income) and Expense. Our Series A Preferred is recorded at fair value with changes in fair value recorded in the statement of operations. Changes in the price of our common stock as well as other valuation assumptions affect the fair values. We experienced a loss on adjustment of fair value with respect to our Series A Preferred of $0.8 million and $0.3 million for the years ended December 31, 2010 and 2009, respectfully. In addition, we incurred interest expense associated with the amortization of the deferred financing costs and discount on the Series A Preferred of $1.9 million and $3.0 million for the years ended December 31, 2010 and 2009, respectively. As a result of the modification of the terms of our Series A Preferred pursuant to the May 22, 2009 Settlement Agreement, we recorded a loss of $2.6 million on deemed extinguishment of debt for the year ended December 31, 2009.

Liquidity and Capital Resources

The primary sources of our liquidity during the year ended December 31, 2010 have come from operations. As of December 31, 2010, our principal sources of liquidity were net accounts receivable of approximately $2.6 million, costs in excess of billings of approximately $1.8 million and the sale of accounts receivable under accounts receivable purchase agreement with Republic Capital Access (RCA), of which RCA has not received payment from our customers for approximately $84,000.

As of December 31, 2009, our principal sources of liquidity were net accounts receivable of approximately $2.3 million and costs in excess of billings of approximately $7.8 million.

As of December 31, 2010, we had working capital deficit of $14,067,221, an accumulated deficit of $26,321,796, shareholders’ deficiency of $9,760,747 and cash on hand of $428,160. We had losses from continuing operations of $8,982,359 and $15,714,816 and net losses of $9,382,359 and $16,289,816 for the years ended December 31, 2010 and 2009, respectively. We generated cash flows from operations of $780,754 and $1,244,497 for the years ended December 31, 2010 and 2009. The Series A Convertible Preferred Stock had a mandatory redemption date of December 31, 2010 and we entered into a series of waiver agreements with the holders of the Series A Convertible Preferred Stock, which extended the maturity redemption date from December 31, 2010 to April 1, 2011, then to July 1, 2011, and then to October 1, 2011. On March 22, 2011, the Company entered into an agreement with the holders of the Series A Convertible Preferred Stock to redeem the Series A Convertible Preferred Stock. In addition, we are currently seeking to raise capital or obtain access to capital sufficient to permit us to meet our future cash flow needs though there can be no assurance that we will be able to obtain additional financing on commercially reasonable terms or at all. We also continue to explore all sources of increasing revenue. If we are unable to timely raise capital or increase revenue, our cash flow could be adversely affected and our business significantly harmed. As a result we may be forced to further reduce or even curtail our operations. These factors raise substantial doubt about our ability to continue as a going concern.

Cash Flows from Operating Activities. Net cash provided by operating activities was $0.8 million for the year ended December 31, 2010 compared to net cash provided by operating activities of $1.2 million for the year ended December 31, 2009. Net cash provided by operating activities during the year ended December 31, 2010 consisted primarily of changes in our operating assets and liabilities mainly due to a reduction of inventory offset by an increase in accounts receivable.

As of December 31, 2010, we had net operating loss carryforwards of $14.7 million available to reduce future taxable income.

Net Cash Used in Investing Activities. Net cash used in investing activities for the years ended December 31, 2010 and 2009 was $0.3 million and $0.4 million, respectively.

Net Cash Used in Financing Activities. Net cash used in financing activities for the years ended December 31, 2010 and 2009 was $49,000 and $1.2 million, respectively.

Cash flows from discontinued operations were not reported separately for the years ended December 31, 2010 and 2009. There were no cash flows from discontinued operations for the years ended December 31, 2010 and 2009.

Accounts Receivable Purchase Agreement

In July 2009, we entered into an accounts receivable purchase agreement with Republic Capital Access, LLC (RCA), which was amended in October 2009. Under the purchase agreement, we can sell eligible accounts receivables to RCA. Eligible accounts receivable, subject to the full definition of such term in the purchase agreement, generally are our receivables under prime government contracts.

Under the terms of the purchase agreement, we may offer eligible accounts receivable to RCA and if RCA purchases such receivables, we will receive an initial upfront payment equal to 90% of the receivable. Following RCA’s receipt of payment from our customer for such receivable, they will pay to us the remaining 10% of the receivable less its fees. In addition to a discount factor fee and an initial enrollment fee, we are required to pay RCA a program access fee equal to a stated percentage of the sold receivable, a quarterly program access fee if the average daily amount of the sold receivables is less than $2.25 million and RCA’s initial expenses in negotiating the purchase agreement and other expenses in certain specified situations. The purchase agreement also provides that in the event, but only to the extent, that the conveyance of receivables by us is characterized by a court or other governmental authority as a loan rather than a sale, we shall be deemed to have granted RCA effective as of the date of the first purchase under the purchase agreement, a security interest in all of our right, title and interest in, to and under all of the receivables sold by us to RCA, whether now or hereafter owned, existing or arising.

The initial term of the purchase agreement ended on December 31, 2009 and will renew annually after the initial term, unless earlier terminated by either of the parties. Pursuant to an amendment to the purchase agreement in October 2009, the term during which we may offer and sell eligible accounts receivable to RCA (Availability Period) has been extended from December 31, 2009 to October 15, 2010, and the discount factor rate has been reduced from 0.524% to 0.4075%. On November 12, 2010, we signed an amendment to the purchase agreement which extended the term to October 15, 2011. As of December 31, 2010, RCA held approximately $84,000 of accounts receivable for which RCA has not received payment from our customers.

Series A Convertible Preferred Stock

In March and April 2008, we sold shares of our Series A Convertible Preferred Stock (or Series A Preferred) and warrants to purchase our common stock (or Investor Warrants). We received aggregate gross proceeds of $15.0 million, before fees and expenses of the placement agent in the transaction and other expenses.

In connection with our application to list our common stock on the NYSE Amex, we entered into a Consent and Agreement (or Consent Agreement) on May 23, 2008 with the holders of our Series A Preferred (or Series A Holders) where the Series A Holders agreed to limit the number of shares of common stock issuable upon conversion of, or as dividends on, the Series A Preferred and upon the exercise of the Investor Warrants without approval of our common stockholders (which stockholder approval was received on December 12, 2008). In return, among other things, we agreed for the fiscal year ending December 31, 2008 (A) to achieve (i) revenues equal to or exceeding $50,000,000 and (ii) consolidated EBITDA equal to or exceeding $13,500,000, and (B) to publicly disclose and disseminate, and to certify to the Series A Holders, our operating results for such period, no later than February 15, 2009 (we collectively refer to these as the Financial Covenants). Under the Consent Agreement, the breach of the Financial Covenants were each deemed a ‘‘Triggering Event’’ under the Certificate of Designations, Preferences and Rights of the Series A Convertible Preferred Stock (or Certificate of Designations), which would purportedly give the Series A Holders the right to require us to redeem all or a portion of their Series A Preferred shares at a price per share calculated under the Certificate of Designations.

We did not satisfy the terms of the Financial Covenants and in April 2009 we received a Notice of Triggering Event Redemption from the holder of 94% of our Series A Preferred. The notice demanded the full redemption of such holder’s Series A Preferred as a consequence of the breach of the Financial Covenants, and demanded payment of accrued dividends on the Series A Preferred and legal fees and expenses incurred in connection with negotiations concerning the breach of the Financial Covenants.

On May 22, 2009, we entered into a Settlement Agreement, Waiver and Amendment with the Series A Holders (or Settlement Agreement) pursuant to which, among other things, (i) the Series A Holders waived any breach by us of the Financial Covenants or our obligation to timely pay dividends on the Series A Preferred for any period through September 30, 2009, and waived any ‘‘Equity Conditions Failure’’ and any ‘‘Triggering Event’’ under the certificate of designations of the Series A Preferred otherwise arising from such breaches, (ii) the Investor Warrants were amended to reduce their exercise price from $2.40 per share to $0.01 per share, (iii) we issued the Series A Holders an aggregate of 2,000,000 shares of our common stock (Settlement Shares), in full satisfaction of our obligation to pay dividends under the Certificate of Designations as of March 31, 2009, June 30, 2009 and September 30, 2009, and (iv) we agreed to redeem $7.5 million in stated value of the Series A Preferred Stock by December 31, 2009. We agreed that, if we fail to so redeem $7.5 million in stated value of the Series A Preferred Stock by that date (a Redemption Failure), then, in lieu of any other remedies or damages available to the Series A Holders (absent fraud), (i) the redemption price payable by us will increase by an amount equal to 10% of the stated value, (ii) we will use our best efforts to obtain stockholder approval to reduce the conversion price of the Series A Preferred from $2.00 to $0.50 (which would increase the number of shares of common stock into which the Series A Preferred is convertible), and (iii) we will expand the size of our board of directors by two, will appoint two persons designated by the Series A Holders to fill the two newly-created vacancies, and will use our best efforts to amend our certificate of incorporation to grant the Series A Holders the right to elect two persons to serve on the board (or Series A Directors).

Pursuant to the terms of the Settlement Agreement, we also entered into a Registration Rights Agreement with the Series A Holders, in which we agreed to file with the SEC, by June 1, 2009, a registration statement covering the resale of the Settlement Shares, and to use our best efforts to have such registration statement declared effective as soon as practicable thereafter. We further agreed with the Series A Holders to include in such registration statement the shares of common stock issued upon the exercise of the Investor Warrants. A registration statement was filed, and subsequently declared effective on August 10, 2009.

Also pursuant to the terms of the Settlement Agreement, each of our directors and executive officers entered into a Lock-Up Agreement, pursuant to which each such person agreed that, for so long as any shares of Series A Preferred remain outstanding, he will not sell any shares of our common stock owned by him as of May 22, 2009.

Also pursuant to the terms of the Settlement Agreement, on May 22, 2009 our Chief Executive Officer, President and Chairman, entered into an Irrevocable Proxy and Voting Agreement with the Series A Holders, pursuant to which he agreed, among other things, that if a Redemption Failure occurs he will vote all shares of voting stock owned by him in favor of (i) reducing the conversion price of the Series A Preferred from $2.00 to $0.50 and (ii) amending our certificate of incorporation to grant the Series A Holders the right to elect two persons to serve on the board of directors (collectively referred to as the Company Actions). Our CEO also appointed one of the Series A Holders as his proxy to vote his shares of voting stock in favor of the Company Actions, and against approval of any opposing or competing proposal, at any stockholder meeting or written consent of our stockholders at which such matters are considered.

The Settlement Agreement provides that if as of December 1, 2009, we do not reasonably believe that we can fund the required redemption on or before December 31, 2009, we need to take actions required to seek to obtain the stockholder approval for an amendment to our certificate of incorporation necessary for reducing the conversion price and granting the Series A Holders the right to elect two directors designated by such preferred stockholder (or Series A Directors), including, without limitation, (i) calling a meeting of our stockholders to consider such amendment; (ii) submitting to the SEC a preliminary proxy statement for such meeting of stockholders; and (iii) upon receipt of the requisite stockholder approval, filing the amendment to our certificate of incorporation.

We were unable to effect the redemption of the $7.5 million in stated value of the Series A Preferred by December 31, 2009 and we have accordingly increased the number of directors constituting our board of directors by two and held a special meeting of our stockholders on April 8, 2010. At this special meeting, the stockholders approved the amendments to our certificate of incorporation to reduce the conversion price of the Series A Preferred from $2.00 to $0.50 and provide for the ability of the Series A Holders to elect the Series A Directors, and we amended the certificate of incorporation as of April 9, 2010. Based on the reduction of the conversion price of the Series A Preferred, the number of our common stock into which the Series A Preferred is convertible into increased from 7.5 million to 30.0 million. Notwithstanding the Settlement Agreement and compliance with the remedies described above for the failure to redeem the $7.5 million in stated value of the Series A Preferred by December 31, 2009, the terms of the Series A Preferred provided that we are to redeem any such preferred stock outstanding on the Maturity Date, December 31, 2010, as such term is further defined in the Certificate of Designations (such redemption provision hereinafter referred to as the Mandatory Redemption Provision).

On April 8, 2010, we entered into a waiver agreement with the Series A Holders, pursuant to which the Series A Holders agreed to extend the Maturity Date from December 31, 2010 to April 1, 2011. On August 13, 2010, the Company entered into a waiver agreement with the Series A Holders which further extended the maturity date for mandatory redemption of all outstanding Series A Preferred from April 1, 2011 to July 1, 2011. On November 12, 2010, the Company entered into a waiver agreement with the Series A Holders which further extended the maturity date for mandatory redemption of all outstanding Series A Preferred from July 1, 2011 to October 1, 2011.

On March 22, 2011, the Company entered into a Securities Redemption Agreement (the “Redemption Agreement”) with the holders of our Series A Convertible Preferred Stock, pursuant to which we sold all of the issued and outstanding membership interests in American Physical Security Group, LLC (“APSG”), the Company’s wholly-owned subsidiary, to the holders of our Series A Convertible Preferred Stock. In exchange for the sale of the APSG interests, the holders of our Series A Convertible Preferred Stock (i) paid $1,000,000 in cash to us at the closing of the transactions contemplated by the Redemption Agreement and (ii) tendered to the Series A Convertible Preferred Stock, which had an aggregate redemption price of $16,500,000. Upon the closing of the transactions contemplated by the Redemption Agreement, APSG is no longer a subsidiary of our company. In connection with the Redemption Agreement, the Company and the holders of our Series A Convertible Preferred Stock entered into that certain Membership Interest Option Agreement (the "Option Agreement") pursuant to the Company was granted an option (the “Option”) to repurchase APSG within six (6) months following the closing of the transactions contemplated by the Redemption Agreement at a cash purchase price equal to the sum of (i) $15,525,000, plus (ii) the amount of any net investment made in APSG concurrently with and following the closing of the Redemption Agreement and prior to the closing of the purchase of the APSG membership interests pursuant to exercise of the Option.

Contractual Obligations

We are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide tabular disclosure of contractual obligations under this Item 7.

Item 7A.

Quantitative and Qualitative Disclosure about Market Risk

We are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide the information required under this Item 7A.

Item 8. Financial Statements and Supplementary Data

Our consolidated financial statements and related notes required by this item are set forth as a separate section of this report. See Part IV, Item 15 of this Form 10-K.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

Not applicable.

Item 9A. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

The information contained in this section covers management’s evaluation of our disclosure controls and procedures and our assessment of our internal control over financial reporting for the period since our last periodic report (September 30, 2010) through December 31, 2010. This assessment is as of December 31, 2010.

Evaluation of Disclosure Controls and Procedures

Disclosure controls and procedures, as defined in Rules 13(a)-15(e) and 15(d)-15(e) under the Securities Exchange Act of 1934 (or Exchange Act), are controls and other procedures that are designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized, and reported, within the time periods specified by the rules and forms promulgated by the SEC. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. As a result of this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of December 31, 2010 because of the material weakness set forth below.

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate “internal control over financial reporting”, as defined in Rules 13(a)-15(f) and 15(d)-15(f) under the Exchange Act. Our system of internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial statements for external reporting purposes in accordance with GAAP. Because of its inherent limitations, internal control over financial reporting may not prevent or detect every misstatement. An evaluation of effectiveness is subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with policies or procedures may decrease over time.

Our internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial statements in accordance with GAAP, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized use, acquisition, or disposition of our assets that could have a material effect on the consolidated financial statements.

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our internal control over financial reporting as of the year ended December 31, 2010. In making this assessment, we utilized the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control - Integrated Framework.

A material weakness is a deficiency or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. As a result of this evaluation, we concluded that our internal control over financial reporting was not effective as of December 31, 2010 because of the material weakness set forth below.

The following is a summary of our material weakness as of December 31, 2010:

Due to a lack of adequate systems, processes, and resources we did not maintain effective controls over the period-end financial close and reporting processes as of December 31, 2010. Due to the actual and potential effect on financial statement balances and disclosures, and the importance of the financial closing and reporting processes, we concluded that, in the aggregate, these deficiencies in internal controls over the period-end financial close and reporting process constituted a material weakness in internal control over financial reporting. The specific deficiencies contributing to this material weakness were as follows:

Inadequate documentation of review process. We did not maintain procedures for a formalized timely documented review process to ensure significant, complex, and non-routine transactions are recorded correctly in the financial statements.

Inadequate policies and procedures for inventory. We did not design, establish, and maintain effective documented financial accounting policies and procedures related to inventory counting, pricing and valuation.

The following material weaknesses in internal control over financial reporting as of December 31, 2009 were remediated as of December 31, 2010. This was accomplished by retaining the services of a third-party consulting firm to assist in preparing closing entries, financial statements and Form 10-Q for the quarters ended March 31, 2010 and June 30, 2010, and hiring a Chief Accountant with GAAP and SEC reporting experience in August 2010.

Inadequate policies and procedures. We did not design, establish, and maintain effective documented GAAP compliant financial accounting policies and procedures, nor a formalized process for determining, documenting, communicating, implementing, monitoring, and updating accounting policies and procedures, including policies and procedures related to significant, complex, and non-routine transactions.

Inadequate GAAP expertise. We did not have adequate resources with GAAP knowledge in specific complex areas such as preferred stock, warrants, discontinued operations, costs related to registration, acquisitions, and financing.

Equity Compensation. We did not maintain adequate policies and procedures to ensure effective controls over the administration, accounting, and disclosure for stock-based compensation sufficient to prevent a material misstatement of related compensation expense. Specifically deficiencies were identified in our granting, administration, and accounting for awards.

The following general computing control material weaknesses as of December 31, 2009 were remediated as of December 31, 2010. This was accomplished by retaining a third-party consulting firm to conduct an assessment and set forth a remediation plan. Follow up testing was performed and all items listed below were resolved.

Inadequate system access controls. System access controls over our accounting information system were not in place to appropriately prohibit or limit user access in areas including journal entries, invoice processing, master-file maintenance.

Inadequate general computing controls. Overall general user and system administration were inadequate in the following areas where procedures were in place but not formalized or documented;

Backup and recovery of financial data

Systems development and change management

Incident management

Security monitoring

Our efforts to improve our internal controls are ongoing and focused on expanding our organizational capabilities to improve our control environment and on implementing process changes to strengthen our internal control and monitoring activities.

Item 9B.Other Information

None.

PART III

Item 10. Directors, Executive Officers, and Corporate Governance

The information required by this Item is incorporated by reference to the applicable information in our Proxy Statement related to the 2011 Annual Meeting of Stockholders which was filed with the SEC on December 9, 2011 (the “2011 Proxy Statement”).

Item 11. Executive Compensation

The information required by this Item is incorporated by reference to the applicable information in the 2011 Proxy Statement.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information required by this Item is incorporated by reference to the applicable information in the 2011 Proxy Statement.

Item 13. Certain Relationships and Related Transactions, and Director Independence

The information required by this Item is incorporated by reference to the applicable information in the 2011 Proxy Statement.

Item 14. Principal Accountant Fees and Services

The information required by this Item is incorporated by reference to the applicable information in the 2011 Proxy Statement.

Part IV

Item 15. Exhibits and Financial Statement Schedules

(a) Documents filed as part of this report:

Consolidated Financial Statements:

Report of Marcum LLP Independent Registered Public Accounting Firm;

Consolidated Balance Sheets as of December 31, 2010 and 2009;

Consolidated Statements of Operations for the years ended December 31, 2010 and 2009;

Consolidated Statements of Shareholders’ (Deficiency) Equity for the years December 31, 2010 and 2009;

Consolidated Statements of Cash Flows for the years ended December 31, 2010 and 2009; and

Notes to Consolidated Financial Statements.

All other financial schedules are not required under the related instructions or are inappropriate and therefore have been omitted.

(b) Exhibits

Exhibit Numbers		Exhibits

3.1		Third Amended and Restated Certificate of Incorporation (5)

3.2		Amended and Restated Bylaws (5)

3.3		Certificate of Designation of Series A Convertible Preferred Stock (2)

3.4		First Amendment to Amended and Restated Bylaws (20)

4.1		Form of common stock certificate (1)

4.2		Registration Rights Agreement by and among the Registrant and the holders of the Registrant’s Series A Convertible Preferred Stock, dated May 22, 2009 (13)

4.3		Form of 2009 financial advisor warrant (1)

4.4		Form of 2008 investor warrant (2)

4.5		Form of 2008 placement agent warrant (2)

4.6		Form of Series A Convertible Preferred Stock Certificate (2)

10.1		Agreement of Lease, dated 9/23/2004, between the Registrant and Industrial Management LLC (1)

10.2		Amendment to Lease, dated 5/31/2006, between the Registrant and Industrial Management LLC (1)

10.3		Second Amendment to Lease dated 2/1/2007, between the Registrant and Industrial Management LLC (1)

10.4		Contract between the Registrant and Marine Corps Systems Command dated 2/15/07, as amended by the Modification of Contract, dated 9/17/2007 (1)

10.5		Contract between the Registrant and the U.S. Army Tank and Automotive Command, Life Cycle Management Command, dated 10/7/2005, as amended (1)

10.6		Contract between the Registrant and the U.S. Army Tank and Automotive Command, Life Cycle Management Command, dated 10/21/2005, as amended (1)

10.7		Contract between the Registrant and NAVFAC Southwest Specialty Center Contracts Core, dated 6/7/2007, as amended (1)

10.8		Subcontract between CH2M Hill Constructors, Inc. and American Physical Security Group, LLC (10)

10.9		Employment Agreement with Anthony J. Piscitelli dated 1/1/2007 (1)

10.10		Amendment to Employment Agreement with Gary Sidorsky dated 1/9/2009 (9)

10.11		Employment Agreement with Gary Sidorsky dated 1/1/2007 (1)

10.13		Employment Agreement with Curtis Taufman dated 1/1/2007 (1)

10.14		Employment Agreement with Fergal Foley dated 1/9/2009 (9)

10.15		Agreement between the Registrant and Stifel, Nicolaus & Company, Inc., dated 8/29/2006 (1)

10.16		Agreement between the Registrant and Action Group (2)

10.17		2007 Incentive Compensation Plan (1)

10.18		Amendment to Forbearance Agreement by and among the Registrant, A. J. Piscitelli & Associates, Inc., American Physical Security Group, LLC and TD Bank, N.A., dated May 27, 2009 (15)

10.19		Second Amendment to Forbearance Agreement by and among the Registrant, A. J. Piscitelli & Associates, Inc., American Physical Security Group, LLC and TD Bank, N.A., dated June 15, 2009 (15)

10.20		Forbearance Agreement and Amendment to Loan Agreement by and among American Defense Systems, Inc., A. J. Piscitelli & Associates, Inc., American Physical Security Group, LLC and TD Bank, N.A., dated as of April 27, 2009 (11)

10.21		First Amendment to Loan Agreement between the Registrant, A.J. Piscitelli & Associates, Inc. and Commerce Bank, N.A., dated July 12, 2007 (11)

10.22		Assumption Agreement made by American Physical Security Group, LLC, dated January 28, 2008(11)

10.23		Loan Agreement, dated May 2, 2007, with Commerce Bank, N.A. (2)

10.24		Settlement Agreement, Agreement and Waiver by and among the Registrant and the Series A Holders, dated May 22, 2009 (13)

10.25		Form of Lock-Up Agreement executed by each of the directors and executive officers of the Registrant (13)

10.26		Irrevocable Proxy and Voting Agreement by and among Anthony Piscitelli and the Series A Holders, dated May 22, 2009 (13)

10.27		Consent and Agreement of Series A Convertible Preferred Stockholders, dated May 23, 2008 (5)

10.28		Form of Voting Agreement for Anthony Piscitelli, Gary Sidorsky and Curtis Taufman (5)

10.29		Letter Agreement between the Registrant and West Coast Opportunity Fund, LLC, dated May 29, 2008 (6)

10.30		Letter Agreement between the Registrant and Centaur Value Fund, LP and United Centaur Master Fund dated May 29, 2008 (6)

10.31		Securities Purchase Agreement, dated March 7, 2008 (2)

10.32		Form of Lock-Up Agreement for Anthony Piscitelli, Gary Sidorsky, Fergal Foley, Victor La Sala, John Rutledge and Curtis Taufman (2)

10.33		Consulting Services Agreement between the Registrant and Berthel Fisher & Company Financial Services, Inc. dated February 29, 2008 (3).

10.34		Amendment No. 1 to Independent Consulting Agreement between Richard Torykian and the Registrant dated July 23, 2008 (8)

10.35		Independent Consulting Agreement between the Registrant and Richard Torykian dated August 1, 2007 (3)

10.36		Asset Purchase Agreement among the Registrant, Tactical Applications Group and Lisa Sue Quinlan dated November 15, 2007 (3)

10.37		Side letter between the Registrant and West Coast Opportunity Fund, LLC dated March 28, 2008(3).

10.38		Contract No. M67854-09-D-5069 between the Registrant and the U.S. Marine Corps Systems Command, effective as of March 27, 2009 (12)

10.39		Contract No. M67854-09-D-5038 between the Registrant and the U.S. Marine Corps Systems Command, effective as of May 20, 2009 (14)

10.40		Accounts Receivable Purchase Agreement between the Registrant and Republic Capital Access, LLC, dated July 23, 2009 (16)

10.41		Form of Incentive Stock Option Agreement (21)

10.42		Form of Non-Qualified Stock Option Agreement (21)

10.43		Form of Director and Officer Indemnification Agreement (21)

10.44		First Amendment to Account Receivable Purchase Agreement between the Registrant and Republic Capital Access, LLC dated October 20, 2009 (18)

10.45		Employment Agreement with Victor La Sala dated January 1, 2007 (21)

10.46		Employment Agreement with Chuck Pegg dated January 1, 2007 (21)

10.47		Employment Agreement with Robert Aldrich dated August 1, 2008 (21)

10.48		Contact No. W56HZV-08-C-0311 between the Registrant and the U.S. Army TACOM, effective as of March 10, 2008 (21)

10.49		Amendment/Modification No. P00042 to Contract No. W56HZV-05-D-0382 between the Registrant and the U.S. Army Tank and Automotive Command, Life Cycle Management Command, effective as of December 28, 2009 (19)

10.50		Securities Redemption Agreement, dated March 22, 2011, by and among American Defense Systems, Inc.; West Coast Opportunity Fund, LLC; and Centaur Value Fund, L.P. (22)

10.51		Membership Interest Option Agreement, dated March 22, 2011, by and among American Defense Systems, Inc.; West Coast Opportunity Fund, LLC; and Centaur Value Fund, L.P. (22)

21.1		Subsidiaries of Registrant*

23.1		Consent of Marcum LLP*

31.1		Certification of Chief Executive Officer pursuant to Rules 13a-14 and 15d-14 promulgated under the Securities Exchange Act of 1934.*

31.2		Certification of Chief Financial Officer pursuant to Rules 13a-14 and 15d-14 promulgated under the Securities Exchange Act of 1934.*

32.1		Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 906 of the Sarbanes-Oxley Act of 2002.*

* Filed herewith

(1)	Previously filed as an Exhibit to the Form 10, filed on February 11, 2008.

(2)	Previously filed as an Exhibit to Amendment No. 1 to the Form 10, filed on March 21, 2008.

(3)	Previously filed as an Exhibit to Amendment No. 2 to the Form 10, filed on April 11, 2008.

(4)	Previously filed as an Exhibit to Amendment No. 3 to the Form 10, filed on April 22, 2008.

(5)	Previously filed as an Exhibit to the Form 8-A filed on May 23, 2008.

(6)	Previously filed as an Exhibit to the Current Report on Form 8-K filed on May 27, 2008.

(7)	Previously filed as an Exhibit to the Current Report on Form 8-K filed on May 30, 2008.

(8)	Previously filed as an Exhibit to the Current Report on Form 8-K filed on August 8, 2008.

(9)	Previously filed as an Exhibit to the Current Report on Form 8-K filed on January 15, 2009.

(10)	Previously filed as an Exhibit to the Current Report on Form 8-K filed on January 16, 2009.

(11)	Previously filed as an Exhibit to the Current Report on Form 8-K filed on May 1, 2009.

(12)	Previously filed as an exhibit to the Current Report on Form 8-K filed on May 20, 2009.

(13)	Previously filed as an exhibit to the Current Report on Form 8-K filed on May 26, 2009.

(14)	Previously filed as an exhibit to the Current Report on Form 8-K filed on May 26, 2009.

(15)	Previously filed as an exhibit to the Current Report on Form 8-K filed on June 17, 2009.

(16)	Previously filed as an exhibit to the Current Report on Form 8-K filed on July 28, 2009.

(17)	Previously filed as an exhibit to the Current Report on Form 8-K filed on August 26, 2009.

(18)	Previously filed as an exhibit to the Current Report on Form 8-K filed on October 26, 2009.

(19)	Previously filed as an exhibit to the Current Report on Form 8-K filed on January 15, 2010.

(20)	Previously filed as an exhibit to the Current Report on Form 8-K filed on January 28, 2010.

(21)	Previously filed as an exhibit to Amendment No. 1 to the Annual Report on Form 10-K filed on April 15, 2010

(22)	Previously filed as an exhibit to the Annual Report on Form 10-K filed on March 28, 2010

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	AMERICAN DEFENSE SYSTEMS, INC.

	By:		/s/ General Alfred M. Gray
			General Alfred M. Gray
			Acting Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the date indicated.


Signature	Title	Date

	Chairman of the Board and Acting Chief Executive Officer	January 19, 2012
/s/ General Alfred M. Gray	(Principal Executive Officer)
General Alfred M. Gray
		January 19, 2012
/s/ Gary Sidorsky	Chief Financial Officer,
Gary Sidorsky	(Principal Financial and Accounting Officer)

/s/ Pasquale J. D'Amuro
Pasquale J. D'Amuro	Director	January 19, 2012

/s/ Stephen R. Seiter
Stephen R. Seiter	Director	January 19, 2012

/s/ Victor Trizzino
Victor Trizzino	Director	January 19, 2012

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

FINANCIAL INFORMATION

TABLE OF CONTENTS

PART I — FINANCIAL INFORMATION

Item 1.	Consolidated Financial Statements

	Report of Marcum LLP Independent Registered Public Accounting Firm	F-1

	Consolidated Balance Sheets as of December 31, 2010 and 2009	F-2

	Consolidated Statements of Operations for the years ended December 31, 2010 and 2009	F-4

	Consolidated Statements of Shareholders’ Equity (Deficiency) for the years ended
	December 31, 2010 and 2009	F-5

	Consolidated Statements of Cash Flows for the years ended December 31, 2010 and 2009	F-6

	Notes to Consolidated Financial Statements	F-8

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Audit Committee of the

Board of Directors and Shareholders of

American Defense Systems, Inc.

We have audited the accompanying consolidated balance sheets of American Defense Systems, Inc. and Subsidiaries (the “Company”) as of December 31, 2010 and 2009 and the related consolidated statements of operations, changes in shareholders’ equity (deficiency) and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of American Defense Systems, Inc. and Subsidiaries, as of December 31, 2010 and 2009, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, as of December 31, 2010, the Company had a working capital deficiency of $14,067,221, an accumulated deficit of $26,321,796, shareholders’ deficiency of $9,760,747 and cash on hand of $428,160. The Company had losses from continuing operations of $8,982,359 and $15,714,816 and net losses of $9,382,359 and $16,289,816 for the years ended December 31, 2010 and 2009, respectively. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plan in regard to these matters is also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties.

/s/ Marcum LLP

Marcum LLP

Melville, New York

April 15, 2011, except for Notes 11 and 12 of which the date is January 19, 2012

F-1

PART I

Item 1. Consolidated Financial Statements

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

	As of December 31,
	2010		2009
ASSETS

CURRENT ASSETS
Cash	$	428,160	$	-
Accounts receivable, net of allowance for doubtful accounts of $547,204 and $222,448 as of December 31, 2010 and 2009, respectively		2,609,665		2,288,666
Accounts receivable factoring		84,463		199,876
Other tax receivable		101,641		108,741
Costs in excess of billings on uncompleted contracts, net		1,780,338		7,762,836
Prepaid expenses and other current assets		244,910		330,381
Deferred tax assets		1,928		521

TOTAL CURRENT ASSETS		5,251,105		10,691,021

Property and equipment, net		1,979,536		3,078,724
Deferred financing costs, net		454,741		1,547,551
Notes receivable, net		-		400,000
Intangible assets		634,450		606,000
Goodwill		812,500		660,000
Deposits		639,138		407,137
Other assets		-		138,001

TOTAL ASSETS	$	9,771,470	$	17,528,434

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

F-2

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

	As of December 31,
	2010			2009
LIABILITIES AND SHAREHOLDERS' DEFICIENCY

CURRENT LIABILITIES
Accounts payable	$	4,829,161		$	6,695,712
Cash overdraft		-			48,573
Accrued expenses		470,343			498,795
Warrant liability		8,822			35,413
Mandatory redeemable Series A convertible preferred stock (cumulative), 15,000 shares authorized issued and outstanding		14,010,000			-

TOTAL CURRENT LIABILITIES		19,318,326			7,278,493

LONG TERM LIABILITIES
Mandatory redeemable Series A convertible preferred stock (cumulative), 15,000 shares authorized issued and outstanding		-			12,429,832
Deferred rent		211,963			-
Deferred tax liability		1,928			521

TOTAL LIABILITIES		19,532,217			19,708,846

COMMITMENTS AND CONTINGENCIES

SHAREHOLDERS' DEFICIENCY

Common stock, $0.001 par value, 100,000,000 shares authorized, 54,341,685 and 46,611,457 shares issued and outstanding as of December 31, 2010 and 2009, respectively		54,341			46,611
Additional paid-in capital		16,506,708			14,712,414
Accumulated deficit		(26,321,796	)		(16,939,437	)

TOTAL SHAREHOLDERS' DEFICIENCY		(9,760,747	)		(2,180,412	)

TOTAL LIABILITIES AND SHAREHOLDERS' DEFICIENCY	$	9,771,470		$	17,528,434

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

F-3

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

	Years Ended December 31,
	2010			2009

CONTRACT REVENUES EARNED	$	39,519,054		$	45,893,979

COST OF REVENUES EARNED (exclusive of depreciation and amortization shown separately below)		27,372,829			33,929,327

GROSS PROFIT		12,146,225			11,964,652

OPERATING EXPENSES
General and administrative expenses		6,641,753			7,191,767
General and administrative salaries		3,519,582			4,144,666
Sales and marketing		1,895,741			2,661,636
T2 expenses		820,819			531,506
Research and development		744,645			739,632
Settlement of litigation		-			63,441
Depreciation and amortization		1,403,209			1,085,331
Professional fees		1,622,587			2,734,816
TOTAL OPERATING EXPENSES		16,648,336			19,152,795

OPERATING LOSS		(4,502,111	)		(7,188,143	)

OTHER INCOME (EXPENSE)
Unrealized loss on adjustment of fair value Series A convertible preferred stock classified as a liability		(838,247	)		(325,837	)
Unrealized gain on warrant liability		26,591			35,673
Loss on deemed extinguishment of debt		-			(2,613,630	)
Other income		-			8,869
Interest expense		(1,896,100	)		(3,019,079	)
Interest expense - mandatorily redeemable preferred stock dividends		(1,500,000	)		(1,650,000	)
Finance charges		(272,492	)		(209,698	)
TOTAL OTHER EXPENSE		(4,480,248	)		(7,773,702	)

LOSS BEFORE INCOME TAXES FROM CONTINUING OPERATIONS		(8,982,359	)		(14,961,845	)

INCOME TAX PROVISION		-			752,971

LOSS FROM CONTINUING OPERATIONS		(8,982,359	)		(15,714,816	)

LOSS FROM DISCONTINUED OPERATIONS, NET OF TAX		(400,000	)		(575,000	)

NET LOSS	$	(9,382,359	)	$	(16,289,816	)

Weighted Average Shares Outstanding (Basic and Diluted)		49,025,814			43,192,175

Loss per Share - Basic and Diluted
LOSS FROM CONTINUING OPERATIONS	$	(0.18	)	$	(0.37	)
LOSS FROM DISCONTINUED OPERATIONS, NET OF TAX	$	(0.01	)	$	(0.01	)
NET LOSS	$	(0.19	)	$	(0.38	)

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

F-4

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (DEFICIENCY)

FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009

												Shareholders’
	Common Stock					Additional			Retained Earnings			Equity
	Shares			Par Value		Paid-In Capital			(Accumulated Deficit)			(Deficiency)

BALANCE AT JANUARY 1, 2009		39,585,960		$	39,586	$	10,258,077		$	(649,621	)	$	9,648,042

Shares issued for compensation		250,000			250		139,250			-			139,500
Exercise of investor warrants		3,695,505			3,695		(3,695	)		-			-
Payment of dividends recorded as
interest expense		3,080,000			3,080		1,646,920			-			1,650,000
Reconciling share amount		(8	)		-		-			-			-
Stock option compensation expense		-			-		121,862			-			121,862
Reclassification of derivative warrants
upon exercise		-			-		2,550,000			-			2,550,000
Net loss		-			-		-			(16,289,816	)		(16,289,816	)

BALANCE AT DECEMBER 31, 2009		46,611,457			46,611		14,712,414			(16,939,437	)		(2,180,412	)

Shares issued for compensation		350,228			350		115,851			-			116,201
Payment of dividends recorded as
interest expense		7,380,000			7,380		1,492,620			-			1,500,000
Modification of Series A Preferred		-			-		53,887			-			53,887
Stock option compensation expense		-			-		131,936						131,936
Net loss		-			-		-			(9,382,359	)		(9,382,359	)

BALANCE AT DECEMBER 31, 2010		54,341,685		$	54,341	$	16,506,708		$	(26,321,796	)	$	(9,760,747	)

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

F-5

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

	Years Ended December 31,
	2010			2009

CASH FLOWS FROM OPERATING ACTIVITIES:
NET LOSS	$	(9,382,359	)	$	(16,289,816	)
Adjustments to reconcile net loss to net cash provided by
operating activities:
Change in costs in excess of billings reserve		155,397			-
Loss on deemed extinguishment of debt		-			2,613,630
Change in fair value associated with preferred stock and warrants liabilities		811,656			290,164
Stock based compensation expense		248,137			261,362
Amortization of deferred financing costs		1,092,810			1,135,465
Amortization of discount on Series A preferred stock		795,808			834,770
Depreciation and amortization		1,403,209			1,085,331
Bad debt expense		417,983			222,448
Deferred rent		211,963			-
Stock issued for payment of dividends on preferred stock		1,500,000			1,650,000
Reserve on notes receivable		400,000			575,000
Deferred tax assets		-			1,167,831

Changes in operating assets and liabilities:
Accounts receivable		(738,982	)		2,470,036
Accounts receivable factoring		115,413			(199,876	)
Tax receivable		7,100			(108,741	)
Deposits and other assets		(122,450	)		30,359
Cost in excess of billing on uncompleted contracts, net		5,827,101			1,301
Prepaid expenses and other current assets		85,471			1,498,419
Accounts payable and accrued expenses		(2,047,503	)		4,006,814
NET CASH PROVIDED BY OPERATING ACTIVITIES		780,754			1,244,497
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of equipment		(304,021	)		(420,119	)
Advances for future acquisitions		-			21,559
NET CASH USED IN INVESTING ACTIVITIES		(304,021	)		(398,560	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Cash overdraft		(48,573	)		-
Repayments of line of credit		-			(76,832	)
Deferred financing costs		-			(1,143,562	)
NET CASH USED IN FINANCING ACTIVITIES		(48,573	)		(1,220,394	)

NET INCREASE (DECREASE) IN CASH		428,160			(374,457	)

CASH AT BEGINNING OF YEAR		-			374,457
CASH AT THE END OF PERIOD	$	428,160		$	-

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

F-6

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

	Years Ended December 31,
	2010		2009

Supplemental disclosure of cash flow information:
Cash paid during the period for interest	$	-	$	33,770
Cash paid during the period for taxes	$	-	$	-

Supplemental disclosure of non-cash investing and financing activities:
Modification of the terms of the Series A preferred stock	$	53,887	$	-
Accrued contingent payment for APSG acquisition	$	152,500	$	-
Stock issued in connection with investor warrants	$	-	$	2,550,000

Cumulative effect of a change in accounting principle on:
Warrants	$	-	$	165,775
Additional paid-in capital	$	-	$	(837,954	)
Accumulated deficit	$	-	$	672,179

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

F-7

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.	NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization

American Defense Systems, Inc. (the “Company” or “ADSI”) was incorporated under the laws of the State of Delaware on December 6, 2002. The consolidated financial statements of the Company have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) for annual reports on Form 10-K.

On May 1, 2003, the stockholder of A. J. Piscitelli & Associates, Inc. (“AJP”) exchanged all of his issued and outstanding shares for shares of American Defense Systems, Inc. The exchange was accounted for as a recapitalization of the Company, wherein the stockholder retained all the outstanding stock of American Defense Systems, Inc. At the time of the acquisition American Defense Systems, Inc. was substantially inactive.

On November 15, 2007, the Company entered into an Asset Purchase Agreement with Tactical Applications Group (“TAG”), a North Carolina based sole proprietorship, and its owner. TAG has a retail establishment located in Jacksonville, North Carolina that supplies tactical equipment to military and security personnel. As discussed more fully in Note 8, the operations of TAG were discontinued on January 2, 2009.

In January 2008, American Physical Security Group, LLC (“APSG”) was established as a wholly owned subsidiary of the Company for the purposes of acquiring the assets of American Anti-Ram, Inc., a manufacturer of crash tested vehicle barricades. APSG is located in North Carolina. On March 22, 2011, the Company entered into a Securities Redemption Agreement, as more fully discussed in Note 12, with the Series A Holders, pursuant to which the Company sold to the Series A Holders all of the issued and outstanding membership interests in APSG.

Nature of Business

The Company designs and supplies transparent and opaque armor solutions for both military and commercial applications. Its primary customers are United States government agencies and general contractors who have contracts with governmental entities. These products, sold under Vista trademarks, are used in transport and fighting vehicles, construction equipment, sea craft and various fixed structures which require ballistic and blast attenuation.

The Company also provides engineering and consulting services, develops and installs detention and security hardware, entry control and monitoring systems, intrusion detection systems, and security glass. The Company also supplies vehicle anti-ram barriers. Its primary customer for these services and products are the detention and security industry.

Principles of Consolidation

The consolidated financial statements include the accounts of American Defense Systems, Inc. and its wholly-owned subsidiaries, AJP, American Institute for Defense and Tactical Studies, Inc. (“T2”) and APSG. All significant intercompany accounts and transactions have been eliminated in consolidation.

F-8

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Management Liquidity Plans

As of December 31, 2010, the Company had working capital deficit of $(14,067,221), an accumulated deficit of $26,321,796, shareholders’ deficiency of $9,760,747 and cash on hand of $428,160. The Company had losses from continuing operations of $8,982,359 and $15,714,816 and net losses of $9,382,359 and $16,289,816 for the years ended December 31, 2010 and 2009, respectively. The Company has generated cash flows from operations of $780,754 and $1,244,497 for the years ended December 31, 2010 and 2009. The Series A convertible preferred stock (the “Series A Preferred”) had a mandatory redemption date of December 31, 2010. The Company entered into a series of waiver agreements with the holders of its Series A Preferred (the “Series A Holders”) which extended the maturity redemption date from December 31, 2010 to April 1, 2011, then to July 1, 2011, and then to October 1, 2011. The Company entered into an agreement with the Series A Holders on March 22, 2011 to redeem the Series A Preferred, as more fully discussed in Note 12. In addition, the Company is currently seeking to raise capital or obtain access to capital sufficient to permit the Company to meet its future cash flow needs though there can be no assurance that the Company will be able to obtain additional financing on commercially reasonable terms or at all. The Company also continues to explore all sources of increasing revenue. If the Company is unable to timely raise capital or increase revenue, its cash flow could be adversely affected and its business significantly harmed. As a result the Company may be forced to further reduce or even curtail its operations. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The accompanying financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.

Reclassifications

Certain amounts in the prior year financial statements have been reclassified for comparative purposes to conform to the presentation in the current year financial statements. These reclassifications had no effect on previously reported income.

Use of Estimates

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

Significant estimates for all periods presented include cost in excess of billings, allowance for doubtful accounts, liabilities associated with the Series A Preferred and warrants, and valuation of deferred tax assets.

Revenue and Cost Recognition

The Company recognizes revenue in accordance with the provisions of Accounting Standards Codification (“ASC”) 605, “Revenue Recognition”, which states that revenue is realized and earned when all of the following criteria are met:

(a) persuasive evidence of the arrangement exists,

(b) delivery has occurred or services have been rendered,

(d) collectibility is reasonably assured.

The Company recognizes revenue and reports profits from purchase orders filled under master contracts when an order is complete. Purchase orders received under master contracts may extend for periods in excess of one year. However, no revenues, costs or profits are recognized in operations until the period of completion of the order. An order is considered complete when all costs, except insignificant items, have been incurred and the installation or product is operating according to specification or the shipment has been accepted by the customer. Provisions for estimated contract losses are made in the period that such losses are determined. As of December 31, 2010 and December 31, 2009, there were no such provisions made.

In addition, the Company recognizes revenue on an arrangement with one customer under the percentage of completion method based on the costs incurred to date compared to the estimated total cost of the project as the customer has an enforceable right to the work performed and the Company has an enforceable right to demand payment for the work performed.

F-9

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Contract Revenue

Cost in Excess of Billing

All costs associated with uncompleted customer purchase orders under contract are recorded on the balance sheet as a current asset called “Costs in Excess of Billings on Uncompleted Contracts, net.” Such costs include direct material, direct labor, and project-related overhead. Upon completion of a purchase order, costs are then reclassified from the balance sheet to the statement of operations as costs of revenue. A customer purchase order is considered complete when a satisfactory inspection has occurred, resulting in customer acceptance and delivery.

Series A Convertible Preferred Stock, Investor Warrants and Placement Agent Warrants

See Note 6 for the Company’s accounting policy related to its preferred stock, investor warrants and placement agent warrants.

Cash

The Company’s cash balance consists of cash held in bank accounts.

Concentrations

The Company’s bank accounts are maintained in financial institutions. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and therefore bear minimal risk.

The Company received certain of its components from a limited number of suppliers. The Company has two suppliers that each provide greater than 10% of its supply needs (see Note 4). Additionally, the Company relies on a limited number of contract manufacturers and suppliers to provide manufacturing services for its products. The inability of any contract manufacturer or supplier to fulfill supply requirements of the Company could materially impact future operating results.

For the years ended December 31, 2010 and 2009, the Company derived 67% and 72%, respectively, of its revenues from various U.S. government entities. In addition, the Company derived 11% of its revenues from a private customer for the year ended December 31, 2010. (See Note 4)

Property and Equipment

Property and equipment is carried at original cost. Depreciation is recorded on a straight-line basis over the estimated useful lives of the related assets. The Company depreciates general equipment, light vehicles, trailers, aircraft, and T2 demonstration range and fire arms over three to five years; office equipment over three to five years; and furniture and fixtures over five years. Leasehold improvements are capitalized and amortized on a straight-line basis over the shorter of their useful life or the remaining term of the lease. Maintenance and repairs are expensed as incurred. When the property or equipment is retired or otherwise disposed of, related costs and accumulated depreciation are removed from the accounts and any resulting gain or loss is included in the consolidated statement of operations.

Allowance for Doubtful Accounts

The allowance for doubtful accounts reflects management’s best estimate of probable losses inherent in the account receivable balance. Management determines the allowance based on known troubled accounts, historical experience, and other currently available evidence. Management performs on-going credit evaluations of its customers and adjusts credit limits based upon payment history and the customer’s current credit worthiness, as determined by the review of their current credit information. Collections and payments from customers are continuously monitored. While such bad debt expenses have historically been within expectations and allowances established, the Company cannot guarantee that it will continue to experience the same credit loss rates that it has in the past. At December 31, 2010 and 2009, the allowance for doubtful accounts was $547,204 and $222,448, respectively.

Long-Lived Assets

The Company periodically reviews long-lived assets and certain identifiable assets related to those assets for impairment whenever circumstances and situations change, such that there is an indication that the carrying amounts may not be recoverable. If the anticipated undiscounted cash flows of the long-lived assets are less than the carrying amount, their carrying amounts are reduced to fair value, and an impairment loss is recognized.

F-10

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Goodwill and Indefinite-Lived Intangible Assets

In accordance with ASC 350, “Intangibles - Goodwill and Other,” goodwill represents the excess of the purchase price over the fair value of net assets, including the amount assigned to identifiable intangible assets. The Company accounts for business combinations using the purchase method of accounting and accordingly, the assets and liabilities of the acquired entities are recorded at their estimated fair values at the acquisition date. The primary driver that generates goodwill is the value of synergies between the acquired entities and the company, which does not qualify as an identifiable intangible asset. The Company does not amortize the goodwill balance.

The Company assesses goodwill and indefinite-lived intangible assets for impairment annually during the fourth quarter, or more frequently if events and circumstances indicate impairment may have occurred. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, the Company records an impairment loss equal to the difference. ASC 350 also requires that the fair value of indefinite-lived purchased intangible assets be estimated and compared to the carrying value. The Company recognizes an impairment loss when the estimated fair value of the indefinite-lived purchased intangible assets is less than the carrying value. The Company has recorded goodwill associated with the APSG asset purchase agreement in the amount of $812,500 as of December 31, 2010. During the year ended December 31, 2010, the Company recorded additional goodwill in the amount of $152,500 associated with contingent payments under the APSG asset purchase agreement. The Company recognized no goodwill impairment during the years ended December 31, 2010 or 2009.

The Company has recorded an indefinite-lived intangible asset of $634,450 and $606,000 as of December 31, 2010 and 2009, respectively for a certification mark for research and development related to the acquisition of the assets of American Anti-Ram as of December 31, 2010. The Company did not recognize any impairment in 2010 or 2009 for this indefinite-lived intangible asset.

Advertising Costs

The Company expenses all advertising costs as incurred. The Company incurred advertising costs of approximately $117,000 and $157,000 during the years ended December 31, 2010 and 2009, respectively.

Shipping and Handling

The Company expenses all shipping and handling costs as incurred, which are recorded in costs of goods sold in the accompanying consolidated financial statements. The Company incurred shipping and handling costs of approximately $242,000 and approximately $537,000 during the years ended December 31, 2010 and 2009, respectively.

Research and Development

Research and development expenses are incurred as the Company performs ongoing evaluations of materials and processes for existing products, as well as the development of new products and processes. Research and development costs are charged to expense as incurred. The Company incurred research and development costs of approximately $745,000 and $740,000 during the years ended December 31, 2010 and 2009, respectively.

Stock-Based Compensation

The Company accounts for stock based compensation in accordance with ASC 718, “Compensation - Stock Compensation” (“ASC 718”). ASC 718 establishes accounting for stock-based awards exchanged for employee services. Under the provisions of ASC 718, share-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as expense over the employee’s requisite service period (generally the vesting period of the equity grant). The fair value of the Company’s common stock options are estimated using the Black Scholes Model with the following assumptions: stock price, exercise price, expected volatility, dividend rate, risk free interest rate and the expected life. The Company expenses stock-based compensation by using the straight-line method. In accordance with ASC 718, excess tax benefits realized from the exercise of stock-based awards are classified in cash flows from financing activities. The future realization of the reserved deferred tax assets related to these tax benefits associated with the exercise of stock options will result in a credit to additional paid in capital if the related tax deduction reduces taxes payable. The Company has selected a “with-and-without” approach regarding the accounting for the tax effects of share-based compensation awards.

F-11

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Loss per Share

Basic loss per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net loss per share is computed using the weighted-average number of common shares and excludes dilutive potential common shares outstanding, as their effect is anti-dilutive. Dilutive potential common shares would primarily consist of employee stock options, warrants and convertible preferred stock.

Securities that could potentially dilute basic EPS in the future that were not included in the computation of the diluted EPS because to do so would be anti-dilutive consist of the following:

	December 31
In Thousands	2010		2009

Warrants to purchase Common Stock		675,001		1,449,000

Options to purchase Common Stock		2,505,000		2,230,000

Series A Convertible Preferred Stock		30,000,000		7,500,000	*

Total potential Common Stock		33,180,001		11,179,000

* On April 9, 2010, pursuant to the amendment of the Company’s certificate of incorporation, the conversion price of the Series A Preferred was reduced to $0.50 and all of the outstanding shares of the Series A Preferred were convertible into 30,000,000 shares of common stock.

Debt Extinguishment

The Company accounted for the effects of the May 22, 2009 settlement agreement (see Note 7) in accordance with the guidelines enumerated in EITF Issue No. 96-19 “Debtor’s Accounting for a Modification of Exchange of Debt Instruments” as codified in ASC 470-50. ASC 470-50 provides that a substantial modification of terms in an existing debt instrument should be accounted for like, and reported in the same manner as, an extinguishment of debt. ASC 470-50 further provides that the modification of a debt instrument by a debtor and a creditor in a non-troubled debt situation is deemed to have been accomplished with debt instruments that are substantially different if the present value of cash flows under the terms of the new debt instrument is at least ten percent different from the present value of the remaining cash flows under the terms of the original instrument at the date of the modifications.

The Company evaluated the modification of the payment terms and the related adjustment to financial instruments to determine whether these modifications resulted in the issuance of a substantially different instrument. The Company determined after giving effect to the changes in the due dates of payments and the consideration paid to the debt holders, in the form of reduced conversion and exercise prices, that the Company had issued substantially different debt instruments, which resulted in a constructive extinguishment of the original debt instrument. Accordingly, the Company recorded a loss on the deemed extinguishment of debt in the amount of $2,613,630 which represented the difference in the carrying value of the old debt and fair value of the new debt. The debt instrument charge is included in the accompanying statement of operations for the year ended December 31, 2009.

Fair Value of Financial Instruments

Fair value of certain of the Company’s financial instruments including cash, accounts receivable, note receivable, accrued compensation, and other accrued liabilities approximate cost because of their short maturities. The Company measures and reports fair value in accordance with ASC 820, “Fair Value Measurements and Disclosure” which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value investments.

Fair value, as defined in ASC 820, is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value of an asset should reflect its highest and best use by market participants, principal (or most advantageous) markets, and an in-use or an in-exchange valuation premise. The fair value of a liability should reflect the risk of nonperformance, which includes, among other things, the Company’s credit risk.

F-12

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Valuation techniques are generally classified into three categories: the market approach; the income approach; and the cost approach. The selection and application of one or more of the techniques may require significant judgment and are primarily dependent upon the characteristics of the asset or liability, and the quality and availability of inputs. Valuation techniques used to measure fair value under ASC 820 must maximize the use of observable inputs and minimize the use of unobservable inputs. ASC 820 also provides fair value hierarchy for inputs and resulting measurement as follows:

Level 1

Quoted prices (unadjusted) in active markets that are accessible at the measurement date for identical assets or liabilities;

Level 2

Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from or corroborated by observable market data for substantially the full term of the assets or liabilities; and

Level 3

Unobservable inputs for the asset or liability that are supported by little or no market activity and that are significant to the fair values.

Fair value measurements are required to be disclosed by the Level within the fair value hierarchy in which the fair value measurements in their entirety fall. Fair value measurements using significant unobservable inputs (in Level 3 measurements) are subject to expanded disclosure requirements including a reconciliation of the beginning and ending balances, separately presenting changes during the period attributable to total gains or losses for the period (realized and unrealized), segregating those gains or losses included in earnings, and a description of where those gains or losses included in earning are reported in the statement of operations.

The Company did not have any assets or liabilities categorized as Level 1 or Level 2 as of December 31, 2010 and 2009. There were no transfers into or out of Level 1 or Level 2 during the years ended December 31, 2010 and 2009.

The following summarizes the Company’s assets and liabilities measured at fair value as of December 31, 2010 and 2009:

			Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical		Significant Other Observable		Significant Unobservable
	Balance as of		Assets		Inputs		Inputs
Description	December 31, 2010		(Level 1)		(Level 2)		(Level 3)
Liabilities
Series A Preferred (1)	$	14,010,000	$	-	$	-	$	14,010,000
Placement Agent Warrants (1)		8,822		-		-		8,822

Total Liabilities	$	14,018,822	$	-	$	-	$	14,018,822

F-13

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

			Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical		Significant Other Observable		Significant Unobservable
	Balance as of		Assets		Inputs		Inputs
Description	December 31, 2009		(Level 1)		(Level 2)		(Level 3)
Liabilities
Series A Preferred (1)	$	12,429,832	$	-	$	-	$	12,429,832
2005 Warrants		4,372		-		-		4,372
2006 Warrants		1,494		-		-		1,494
Placement Agent Warrants (1)		29,547		-		-		29,547

Total Liabilities	$	12,465,245	$	-	$	-	$	12,465,245

(1)	Methods and significant inputs and assumptions are discussed in Note 6 below.

The following is a reconciliation of the beginning and ending balances for the Company’s liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2010 and 2009:

	Series A Preferred			2005 Warrants			2006 Warrants			Placement Agent Warrants			Total
Balance – January 1, 2010	$	12,429,832		$	4,372		$	1,494		$	29,547		$	12,465,245
Amortization of debt discount		795,808			-			-			-			795,808
Change in fair value		838,247			(4,372	)		(1,494	)		(20,725	)		811,656
Modification of terms		(53,887	)		-			-			-			(53,887	)

Balance – December 31, 2010	$	14,010,000		$	-		$	-		$	8,822		$	14,018,822

	Series A Preferred		2005 Warrants			2006 Warrants			Placement Agent Warrants			Investor Warrants			Total
Balance – January 1, 2009	$	10,981,577	$	55,172		$	18,860		$	91,743		$	129,329		$	11,276,681
Amortization of debt discount		834,770		-			-			-			-			834,770
Change in fair value		325,837		(50,800	)		(17,366	)		(62,196	)		94,689			290,164
Reclassification upon exercise		-		-			-			-			(2,550,000	)		(2,550,000	)
Loss on deemed extinquishment of debt		287,648		-			-			-			2,325,982			2,613,630

Balance – December 31, 2009	$	12,429,832	$	4,372		$	1,494		$	29,547		$	-		$	12,465,245

The change in fair value recorded for Level 3 liabilities for the periods above are reported in other income (expense) on the consolidated statement of operations.

F-14

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Income Taxes

The Company accounts for income taxes according to ASC 740 “Income Taxes” which requires an asset and liability approach to financial accounting for income taxes. Deferred income tax assets and liabilities are computed annually for the difference between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future, based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense is the tax payable or refundable for the period, plus or minus the change during the period in deferred tax assets and liabilities.

The Corporation adopted the provisions of ASC 740-10 “Accounting for Uncertainty in Income Taxes” effective January 1, 2007. ASC 740-10 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Benefits from tax positions should be recognized in the financial statements only when it is more likely than not that the tax position will be sustained upon examination by the appropriate taxing authority that would have full knowledge of all relevant information. A tax position that meets the more-likely-than-not recognition threshold is measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent financial reporting period in which that threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not recognition threshold should be derecognized in the first subsequent financial reporting period in which that threshold is no longer met. ASC 740-10 also provides guidance on the accounting for and disclosure of unrecognized tax benefits, interest and penalties. The adoption of ASC 740-10 did not have a significant impact on the Company’s consolidated financial statements. The Company classifies tax related penalties and interest as income tax expense in the consolidated statement of operations. The Company is subject to taxation in the United States and various state jurisdictions. The Company remains subject to examination by tax authorities for tax years 2007 through 2010.

The Company files income tax returns in the U.S. federal jurisdiction and various states. The Company has not been subject to U.S. federal income tax examinations by tax authorities nor state authorities since its inception in 2000.

Recent Accounting Pronouncements

In June 2009, the Financial Accounting Standards Board (“FASB”) issued new accounting guidance, under ASC Topic 810, which modifies how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. This guidance clarified that the determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. An ongoing reassessment is required of whether a company is the primary beneficiary of a variable interest entity. Additional disclosures are also required about a company’s involvement in variable interest entities and any significant changes in risk exposure due to that involvement. This guidance was effective as of the beginning of each reporting entity’s first annual reporting period that began after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. The adoption of this guidance did not have a material effect on the Company’s consolidated financial position or results of operations.

F-15

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In October 2009, the FASB issued new accounting guidance, under ASC Topic 605, on revenue recognition which addresses the accounting for multiple-deliverable arrangements to enable vendors to account for products or services (deliverables) separately rather than as a combined unit. Specifically, this guidance amends the criteria for Subtopic 605-25, Revenue Recognition-Multiple Element Arrangements, for separating consideration in multiple-deliverable arrangements. This guidance establishes a selling price hierarchy for determining the selling price of a deliverable, which is based on: (a) vendor-specific objective evidence, (b) third-party evidence, or (c) estimates. This guidance also eliminates the residual method of allocation and requires that arrangement consideration be allocated at the inception of the arrangements to all deliverables using the relative selling price method and also requires expanded disclosures. This guidance is effective for all new or materially modified arrangements entered into on or after January 1, 2011 with earlier application permitted as of the beginning of a fiscal year. Full retrospective application of the new guidance is optional. The adoption of this standard will have an impact on the Company’s consolidated financial position and results of operations for all multiple deliverable arrangements entered into or materially modified in 2011.

In January 2010, the FASB issued new accounting guidance, under ASC Topic 820, on Fair Value Measurements and Disclosures, which requires new disclosures and clarifies some existing disclosure requirements about fair value measurement. Under the new guidance, a reporting entity should (a) disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers, and (b) present separately information about purchases, sales, issuances, and settlements in the reconciliation for fair value measurements using significant unobservable inputs. This guidance was effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements which are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The adoption of the guidance effective for interim and annual reporting periods beginning after December 15, 2009 did not have a material impact upon the Company’s consolidated financial position or results of operations. The adoption of the guidance effective for fiscal years beginning after December 15, 2010 is not expected to have a material effect on the Company’s consolidated financial position or results of operations.

In April 2010, the FASB issued ASU No. 2010-17, Revenue Recognition – Milestone Method (Topic 605): Milestone Method of Revenue Recognition. This standard provides guidance on defining a milestone and determining when it may be appropriate to apply the milestone method of revenue recognition for research or development transactions. Revenue that is contingent upon achievement of a milestone can be recognized in the period in which the milestone is achieved only if the milestone meets all criteria to be considered substantive. Determining whether a milestone is substantive requires judgment that should be made at the inception of the arrangement. To meet the definition of a substantive milestone, the consideration earned by achieving the milestone (1) would have to be commensurate with either the level of effort required to achieve the milestone or the enhancement in the value of the item delivered, (2) would have to relate solely to past performance, and (3) should be reasonable relative to all deliverables and payment terms in the arrangement. No bifurcation of an individual milestone is allowed and there can be more than one milestone in an arrangement. The new standard is effective for annual periods beginning on or after June 15, 2010 and interim periods within those fiscal years. The adoption of this standard is not expected to have any impact on the Company’s consolidated financial position or results of operations.

In July 2010, the FASB issued ASU 2010-20, Receivables (Topic 310): Disclosure about the Credit Quality of Financial Receivables and the Allowance for Credit Losses, which amends ASC Topic 310 by requiring additional disclosures about the credit quality of an entity’s financing receivables and its allowance for credit losses on a disaggregated basis. The objective of enhancing these disclosures is to improve financial statement users’ understanding of (1) the nature of an entity’s credit risk associated with its financing receivables and (2) the entity’s assessment of that risk in estimating its allowance for credit losses as well as changes in the allowance and the reasons for those changes. The guidance is effective for the first reporting period ending on or after December 15, 2010. The adoption of this standard is not expected to have a material impact on the Company’s consolidated financial position and results of operations.

F-16

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

2.	COSTS IN EXCESS OF BILLINGS (BILLINGS IN EXCESS OF COSTS) ON UNCOMPLETED CONTRACTS AND ACCOUNTS RECEIVABLE

Costs in Excess of Billings and Billing in Excess of Costs

The cost in excess of billings on uncompleted purchase orders issued pursuant to contracts reflects the accumulated costs incurred on purchase orders in production but not completed. Upon completion, inspection and acceptance by the customer, the purchase order is invoiced and the accumulated costs are charged to the statement of operations as costs of revenues earned. During the production cycle of the purchase order, should any progress billings occur or any interim cash payments or advances be received, such billings and/or receipts on uncompleted contracts are accumulated as billings in excess of costs. The Company fully expects to collect net costs incurred in excess of billings within twelve months and periodically evaluates each purchase order and contract for potential disputes related to overruns and uncollectable amounts.

Costs in excess of billing on uncompleted contracts were $1,780,338 and $7,762,836 as of December 31, 2010 and 2009, respectively. The Company recorded inventory reserve expense of $155,397 and $0 for the years ended December 31, 2010 and 2009, respectively.

Backlog

The estimated gross revenue on work to be performed on backlog was approximately $16 million and $45 million as of December 31, 2010 and 2009, respectively.

Accounts Receivable

The Company records accounts receivable related to its long-term contracts, based on billings or on amounts due under the contractual terms. Accounts receivable consist primarily of receivables from completed purchase orders and progress billings on uncompleted contracts. Allowance for doubtful accounts is based upon a review of outstanding receivables, historical collection information, and existing economic conditions. Any amounts considered recoverable under the customer’s surety bonds are treated as contingent gains and recognized only when received.

Accounts receivable throughout the year may decrease based on payments received, credits for change orders, or back charges incurred. At December 31, 2010 and 2009, the Company had accounts receivable of $2,609,665 and $2,288,666, respectively, and an allowance for doubtful accounts of $547,204 and $222,448, respectively. The Company recorded bad debt expense of $417,983 and $222,448 for the years ended December 31, 2010 and 2009, respectively.

3. PROPERTY AND EQUIPMENT

Property and equipment at December 31, 2010 and 2009 consisted of the following:

		December 31,
		2010			2009
Leasehold improvements	$	1,816,010		$	1,787,709
General equipment		736,678			697,762
Light vehicles and trailers		221,247			221,247
T2 Demonstration range and firearms		740,433			740,433
Office equipment		1,440,951			1,205,446
Furniture and fixtures		193,525			192,223
Aircraft		868,750			868,750
		6,017,594			5,713,570
Less: accumulated depreciation and amortization		(4,038,058	)		(2,634,846	)
	$	1,979,536		$	3,078,724

For the years ended December 31, 2010 and 2009, the Company recorded $1,403,209 and $1,085,331 in depreciation and amortization expense, respectively.

The Company maintains its firearms under the custodianship of an individual in accordance with New York State law. The firearms are used for testing and demonstrating the effectiveness of the Company’s bullet resistant and blast mitigation products.

F-17

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

4. MAJOR CUSTOMERS AND SUPPLIERS

The Company serves primarily the defense market and its sales are highly concentrated within the U.S. government. The Company’s customers include various branches of the U.S. military through the U.S. Department of Defense and to a much lesser extent other U.S. government, law enforcement and corrections agencies as well as multinational companies.

A limited number of contracts have generated a substantial majority of the Company’s historical and current revenue. During the year ended December 31, 2010, three contracts with the U.S. Department of Defense organizations represented approximately 67% of the Company’s revenue. The revenue from the U.S. Department of Defense organizations is recorded in the ADSI segment. During the year ended December 31, 2009, four contracts with the U.S. Department of Defense organizations represented approximately 72% of its revenue. The accounts receivable balance for the U.S. Department of Defense organizations was $1.7 million and $2.1 million as of December 31, 2010 and 2009, respectively. In addition, the Company derived 11% of its revenues from a private customer for the year ended December 31, 2010 which was recorded in the APSG segment.

The Company purchases most of the components and materials used in its products from various suppliers. The primary materials used in the manufacturing of the Company’s products are polycarbonate glass and steel. One of the Company’s suppliers supplied approximately $5.7 million, or 21% of the costs of revenue earned, and $14.2 million, or 42% of the costs of revenue earned during the years ended December 31, 2010 and 2009, respectively. As of December 31, 2010 and 2009 there was approximately $1.2 million and $1.4 million, respectively, in accounts payable for this vendor.

5.	COMMITMENTS AND CONTINGENCIES

Legal Proceedings

The Company is subject to various claims and contingencies in the ordinary course of its business, including those related to litigation, business transactions, employee-related matters, and others. When the Company is aware of a claim or potential claim, it assesses the likelihood of any loss or exposure. If it is probable that a loss will result and the amount of the loss can be reasonably estimated, the Company will record a liability for the loss. If the loss is not probable or the amount of the loss cannot be reasonably estimated, the Company discloses the claim if the likelihood of a potential loss is reasonably possible and the amount involved could be material. While there can be no assurances, the Company does not expect that any of its pending legal proceedings will have a material financial impact on the Company’s results.

On February 29, 2008, Roy Elfers, a former employee commenced an action against the Company for breach of contract arising from his termination of employment in the Supreme Court of the State of New York, Nassau County. The Complaint seeks damages of approximately $87,000. The Company filed an answer to the complaint. The parties have completed discovery and have completed taking depositions. Trial is scheduled for the end of April 2011. The Company intends to vigorously defend this action. While it is reasonably possible that an unfavorable outcome may occur, management has concluded that is not probable that a loss has been incurred and it is unable to estimate the possible loss or range of loss that could result from an unfavorable outcome and accordingly, has not provided any amounts in the consolidated financial statements for an unfavorable outcome.

On March 4, 2008, Thomas Cusack, the Company’s former General Counsel, commenced an action with the United States Department of Labor, Occupational Safety and Health and Safety Administration, alleging retaliation in contravention of the Sarbanes-Oxley Act. Mr. Cusack seeks damages in excess of $3,000,000. On April 2, 2008, the Company filed a response to the charges. The Company believes the allegations to be without merit and intends to vigorously defend against the action. On March 7, 2008, Mr. Cusack also commenced a second action against the Company for breach of contract and related issues arising from his termination of employment in New York State Supreme Court, Nassau County. On May 7, 2008, the Company served a motion to dismiss the complaint, and on or about September 26, 2008, the Court dismissed several claims (tortious interference with a contract, tortious interference with economic opportunity, fraudulent inducement to enter into a contract and breach of good faith and fair dealing). The remaining claims are Mr. Cusack's breach of contract claims, stock conversion claim, as well one claim for conversion of his personal property which Mr. Cusack has also asserted against the Company’s executive officers. On October 13, 2008, Mr. Cusack filed an amended complaint as to the remaining claims, and on November 5, 2008, the Company filed an answer to the complaint and filed counterclaims against Mr. Cusack for fraud. The parties have completed the discovery and depositions. The parties submitted motions for summary judgment and on August 19, 2010, the Court granted Mr. Cusack’s motion as to his stock conversion claim and narrowed certain issues as to his breach of contract claims. On September 13, 2010, the Company appealed this decision. On January 14, 2011, the Court stayed the trial pending the appeal of the summary judgment decision. The Company intends to vigorously defend this action. While it is reasonably possible that an unfavorable outcome may occur, management has concluded that is not probable that a loss has been incurred and it is unable to estimate the possible loss or range of loss that could result from an unfavorable outcome and accordingly, has not provided any amounts in the consolidated financial statements for an unfavorable outcome.

F-18

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

On January 7, 2011, Action Group, Inc. commenced an action in the United States District Court for the Eastern District of New York. The complaint seeks $1,187,510 for goods allegedly sold to American Defense Systems, Inc., for which payment was not received. While the parties were engaged in settlement discussions, plaintiff sought and was granted entry of a default on February 8, 2011. Plaintiff then filed a motion with the Court, dated March 7, 2011, seeking entry of a default judgment in the amount of $1,246,542, representing the original demand set forth in the complaint, plus interest, costs and disbursements. On March 16, 2011, the Court issued an Order, directing Defendants to respond to the Court in writing within seven days as to why default judgment should not be entered. On March 28, 2011, counsel for American Defense Systems, Inc. sought and obtained an Order from the Court extending its time to respond to the Court’s March 16, 2011 Order up to and including April 11, 2011. On April 11, 2011, Defendants served and filed a motion to set aside the default entered against them, and in opposition to plaintiff’s motion for entry of a default judgment. Plaintiffs have not yet responded to that motion and, accordingly, the Court has not yet made any determination as to the Defendants’ request to set aside the default.

Operating Leases

The Company occasionally rents various storage facilities and equipment from unrelated parties for in-progress jobs. The Company rents these items on a short-term basis.

The Company entered into a five-year lease commencing on September 23, 2004 for corporate offices, R&D center, and warehouse facility. This lease was amended on October 24, 2008 to include the rental of additional space. This amendment extends the existing lease through September 30, 2016 and includes a three percent per annum rent increase.

On November 1, 2007, the Company entered into a lease agreement for small office space in Stafford, VA. The lease expired on October 31, 2010.

On February 25, 2010, the Company entered into a lease agreement for manufacturing and office space in Lillington, NC for APSG. The lease agreement expires on January 31, 2015.

For the years ended December 31, 2010 and 2009, the Company incurred rent expense of $1,494,228 and $1,168,665, respectively.

Total future minimum rental commitments for the lease agreements noted above for the years ended December 31 are as follows:

2011	$	1,357,471
2012		1,398,398
2013		1,440,551
2014		1,483,982
2015		1,303,844
Thereafter		984,475
Total	$	7,968,721

Employment Agreements

Effective January 9, 2009, the Company entered into a new employment agreement with its chief operating officer. The agreement has an initial term of five years that is automatically extended each year by one additional year unless either party provides written notice of non-renewal. The chief operating officer’s annual base salary under the employment agreement is $274,890, which amount shall be reviewed on an annual basis by the board of directors of the Company and increased from time to time in an amount determined by the board. The employment agreement provides for an annual bonus of an amount of 2.5% of the increase in the Company’s EBITDA over the preceding fiscal year. The agreement also provides for the entitlement to participate in the stock option plan, medical insurance benefits, and payments of the term-life insurance and disability insurance premiums for the benefit of the individuals during the term of the agreements.

In January 2009, the Company entered into an amendment to the employment agreement between the Company and its chief financial officer. The amendment provides for an annual bonus of 2.5% of the increase in the Company’s EBITDA over the preceding fiscal year. The employment agreement, as amended, provides for an annual base salary of $153,000, which amount shall be reviewed on an annual basis by the Company’s chief executive officer and increased from time to time in an amount determined by the Company’s chief executive officer.

In January 2010, the Company’s chief financial officer agreed to reduce and waive 10% of his 2010 annual contractual compensation.

F-19

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The Company’s officers did not earn any bonuses pursuant to their respective employment agreements in 2010 or 2009.

Employee Benefit Plan

The Company sponsors the American Defense Systems, Inc. 401 (k) Plan (“the Plan”) established in December 2004 to provide retirement benefits for its employees. As allowed under Section 401(k) of the Internal Revenue Code, the Plan provides tax-deferred salary contributions for eligible employees.

Employee contributions are limited to a maximum annual amount as set periodically by the Internal Revenue Service. Under the Plan the Company may make discretionary matching contributions. For the years ended December 31, 2010 and 2009, the Company made matching contributions in the amount of approximately $30,000 and $89,000, respectively.

6.	SHAREHOLDERS’ DEFICIENCY

Warrants

The following is a summary of stock warrants outstanding at December 31, 2010:

	Warrants			Weighted Average Exercise Price		Weighted Average Remaining Contractual Lives (in years)
Balance – January 1, 2010		1,448,681		$	1.47		1.75
Granted		-			n/a		-
Exercised		-			n/a		-
Cancelled, Forfeited or expired		(773,680	)		1.00		-
Balance – December 31, 2010		675,001		$	2.00		2.18

Exercisable – December 31, 2010		675,001

Stock Option Plan

The Company accounts for all stock based compensation as an expense in the financial statements and associated costs are measured at the fair value of the award. The Company also recognizes the excess tax benefit related to stock option exercises as financing cash inflows instead of operating inflows. As a result, the Company’s net loss before taxes for the years ended December 31, 2010 and 2009 included $131,936 and $121,862 of stock based compensation, respectively. The stock based compensation expense is included in general and administrative expense in the consolidated statements of operations. The Company has selected a “with-and-without” approach regarding the accounting for the tax effects of share-based compensation awards.

The following is a summary of stock options outstanding at December 31, 2010:

							Weighted Average
							Remaining
			Weighted Average		Aggregate		Contractual Life
	Stock Options		Exercise Price		Intrinsic Value		(In years)

Outstanding, January 1, 2010		2,230,000	$	1.81		-		4.39
Granted		275,000		0.31		-		6.40
Exercised		-		n/a		n/a		n/a
Cancelled/forfeited		-		n/a		n/a		n/a
Outstanding, December 31, 2010		2,505,000	$	1.65		-		4.38
Exercisable, December 31, 2010		1,278,000	$	1.86				4.06

F-20

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

As of December 31, 2010, there was a total of $328,830 of unrecognized compensation on arrangements granted under the Company’s 2007 Incentive Compensation Plan (the “2007 Plan”). The cost is expected to be recognized through 2015.

On January 25, 2010, the Company issued an option to purchase 100,000 shares of its common stock to an officer as compensation under the 2007 Plan pursuant to an amendment to the officer’s employment agreement. The exercise price for the option is $0.40 per share and 40% of the option vested on the grant date and 20% of the option vests annually thereafter with the first 20% vesting upon the first anniversary of the grant date.

On July 31, 2010, the Company issued an option to purchase 175,000 shares of its common stock to a consultant as compensation under the 2007 Plan. The exercise price for the option is $0.26 per share and vests at the rate of 20% per year with the first 20% vesting upon the first anniversary of the grant date.

The Black-Scholes method option pricing model was used to estimate fair value as of the date of grant using the following assumptions:

Risk-Free rate		2.94%-3.12	%
Expected volatility		95.21%-98.76	%
Forfeiture rate		0	%
Expected life	7 Years
Expected dividends		0	%

Based on the assumptions noted above, the fair market value of the options issued during the years ended December 31, 2010 and 2009 was $87,655 and $81,092, respectively.

Stock Grants

On January 1, 2010, the Company issued 125,000 shares of its common stock to the Company’s non-employee directors as part of the director compensation under the 2007 Plan. The fair value on the date of grant was $50,000 based on the stock price on the date of issuance.

On January 19, 2010, the Company issued 75,000 shares of its common stock to an employee as compensation under the 2007 Plan. The fair value on the date of the grant was $28,500 based on the stock price on the date of issuance.

On March 2, 2010, the Company issued 12,500 shares of its common stock to a consultant as compensation for services rendered under the 2007 Plan. The fair value on the date of the grant was $4,500 based on the stock price on the date of issuance.

On May 7, 2010, the Company issued 17,361 shares of common stock to a consultant as compensation for services rendered under the 2007 Plan. The fair value on the date of grant was $5,729 based on the stock price on the date of issuance.

On May 28, 2010, the Company issued 26,136 shares of common stock to a consultant as compensation for services rendered under the 2007 Plan. The fair value on the date of grant was $7,318 based on the stock price on the date of issuance.

On August 24, 2010, the Company issued 75,000 shares of common stock to a consultant as compensation for services rendered under the 2007 Plan. The fair value on the date of grant was $16,500 based on the stock price on the date of issuance.

On September 1, 2010, the Company issued 19,231 shares of common stock to a consultant as compensation for services rendered under the 2007 Plan. The fair value on the date of grant was $3,654 based on the stock price on the date of issuance.

All of these awards were fully vested on the date of grant. The Company recorded stock based compensation of approximately $116,201 and $139,500 for the years ended December 31, 2010 and 2009, respectively, related to these awards.

On March 31, 2010, the Company issued 1,035,000 shares of its common stock to the Series A Holders as settlement of $375,000 of dividends pursuant to the terms of such Series A Preferred. The Company recorded this payment of dividends as interest expense for the three months ended March 31, 2010.

On June 30, 2010, the Company issued 1,455,000 shares of its common stock to the Series A Holders as settlement of $375,000 of dividends pursuant to the terms of such Series A Preferred. The Company recorded this payment of dividends as interest expense for the three months ended June 30, 2010.

On September 30, 2010, the Company issued 2,520,000 shares of its common stock to the Series A Holders as settlement of $375,000 of dividends pursuant to the terms of such Series A Preferred. The Company recorded this payment of dividends as interest expense for the three months ended September 30, 2010.

F-21

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

On December 31, 2010, the Company issued 2,370,000 shares of its common stock to the Series A Holders as settlement of $375,000 of dividends pursuant to the terms of such Series A Preferred. The Company recorded this payment of dividends as interest expense for the three months ended December 31, 2010.

7.	SERIES A CONVERTIBLE PREFERRED STOCK AND WARRANT LIABILITIES

Features of the Series A Preferred and Warrants Liabilities

2005 Warrants

On June 30, 2005, in connection with the closing of its 2005 private placement offering, the Company issued purchase warrants for up to 555,790 shares of common stock at the exercise price of $1.10 per share and with the expiration date of June 30, 2010 (the “2005 Warrants”).

On August 16, 2005, the Company issued 50,000 shares of its common stock at an effective price per share of $1.00 to one of the Company’s employees for accepting a job offer. As a result of this issuance, in accordance with the terms of the 2005 Warrants agreements, the exercise price was adjusted to $1.00 per share and the number of shares of common stock that would be acquired was adjusted to 576,587.

The 2005 Warrants expired on June 30, 2010 pursuant to their terms and there are no outstanding 2005 Warrants as of December 31, 2010.

2006 Warrants

On October 24, 2006, in accordance with the terms and conditions of the Company’s closing of its 2005 private placement offering, the Company issued purchase warrants for up to 179,175 shares of common stock at the exercise price of $1.10 per share and with the expiration date of June 30, 2010 (the “2006 Warrants”).

On February 8, 2007, the Company issued an aggregate of 260,000 shares of its common stock at an effective price per share of $1.00 to certain of its employees for services rendered. As a result of this issuance, in accordance with the terms of the 2006 Warrants agreements, the exercise price was adjusted to $1.00 per share and the number of shares of common stock that would be acquired was adjusted to 197,093.

The 2006 Warrants expired on June 30, 2010 pursuant to their terms and there are no outstanding 2006 Warrants as of December 31, 2010.

Series A Preferred and Investor Warrants and Placement Agent Warrants

The Company entered into a Securities Purchase Agreement (“Purchase Agreement”) on March 7, 2008 to sell shares of its Series A Preferred and warrants to purchase shares of its common stock (“Investor Warrants”), and to conditionally sell shares of the Company’s common stock, to the Series A Holders. The Series A Holders purchased an aggregate of 15,000 shares of Series A Preferred and Investor Warrants to purchase up to 3,750,000 shares of common stock, and to conditionally purchase 100,000 shares of common stock. The aggregate purchase price for the Series A Preferred and Investor Warrants was $15,000,000 and the aggregate purchase price for the common stock was $500,000. The Company completed the sale of the Series A Preferred and Investor Warrants in two rounds, on March 7, 2008 and April 4, 2008, and the Company and the Series A Holders determined not to complete the conditional sale of the 100,000 shares of common stock. The Series A Holders are entitled to receive cumulative dividends, due at each subsequent calendar quarter-end until maturity, at a rate of 9% if settled via cash or at a rate of 10% if settled via shares (at the option of the Company) of the Company’s common stock. The dividends rate is subject to increase in the event of a “Triggering Event” under the Certificate of Designations, Preferences and Rights of the Series A Preferred (the “Certificate of Designations”) and in the event of an “Equity Condition Failure” under the Certificate of Designations, settlement via shares would not be allowed for the remaining dividend payments.

The Series A Holders may convert shares of Series A Preferred, plus the amount of accrued but unpaid dividends, into shares of the Company’s common stock at the conversion price of $0.50, as amended on April 8, 2010. The Conversion Price is subject to certain adjustments upon issuance of certain securities, under the Certificate of Designation, with a lower exercise price and/or with negative dilutive effect. The Series A Holders may require the Company to redeem all or any portion of the outstanding shares of Series A Preferred in cash, at the amount of 100% of the “Conversion Amount” or 110% of the “Conversion Amount”, upon a Triggering Event or Equity Condition Failure.

The Company may redeem all or any portion of the outstanding shares of Series A Preferred in cash at the amount of (i) 100% of the “Conversion Amount” at any time after either the two-year anniversary of the “Public Company Date”, if certain other conditions are met, or the six-month anniversary of the “Qualified Public Offering Date”, if certain other conditions are met under the Certificate of Designations (ii) 110% of the Conversion Amount upon an Equity Condition Failure or (iii) 115% of the Conversion Amount prior to any “Fundamental Transaction” under the Certificate of Designations.

F-22

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Pursuant to the terms of the Series A Preferred, the Company was required to redeem, in cash, any outstanding shares of the Series A Preferred on December 31, 2010. On April 8, 2010, the Company entered into a waiver agreement with the Series A Holders which extended the maturity date for the mandatory redemption of all outstanding Series A Preferred from December 31, 2010 to April 1, 2011. On August 13, 2010, the Company entered into a waiver agreement with the Series A Holders which extended the maturity redemption date from April 1, 2011 to July 1, 2011. On November 12, 2010, the Company entered into a waiver agreement with the Series A Holders which extended the maturity redemption date from July 1, 2011 to October 1, 2011. On March 22, 2011, the Series A Preferred was fully redeemed. (See Note 12).

Settlement Agreement

In connection with a Notice of Triggering Event Redemption received by the Company on April 14, 2009, the Company entered into a Settlement Agreement, Waiver and Amendment with the Series A Holders on May 22, 2009 (the “Settlement Agreement”) pursuant to which, among other things, (i) the Series A Holders waived any breach by the Company of certain financial covenants or its obligation to timely pay dividends on the Series A Preferred for any period through September 30, 2009 and waived any Equity Conditions Failure and any Triggering Event otherwise arising from such breaches, (ii) the Investor Warrants were amended to reduce the exercise price thereof from $2.40 per share to $0.01 per share, (iii) the Company issued the Series A Holders an aggregate of 2,000,000 shares of the Company’s common stock (the “Settlement Shares ”), in full satisfaction of the Company’s obligation to pay dividends under the Certificate of Designations as of March 31, 2009, June 30, 2009 and September 30, 2009, and (iv) the Company agreed to redeem $7,500,000 in stated value of the Series A Preferred by December 31, 2009 (the “December 2009 Redemption”). The Company agreed that, if it fails to so redeem $7,500,000 in stated value of the Series A Preferred by that date (a “Redemption Failure”), then, in lieu of any other remedies or damages available to the Series A Holders (absent fraud), (i) the redemption price payable by the Company will increase by an amount equal to 10% of the stated value, (ii) the Company will use its best efforts to obtain shareholder approval to reduce the Conversion Price of the Series A Preferred from $2.00 to $0.50 (which would increase the number of shares of common stock into which the Series A Preferred is convertible), and (iii) the Company will expand the size of its board of directors by two, will appoint two persons designated by the Series A Holders to fill the two newly-created vacancies, and will use its best efforts to amend the Company’s certificate of incorporation to grant the Series A Holders the right to elect two persons to serve on the board.

Pursuant to the terms of the Settlement Agreement, the Company entered into a Registration Rights Agreement with the Series A Holders pursuant to which, among other things, the Company agreed to file with the SEC, by June 1, 2009, a registration statement covering the resale of the Settlement Shares, and to use its best efforts to have such registration statement declared effective as soon as practicable thereafter. The Company further agreed with the Series A Holders to include in such registration statement the shares of common stock issued upon the exercise of the Investor Warrants in May and June 2009. A registration statement was filed, and subsequently declared effective on August 10, 2009.

Pursuant to the terms of the Settlement Agreement, each of the Company’s directors and executive officers has entered into a Lock-Up Agreement, pursuant to which each such person has agreed that, for so long as any shares of Series A Preferred remain outstanding, he will not sell any shares of the Company’s common stock owned by him as of May 22, 2009. Also pursuant to the terms of the Settlement Agreement, the Company’s Chief Executive Officer, President and Chairman, entered into an Irrevocable Proxy and Voting Agreement with the Series A Holders (the “ Voting Agreement ”), pursuant to which the Company’s CEO agreed, among other things, that if a Redemption Failure occurs he will vote all shares of the Company’s voting stock owned by him in favor of (i) reducing the Conversion Price of the Series A Preferred from $2.00 to $0.50 and (ii) amending the Company’s certificate of incorporation to grant the Series A Holders the right to elect two persons to serve on the board of directors (collectively, the “ Company Actions ”). The Company’s CEO also appointed WCOF as his proxy to vote his shares of the Company’s voting stock in favor of the Company Actions, and against approval of any opposing or competing proposal, at any shareholder meeting or written consent of the Company’s shareholders at which such matters are considered.

The Company did not meet the December 2009 Redemption and has increased the size of its board of directors by two and held a special meeting of shareholders on April 8, 2010. At this special meeting, the shareholders approved the amendments to the Company’s certificate of incorporation to (i) reduce the Conversion Price of the Series A Preferred from $2.00 to $0.50 and (ii) grant the Series A holders the right, voting as a separate class, to elect two persons to serve on the Company’s board of directors. On April 8, 2010, the Company entered into a waiver agreement with the Series A Holders which extended the maturity date for the mandatory redemption of all outstanding Series A Preferred from December 31, 2010 to April 1, 2011. On August 13, 2010, the Company entered into a waiver agreement with the Series A Holders which further extended the maturity date for mandatory redemption of all outstanding Series A Preferred from April 1, 2011 to July 1, 2011. On November 12, 2010, the Company entered into a waiver agreement with the Series A Holders which further extended the maturity date for mandatory redemption of all outstanding Series A Preferred from July 1, 2011 to October 1, 2011.

F-23

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Investor Warrants

In connection with the sale of the Series A Preferred, Investor Warrants to purchase up to 3,750,000 shares of common stock at $2.40 per share were issued with an expiration date of April 11, 2011. The holders of the Investor Warrants may require the Company to repurchase their warrants upon the occurrence of certain defined events in the Investor Warrant agreement. As such the Company recorded the Investor Warrants as a derivative at fair value at issuance and subsequent reporting periods in accordance with ASC 815 “Derivatives and Hedging”. Changes in the fair value from period to period are reported in the statement of operations. In accordance with the Settlement Agreement entered into on May 22, 2009, the Investor Warrants were amended to reduce the exercise price from $2.40 to $0.01. The Investor Warrants were fully exercised on May 27, 2009, June 1, 2009, and June 8, 2009.

Placement Agent Warrants

In connection with the sale of the Series A Preferred and Investor Warrants, the placement agent for such sale received warrants (the “Placement Agent Warrants”) to purchase a total of 6% of the number of common stock issued in the Series A Preferred financing or 675,001 shares at the exercise price of $2.00 per share and with the expiration date of March 7, 2013.

Accounting for the Series A Preferred and Warrant Liabilities

2005 Warrants, 2006 Warrants, and Placement Agent Warrants

Upon issuance, the 2005 Warrants, 2006 Warrants, and Placement Agent Warrants met the requirements for equity classification set forth in Emerging Issues Task Force (“EITF”) Issue 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in a Company’s Own Stock, and Statement of Financial Accounting Standards (“SFAS”) No. 133, as codified in ASC 815. However, effective January 1, 2009, the Company was required to analyze its then outstanding financial instruments in accordance with EITF 07-5 as codified in ASC 815-40. Based on the Company’s analysis, its 2005 Warrants, 2006 Warrants, and Placement Agent Warrants, include price protection provisions whereby the exercise price could be adjusted upon certain financing transaction at a lower price per share and could no longer be viewed as indexed to the Company’s common stock. As a result, the 2005 Warrants, 2006 Warrants, and Placement Agent Warrants are accounted for as “derivatives” under ASC 815 and recorded as liabilities at fair value as of January 1, 2009 with changes in subsequent period fair value recorded in the statement of operations.

Series A Preferred

The Series A Preferred is mandatorily redeemable on October 1, 2011 and convertible into shares of common stock at a rate of 2,000 shares of common stock for each share of Series A Preferred. As a result the Company elected to record the hybrid instrument, preferred stock and conversion option together, at fair value. Subsequent reporting period changes in fair value are to be reported in the consolidated statement of operations.

The proceeds from the issuance of the Series A Preferred and Investor Warrants, net of direct costs including the fair value of warrants issued to placement agent in connection with the transaction, were allocated to the instruments based upon relative fair value upon issuance as these instruments must be measured initially at fair value.

Therefore, after the initial recording of the Series A Preferred based upon net proceeds received, the carrying value of the Series A Preferred was adjusted to the fair value at the date of issuance, with the difference recorded as a gain or loss.

The Settlement Agreement provides that $7,500,000 in stated value of the Series A Preferred was to be redeemed at December 31, 2009. The Company did not effect such redemption. As a result, in lieu of any other remedies or damages available to Series A Holders, the redemption price payable by the Company increased by an amount equal to 10% of the stated value, and the Company amended its certificate of incorporation to (i) reduce the Conversion Price of the Series A Preferred from $2.00 to $0.50 (which increased the number of shares of its common stock into which the Series A Preferred is convertible) and (ii) grant the Series A Holders, voting as a separate class, the right to elect two persons to serve on its board of directors.

F-24

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Valuation – Methodology and Significant Inputs Assumptions

Fair values for the Company’s derivatives and financial instruments are estimated by utilizing valuation models that consider current and expected stock prices, volatility, dividends, market interest rates, forward yield curves and discount rates. Such amounts and the recognition of such amounts are subject to significant estimates which may change in the future. The methods and significant inputs and assumptions utilized in estimating the fair value of the 2005 Warrants, 2006 Warrants, Placement Agent Warrants, and Series A Preferred are discussed below. Each of the measurements is considered a Level 3 measurement as a result of at least one unobservable input.

2005 and 2006 Warrants

All 2005 and 2006 Warrants expired on June 30, 2010.

Placement Agent Warrants

A Black-Scholes option-pricing model was utilized to estimate the fair value of the Placement Agent Warrants as of December 31, 2010. This model is subject to the significant assumptions discussed below and requires the following key inputs with respect to the Company and/or instrument:

Quoted Stock Price	$	0.17
Exercise Price	$	2.00
Expected Life (in years)		2.18
Stock Volatility		98.16	%
Risk-Free Rate		1.02	%
Dividend Rate		0	%

Series A Preferred

A scenario analysis was utilized to estimate the fair value of the Series A Preferred as of December 31, 2010. Two scenarios were considered: 1) the Series A Preferred would be redeemed-in-full; 2) the Series A Preferred would be restructured in order to reduce the redemption price. The probability of the "redeem-in-full" scenario was estimated to be 10% and the probability of the "restructure" scenario was estimated to be 90%. Both scenarios consider the key features of the Series A Preferred, as noted above, and are subject to the significant assumptions discussed below.

An option pricing model ("OPM") was used in the "redeem-in-full" scenario. The OPM assumes that the Series A Preferred would be redeemed in full on October 1, 2011, as specified in the waiver agreement entered into on November 12, 2010. The OPM further assumes that the Company’s publicly traded common stock price appropriately reflected the fair value of the Company’s common equity. Using the Company’s publicly traded common stock price and its capital structure, an implied firm value was calculated and then allocated to each of the Company’s equity securities. This model requires the following key inputs with respect to the Company and/or instrument:

Risk-free Rate		0.24	%
Expected Volatility		110.00	%
Expected Remain Term until Maturity (in years)		0.75
Expected Dividends		0.00	%
Quoted Common Stock Price	$	0.17

In the "restructure" scenario, a discounted cash flow analysis was performed using a distressed debt discount rate. This method requires the following key inputs:

Maturity Date	October 1, 2011
Discount Rate (original redemption value)		35	%
Discount Rate (penalty value)		50	%

F-25

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following are significant assumptions utilized in developing the inputs:



Stock volatility was estimated by considering (i) the annualized daily volatility of the Company’s stock price during the historical period preceding the respective valuation dates and measured over a period corresponding to the remaining life of the instruments and (ii) the annualized daily volatility of comparable companies’ stock price during the historical period preceding the respective valuation dates and measured over a period corresponding to the remaining life of the instrument. Historic prices of the Company and comparable companies’ common stock were used to estimate volatility as the Company did not have traded options as of the valuation dates;



Based on the Company’s historical operations and management’s expectations for the near future, the Company’s stock was assumed to be a non-dividend-paying stock;



Based on management’s expectations for the near future, the Company is expected to settle the future quarterly dividends due to the Series A Holders via shares;



The quoted market price of the Company’s stock was utilized in the valuations because ASC 820-10 requires the use of quoted market prices, if available, without considerations of blockage discounts (if the input is considered as a Level 1 input). Because the stock is thinly traded, the quoted market price may not reflect the market value of a large block of stock; and



The quoted market price of the Company’s stock as of measurement dates and expected future stock prices were assumed to reflect the effect of dilution upon conversion of the instruments to shares of common stock.

The changes in fair value estimate between reporting periods are related to the changes in the price of the Company’s common stock as of the measurement dates, the expected volatility of the Company’s common stock during the remaining term of the instrument, changes in the conversion price and estimated discount rate.

8.	DISCONTINUED OPERATIONS

On January 2, 2009, the Company entered into an agreement with the prior owners of TAG to sell certain assets and liabilities previously acquired from TAG back to TAG. TAG was accounted for as a discontinued operation under Generally Accepted Accounting Principles (“GAAP”), which requires the income statement information be reformatted to separate the divested business from the Company’s continuing operations.

In accordance with the terms of the agreement, the original owners of TAG agreed to repay $1,000,000 of the original $2,000,000 in consideration in annual installments from 2009 to 2013.

The original owners of TAG have collateralized the note receivable with their personal residence and the 250,000 shares issued to them on the date of acquisition. These shares are being held by the Company in escrow since January 2009 and will be returned upon final payment toward the note receivable.

TAG repaid $25,000 of the balance due to the Company during 2009 and has not made any additional payments.

The Company and the original owners of TAG are in the process of negotiating an agreement. The Company recorded an increase of $400,000 and $575,000 in the reserve against the note receivable which is included in loss from disposal of discontinued operations related to TAG for the years ended December 31, 2010 and 2009, respectively.

F-26

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

9. ACCOUNTS RECEIVABLE PURCHASE AGREEMENT

On July 27, 2009, the Company entered into an accounts Receivable Purchase Agreement with Republic Capital Access, LLC (“RCA”), as of July 23, 2009 (the “RCA Purchase Agreement”). Under the RCA Purchase Agreement, the Company can sell eligible accounts receivables to RCA. Eligible accounts receivable, subject to the full definition of such term in the RCA Purchase Agreement, generally are our receivables under prime government contracts.

Under the terms of the RCA Purchase Agreement, the Company may offer eligible accounts receivable to RCA and if RCA purchases such receivables, the Company will receive an initial upfront payment equal to 90% of the receivable. Following RCA’s receipt of payment from customers for such receivables, RCA will pay the remaining 10% of the receivable less its fees. In addition to the Discount Factor fee and an initial enrollment fee, the Company is required to pay RCA a program access fee equal to a stated percentage of the sold receivable, a quarterly program access fee if the average daily amount of the sold receivables is less than $2,250,000 and RCA’s initial expenses in negotiating the RCA Purchase Agreement and other expenses in certain specified situations. The RCA Purchase Agreement also provides that in the event, but only to the extent, that the conveyance of receivables by the Company is characterized by a court or other governmental authority as a loan rather than a sale, the Company shall be deemed to have granted RCA effective as of the date of the first purchase under the RCA Purchase Agreement, a security interest in all of the Company’s right, title and interest in, to and under all of the receivables sold by the Company to RCA, whether now or hereafter owned, existing or arising. The initial term of the RCA Purchase Agreement ended on December 31, 2009 and was extended to October 15, 2010 and further extended to October 15, 2011.

The sale of the receivables is accounted for in accordance with the accounting guidance for transfers and servicing of financial assets and extinguishments of liabilities. In accordance with the Codification, receivables are considered sold when they are transferred beyond the reach of the Company and its creditors, the purchaser has the right to pledge or exchange the receivables, and the Company has surrendered control over the transferred receivables. Receivables factored net of advances from the factor were $84,463 and $199,876 as of December 31, 2010 and 2009, respectively.

10. INCOME TAXES

The provision (benefit) for income taxes from continuing operations for the years ended December 31, 2010 and 2009 consist of the following:

	2010		2009
Current:
Federal	$	-	$	-
State		-		-
Deferred:
Federal	$	-	$	1,002,858
State		-		164,977
		-		1,167,835
Benefit from the operating loss carryforward		-		-
Benefit from operating loss carryback		-		(414,864	)
Provision (benefit) for income taxes, net	$	-	$	752,971

F-27

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The difference in income tax expense computed by applying the federal statutory corporate tax rate and effective rate is as follows:

	2010			2009
Statutory federal income tax rate		34.0	%		34.0	%
Increase in valuation allowance		(22.9	)%		(28.0	)%
State income taxes		-			-
Other		(11.1	)%		(10.8	)%
Effective tax rate		-	%		(4.8	)%

Deferred income taxes result from temporary differences in the recognition of income and expenses for the financial reporting purposes and for tax purposes. The net deferred tax assets and liabilities are comprised of the following:

	2010			2009
Deferred income tax asset:
Net operating loss carry-forwards	$	5,847,809		$	3,727,015
Stock options		253,335			155,054
Allowance for doubtful accounts		216,735			88,107
Charitable contributions		402,341			378,454
Long-term contracts		215,221			1,235,602
Capital loss carryover		217,711			-
Fixed assets		354,283			-
Inventory reserve		61,549			-
Deferred rent		83,954			-
Valuation allowance		(7,584,868	)		(5,392,011	)
Deferred income tax asset	$	68,070		$	192,221

	2010			2009
Deferred income tax liability:
Intangibles	$	(68,070	)	$	(22,774	)
Change from cash to accrual method for income taxes under IRS Section 481(a)		-			(169,447	)
Deferred income tax liability	$	(68,070	)	$	(192,221	)

The Company was required to change from cash to accrual method for income taxes effective for the 2007 tax year. Under IRS regulations section 481(a), the tax effects of this change are to be recognized over a 4 year period thus creating a deferred tax liability.

F-28

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Total current and noncurrent deferred tax asset and liabilities are as follows:

	2010			2009
Current deferred tax
Asset	$	1,928		$	521
Liability		-			-
Net deferred income tax asset	$	1,928			S 521
Non-current deferred tax
Asset	$	66,142		$	191,700
Liability		(68,070	)		(192,221	)
Net deferred income tax liability	$	(1,928	)	$	(521	)

The changes in the valuation allowance for deferred tax asset for the years ended December 31, 2010 and 2009 are as follows:

	2010		2009
Beginning balance	$	5,392,011	$	995,392
Change in allowance		2,192,857		4,396,619
Ending balance	$	7,584,868	$	5,392,011

The Company has a federal net operating loss carryforwards of approximately $14,690,000 available to offset future taxable income through 2030. The Company also has state net operating loss carryforwards of approximately $8,010,000 available to offset future state taxable income which expires in 2029.

Internal Revenue Code Section 382 limits the utilization of net operating loss carryforwards upon a change of control of a company (as defined in Section 382). The Company performed a preliminary evaluation as to whether a change of control has taken place and concluded that no such change has occurred to date. If it is determined that a change of control has taken place either historically or in the future, utilization of the Company’s net operating loss carryforwards could be subject to severe limitations, which could have the effect of eliminating substantial portion of the future income tax benefits of the net operating loss carryforwards.

The implementation of ASC 740-10 did not result in any current or any cumulative effect adjustment. Therefore, no adjustment was recorded to retained earnings upon adoption. For the years ended December 31, 2010 and 2009, the Company performed a tax analysis in accordance with ASC 740-10. Based upon that analysis, the Company was not required to accrue liabilities for uncertain tax positions pursuant to ASC 740-10 for the years ended December 31, 2010 and 2009, respectively, If the Company were to have any liabilities for uncertain tax positions, its accounting policy with respect to interest and penalties is to classify these amounts as income taxes. Since no liabilities for tax uncertainties have been recorded, there is no interest recognized in the statement of operations as of December 31, 2010 and 2009 and no interest is accrued as of December 31, 2010 and 2009.

F-29

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

11. SEGMENT INFORMATION

The Company classifies its business operations into two reportable segments which are ADSI and APSG. The Company believes this method of segment reporting reflects both the way its business segments are managed and the way the performance of each segment is evaluated.

The Company’s management evaluates segment performance based on several factors, of which the key financial measure is operating income (loss). Goodwill is recorded in the Company’s APSG segment. Information as to the operations of the Company’s reportable segments is set forth below.

	2010			2009
REVENUE
ADSI	$	31,461,148		$	41,390,254
APSG		8,057,906			4,503,725
	$	39,519,054		$	45,893,979
OPERATING INCOME (LOSS)
ADSI	$	(4,576,846	)	$	(7,909,858	)
APSG		74,735			721,715
	$	(4,502,111	)	$	(7,188,143	)
TOTAL ASSETS
ADSI	$	6,550,539		$	12,038,818
APSG		3,220,931			5,489,616
	$	9,771,470		$	17,528,434

12. PREFERRED STOCK REDEMPTION

On March 22, 2011, the Company entered into a Securities Redemption Agreement (the "Redemption Agreement") with the Series A Holders, pursuant to which the Company sold to the Series A Holders all of the issued and outstanding membership interests in APSG, the Company’s wholly-owned subsidiary. The Series A Holders own an aggregate of 15,000 shares of the Series A Preferred. In exchange for the sale of the APSG interests to the Series A Holders, the Series A Holders (i) paid the Company $1,000,000 in cash at the closing of the transactions contemplated by the Agreement and (ii) tendered to the Company the Series A Preferred, which had an aggregate redemption price of $16,500,000. Upon the closing of the transactions contemplated by the Redemption Agreement, the Series A Holders will own 100% of the APSG interests and APSG will no longer be a subsidiary of the Company. APSG accounted for $8,057,906 or 20% of consolidated revenue and $74,735 of operating income compared to an operating loss of $4,502,111 for the consolidated Company for the year ended December 31, 2010. As of December 31, 2010, APSG had total assets of $3,220,931 or 33% of consolidated assets.

The major classes of assets and liabilities of APSG as of December 31, 2010 were:

Current Assets:
Cash	$	178,304
Accounts receivable, net		1,270,019
Inventory		307,732
		1,756,055

Long-term Assets:
Property and equipment, net		17,926
Intangibles		634,450
Goodwill		812,500
		1,464,876

Total Assets	$	3,220.931

Liabilities
Accounts payable and accrued expenses	$	1,671,350

F-30

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In connection with the Redemption Agreement, the Company and the Series A Holders entered into a Membership Interest Option Agreement (the "Option Agreement") pursuant to which the Series A Holders granted the Company an option (the “Option”) to repurchase the APSG interests within six months following the closing of the transactions contemplated by the Redemption Agreement at a cash purchase price equal to the sum of (i) $15,525,000, plus (ii) the amount of any net investment made in APSG concurrently with and following the closing of the Redemption Agreement and prior to the closing of the purchase of the APSG membership interests pursuant to exercise of the Option.

13. SUBSEQUENT EVENTS

The Company has evaluated events that occurred subsequent to December 31, 2010 through the date the financial statements were issued, and except as disclosed in Note 12, the Company concluded that no other events required disclosure in these consolidated financial statements.

F-31

EXHIBIT INDEX

Exhibit Numbers		Exhibits
21.1		Subsidiaries of Registrant
23.1		Consent of Marcum LLP
31.1		Certification of Chief Executive Officer pursuant to Rules 13a-14 and 15d-14 promulgated under the Securities Exchange Act of 1934.
31.2		Certification of Chief Financial Officer pursuant to Rules 13a-14 and 15d-14 promulgated under the Securities Exchange Act of 1934.
32.1		Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 906 of the Sarbanes-Oxley Act of 2002.

Attached files

AMERICAN DEFENSE SYSTEMS INC Reports

Also read