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

IMPLANT SCIENCES CORPORATION

TABLE OF CONTENTS

2

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

3

In April 2011, we amended our credit facility with DMRJ. As amended, the conversion price of the senior secured convertible promissory note and warrant to purchase shares of our common stock were both fixed at $0.08 per share. As of that date, the note conversion feature and warrant were no longer subject to adjustment and were no longer required to be recorded as a separate liability under ASC 815-40-15 “Derivatives and Hedging”. For the three and nine months ended March 31, 2012, changes in fair value were no longer required to be recorded in our condensed consolidated statements of operations.

8

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

4.

Restricted Cash and Investments – Current and Long-Term

As of March 31, 2012 and June 30, 2011, we had restricted cash and investments, with maturities of less than one year, of $1,626,000 and $1,275,000, respectively, and restricted investments, with maturities of more than one year, of $0 and $312,000, respectively.  Restricted cash and investments consisted of the following:

In September 2010, we entered into a supplementary agreement with AVITEC, effective as of February 2010, to extend the warranty period for the security products through August 2011.  To guarantee our performance under the supplementary warranty bond, and in view of the fact that we were not able to negotiate an extension to the existing letter of credit, AVITEC claimed compensation and drew against the letter of credit in July 2010, resulting in the transfer of $418,000 of funds held in the money market account to AVITEC. AVITEC agreed to transfer $418,000 to us, less nominal bank fees, upon expiration of the warranty bond in August 2011. The remaining funds held in the money market account, $21,000, were transferred to our operating account in July 2010.  As of June 30, 2011, the funds retained by AVITEC were included in our accounts receivable. In February, 2012 AVITEC transferred the funds which had been retained to guarantee the supplementary warranty bond.

Pursuant to an additional credit agreement with DMRJ, we agreed to cause all of our receivables and collections to be deposited in a bank deposit account pledged to DMRJ pursuant to a blocked account agreement. All funds deposited in the blocked collections account are applied towards the repayment of our obligations to DMRJ under the revolving line of credit. Until the line of credit and all of our obligations thereunder have been paid and satisfied in full, we will have no right to access or make withdrawals from the blocked account without DMRJ’s consent.   As of March 31, 2012 and June 30, 2011, the balance in the blocked collections account was $64,000 and $25,000, respectively.

The restricted investments of $1,562,000 held in certificates of deposit collateralize our performance under three irrevocable letters of credit issued in April 2010, aggregating to $1,488,000, in connection with our contract with the India Ministry of Defence, plus the bank required collateralization deposit of $74,000.  These letters of credit: (1) provide performance security equal to 5% of the contract amount; (2) provide warranty performance security equal to 5% of the contract amount; and (3) provide security equal to 15% of the contract amount against an advance deposit under the terms of the contract. In May 2012, we amended the letters of credit, extending the expiration dates. As amended, the letters of credit expire between February 4, 2013 and December 15, 2014.

5.

Stock-Based Compensation

Our condensed consolidated statements of operations for the three months ended March 31, 2012 and 2011 include $83,000 and $26,000, respectively, of compensation costs and no income tax benefit related to our stock-based compensation arrangements for employee and non-employee director awards.  For the nine months ended March 31, 2012 and 2011 our condensed consolidated statements of operations includes $200,000 and $128,000, respectively, of compensation costs with no income tax benefit, related to our stock-based compensation arrangements for employee and non-employee director awards. As of March 31, 2012, the total amount of unrecognized stock-based compensation expense was approximately $436,000, which will be recognized over a weighted average period of approximately 2.2 years.

9

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

As of March 31, 2012, there were options outstanding to purchase 4,775,500 shares of our common stock at exercise prices ranging from $0.08 to $10.00.

6.

Related Party Transactions

We have entered into a fixed asset lease agreement with Ferran Scientific, Inc., a firm owned by the father of the former chairman of Ion Metrics, Inc., a company we acquired in 2008.  The lease, assumed as part of the Ion Metrics, Inc. acquisition in April 2008, expires on December 31, 2013, under the terms of which we are leasing certain property and equipment, with annual lease payments of approximately $31,000 per year, payable on December 31st.

Robert Liscouski, a member of our Board of Directors, serves as a partner at Secure Strategy Group, a homeland security-focused banking and strategic advisory firm that has been retained by us to assist with our efforts to acquire additional capital.  During the three and nine months ended March 31, 2012, this advisory firm was paid $25,000 and $81,000, respectively.  During the three and nine months ended March 31, 2011, this advisory firm was paid $44,000 and $131,000, respectively.  We also issued 500,000 shares of common stock to this advisory firm in fiscal 2010 and a warrant to purchase 700,000 shares of our common stock in May 2011.  As of March 31, 2012, our obligation to the advisory firm was $65,000. In April 2011, we entered into an advisory and consulting agreement with Mr. Liscouski to assist our U.S. government sales and marketing team with our efforts to advance our interests with the U.S. government.  During the three and nine months ended March 31, 2012, Mr. Liscouski was paid $45,000 and $135,000, respectively.  As of March 31, 2012, our obligation to Mr. Liscouski was $15,000.

7.

Note Payable – Related Party

In June 2009, Michael Turmelle , a member of our Board of Directors, loaned $100,000 to us.  The loan bore interest at 10% and was unsecured.  In November 2009, we issued a convertible promissory note to Mr. Turmelle in consideration of that loan. The principal amount of the loan was convertible in whole or in part at the option of Mr. Turmelle into shares of our common stock at a conversion price of $0.08 per share. In July 2010, Mr. Turmelle converted the entire principal amount of the loan into 1,250,000 shares of our common stock.

As of March 31, 2012 and June 30, 2011, our obligation to Mr. Turmelle for accrued interest approximated $11,000.

8.

Prepaid Expenses and Other Current Assets

Prepaid expenses and other current assets consist of the following:

10

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

9.

Inventories, net

We value our inventories at lower of cost or market.  Cost is determined by the first-in, first-out (FIFO) method, including material, labor and factory overhead.  The components of inventories, net of reserves, consist of the following:

As of March 31, 2012 and June 30, 2011, our reserves for excess and slow-moving inventories were $21,000 and $56,000, respectively.

10.

Property and Equipment, net

Property and equipment consist of the following:

For the three months ended March 31, 2012 and 2011, depreciation expense was approximately $14,000 and $23,000, respectively.  For the nine months ended March 31, 2012 and 2011, depreciation expense was approximately $54,000 and $72,000, respectively.

11.

Accrued Expenses

Accrued expenses consist of the following:

11

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Accrued taxes as of June 30, 2011,  includes our accrual of $270,000 for sales and use tax, penalties and interest incurred as a result of an audit by California’s Board of Equalization on the sale of substantially all of the assets of Accurel Systems International Corporation in May 2007.  We appealed the Board of Equalization’s determination and in July 2011, the Board’s Appeals Division reduced the assessment of sales and use tax and interest to approximately $270,000, which has been reclassified to accounts payable as of March 31, 2012.

In March 2012, we negotiated payment terms with the California Board of Equalization,  providing for thirty-six equal monthly payments of $8,100 to retire the sales and use tax and interest obligation owed to the State of California.

12.

Earnings Per Share

Basic earnings per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period.  Diluted earnings per share are based upon the weighted average number of common shares outstanding during the period plus additional weighted average common equivalent shares outstanding during the period.  Common equivalent shares result from the assumed exercise of outstanding stock options and warrants, the proceeds of which are then assumed to have been used to repurchase outstanding common stock using the treasury stock method and assumed conversion of certain convertible promissory notes and convertible preferred stock.  In addition, the numerator is adjusted for any changes in income or loss that would result from the assumed conversion of potential shares. As of March 31, 2012 and 2011, potentially dilutive shares were excluded from the earnings per share calculation, because their effect would be antidilutive.  Shares deemed to be antidilutive include stock options, warrants, convertible debt and convertible preferred stock.

12

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Common stock equivalents excluded from the earnings per share calculation for the three and nine months ended March 31, 2012 and 2011, were as follows:

13.

Debt and Credit Arrangements

Med-Tec Payment Obligation

In July 2003, we entered into an asset purchase agreement with Med-Tec Iowa, Inc., our former exclusive distributor of prostate seeds, to purchase Med-Tec’s customer lists and further to release each other from further obligations under an earlier distribution agreement.  The purchase price of $1,250,000, which was payable in varying amounts over 28 months, with the final payment payable on December 1, 2005, was recorded at the present value of the future payment stream, using a rate of 10.24%, which equaled $1,007,000.  This amount was recorded as an intangible asset and was amortized over our estimated useful life of 29 months.  The outstanding and past due principal balance as of March 31, 2012 and June 30, 2011 was approximately $33,000 and $42,000, respectively.

Senior Secured Convertible Promissory Note, Senior Secured Promissory Note and Revolving Credit Facility

In December 2008, we entered into a note and warrant purchase agreement with DMRJ, an accredited institutional investor, pursuant to which we issued a senior secured convertible promissory note in the principal amount of $5,600,000 and a warrant to purchase 1,000,000 shares of our common stock.  The note, which is collateralized by all of our assets, originally bore interest at 11.0% per annum.  The effective interest rate on the note, at the time of issuance, was approximately 23.4%.  We prepaid interest in the amount of $616,000 upon the issuance of the note.  In lieu of paying any commitment fees, closing fees or other fees in connection with the purchase agreement, we transferred our entire interest in 1,500,000 shares of the common stock of CorNova, Inc., a privately-held development stage medical device company, to DMRJ.  The note, which has been amended and restated, as described below, was originally convertible in whole or in part at the option of DMRJ into shares of our common stock at a conversion price of $0.26 per share. The warrant, which has been amended and restated, as described below, was originally exercisable in whole or in part at the option of DMRJ into shares of our common stock at an exercise price of $0.26 per share.

The note and warrant contained reset terms providing that, in the event that we issue additional shares of common stock (or securities convertible into or exercisable for additional shares of common stock) at a price below the note conversion price or warrant exercise price then in effect, the conversion price and exercise price would be automatically adjusted to equal the price per share at which such shares are issued or deemed to be issued.   At the adoption of ASC 815-40-15, the note conversion option liability and warrant derivative liability were required to be initially and subsequently be measured at fair value with changes in fair value recorded in earnings in each reporting period.  We adopted ASC 815-40-15, “Derivatives and Hedging”, on July 1, 2009 and recorded a fair value note conversion option liability of $1,183,000.

13

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

We valued the note upon issuance at its residual value of $4,341,000 based on the fair values of the financial instruments issued in connection with this convertible debt financing, including the warrant, the fair value of the note conversion option liability and the fair value of the CorNova common stock transferred to DMRJ.  The amounts recorded in the financial statements represents the amounts attributed to the senior secured convertible debt of $5,600,000, net of the fair value $153,000 allocated to the warrant, $638,000 allocated to the note conversion liability fair value and $468,000 representing the estimated fair value of the CorNova common stock transferred to DMRJ .  The note discount was calculated based upon the residual method. The discount on the note was amortized to interest expense over the initial term of the note.  The fair value of the warrant and note conversion liabilities were determined using a binomial option pricing model, which includes variables such as expected volatility of our share price, interest rates, and dividend yields.  These variables are based on our historical data, experience, and other factors (see Notes 14 and 15).

For the three months ended March 31, 2012 and 2011, we recorded non-cash benefits of $0 and $1,667,000, respectively, in our condensed consolidated statement of operations to record the change in fair value of the note conversion option liability. For the nine months ended March 31, 2012 and 2011, we recorded non-cash charges of $0 and $5,345,000, respectively, in our condensed consolidated statements of operations to record the change in fair value of the note conversion option liability. Fair value is estimated using a binomial option pricing model. See Notes 15 and 15 for the assumptions used in calculating the fair values.  

As required under the terms of the note, we made a principal payment of $1,000,000 on December 24, 2008.  The note required us to make a principal payment in an amount equal to any funds released from the escrow created in connection with the May 2007 sales of the assets of Accurel Systems International to Evans Analytical Group LLC (“Evans”), upon the release of such funds.  DMRJ waived that requirement in connection with the settlement of the subsequent litigation with Evans.

The note contains restrictions and financial covenants including: (i) restrictions against declaring or paying dividends or making any distributions; against creating, assuming or incurring  any liens; against creating, assuming or incurring any indebtedness; against merging or consolidating with any other company, provided, however, that a merger or consolidation is permitted if we are the surviving entity; against the sale, assignment, transfer or lease of our assets, other than in the ordinary course of business and excluding inventory and certain asset sales expressly permitted by the note purchase agreement; against making investments in any company, extending credit or loans, or purchasing stock or other ownership interest of any company; and (ii) covenants that we have authorized or reserved for the purpose of issuance, 150% of the aggregate number of shares of our common stock issuable upon exercise of  the warrant; that we maintain a minimum cash balance of at least $500,000; that the aggregate dollar amount of all accounts payable be no more than 100 days past due; and that we maintain a current ratio, defined as current assets divided by current liabilities, of no less than 0.60 to 1.00.

In March 2009, we entered into a letter agreement with DMRJ pursuant to which we were granted access to $250,000 of previously restricted cash out of funds held in a blocked account.  The effect of the letter agreement made $250,000 available to us until the close of business on April 14, 2009. In consideration of the letter agreement, in March 2009, we issued an amended and restated senior secured convertible promissory note and amended and restated warrant to DMRJ to purchase shares of common stock, which replaced the note and warrant issued in December  2008.  The terms of the amended and restated note and the amended and restated warrant are identical to the terms of the original note and warrant, except that the amended instruments reduced the initial conversion price of the original note from $0.26 to $0.18 and reduced the initial exercise price of the original warrant from $0.26 to $0.18.  

In July 2009, we entered into an amendment to the December 2008 note and warrant purchase agreement with DMRJ, pursuant to which we issued a senior secured promissory note to DMRJ in the principal amount of $1,000,000. We valued the note at its residual value of $726,000 based on the relative fair value of the Series F Convertible Preferred Stock issued in conjunction with the note (see Note 16).

14

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The senior secured promissory note, which has been amended, as described below, originally bore interest at the rate of 2.5% per month. The principal balance of the note, together with all outstanding interest and all other amounts owed under the note, was originally due and payable on the earlier of (i) December 10, 2009 and (ii) the receipt by us of net proceeds of at least $3,000,000 from the issuance of debt and/or equity securities in one or more transactions. In addition, DMRJ may require us to prepay such amounts upon (i) certain consolidations, mergers and business combinations involving us; (ii) the sale or transfer of more than 50% of our assets, other than inventory sold in the ordinary course of business, in one or more related or unrelated transactions; or (iii) the issuance by us, in one or more related or unrelated transactions, of any equity securities or securities convertible into equity securities (other than options granted to employees and consultants pursuant to employee benefit plans approved by our Board of Directors), which results in net cash proceeds to us of more than $500,000; provided, however, that DMRJ could not require us to prepay more than the net cash proceeds of any transaction described in the preceding clause (iii) of this sentence. The note permitted us to prepay all or any portion of the principal amount, without penalty or premium, after prior notice to DMRJ.

In connection with the additional note issued in July 2009, we also issued 1,646,663 shares of our Series F Convertible Preferred Stock to DMRJ. The Series F Preferred Stock was originally convertible into that number of shares of common stock which equaled the original issue price of the Series F Preferred Stock ($0.08 per share) divided by the “Series F Conversion Price.” All of the 1,646,663 shares of Series F Preferred Stock held by DMRJ were convertible into 16,466,630 shares of common stock, or 25% of our common stock, calculated on a fully diluted basis. The Series F Preferred Stock contained reset terms providing that, in the event that we issued additional shares of common stock (or securities convertible into or exercisable for additional shares of common stock) at a price below the Series F Conversion Price then in effect, the Series F Conversion Price would be automatically adjusted to equal the price per share at which such shares are issued. The reset provision did not apply, however, to issuances of stock and options to our employees, directors, consultants and advisors pursuant to any equity compensation plan approved by our stockholders. In April 2011, as further described below, DMRJ exchanged all of the shares of Series F Preferred Stock held by it for shares of a new Series G Convertible Preferred Stock. The terms of the Series G Preferred Stock are identical to the terms of the Series F Preferred Stock, except that the Series G Preferred Stock terms do not include reset provisions for dilutive issuances of our common stock.

In August 2009, we entered into a second amendment to the December 2008 note and warrant purchase agreement, pursuant to which we issued DMRJ a bridge note in the principal amount of $700,000.  The note bore interest at the rate of 25% per annum. The outstanding principal balance and all interest due under this bridge note were paid in September 2009.

In September 2009, we entered into an additional credit agreement with DMRJ, pursuant to which DMRJ provided us with a revolving line of credit in the maximum principal amount of $3,000,000. In connection with the credit agreement, we issued a promissory note to DMRJ evidencing our obligations under the credit facility. Each of our subsidiaries guaranteed our obligations under the credit facility. Our obligations and our subsidiaries’ obligations are secured by grants of first priority security interests in all of our respective assets. In addition, we agreed to cause all of our receivables and collections to be deposited in a bank deposit account pledged to DMRJ pursuant to a blocked account agreement. All funds deposited in the blocked collections account are applied towards the repayment of our obligations to DMRJ under the note. Until the note and all of our obligations thereunder have been paid and satisfied in full, we will have no right to access or make withdrawals from the blocked account without DMRJ’s consent.

15

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The revolving line of credit, which has been amended, as described below, originally bore interest at the rate of 25% per annum. Interest under the note is due on the first day of each calendar month. The principal balance of the note, together with all outstanding interest and all other amounts owed under the note, was originally due and payable in December 2009. We may prepay all or any portion of the principal amount of the note, without penalty or premium, after prior notice to DMRJ. Subject to applicable cure periods, amounts due under the note are subject to acceleration upon certain events of default, including: (i) any failure to pay when due any amount owed under the note; (ii) any failure to observe or perform any other condition, covenant or agreement contained in the note or certain conditions, covenants or agreements contained in the credit agreement; (iii) certain suspensions of the listing or trading of our common stock; (iv) a determination that any misrepresentation made by us to DMRJ in the credit agreement or in any of the agreements delivered to DMRJ in connection with the credit agreement were false or incorrect in any material respect when made; (v) certain defaults under agreements related to any of our other indebtedness; (vi) the institution of certain bankruptcy and insolvency proceedings by or against us; (vii) the entry of certain monetary judgments against us that are not dismissed or discharged within a period of 20 days; (viii) certain cessations of our business in the ordinary course; (ix) the seizure of any material portion of our assets by any governmental authority; and (x) our indictment for any criminal activity.

In lieu of paying DMRJ any commitment fees, closing fees or other fees in connection with the credit agreement, we agreed to pay DMRJ an additional amount equal to 50% of our aggregate net profits, as defined, generated between the closing date through the termination of the credit facility. For the period September 4, 2009 through January 12, 2010, the date as of which this arrangement was cancelled, we experienced a net loss and no such payments were due or payable to DMRJ.

Upon the closing of the credit facility, we requested and were granted an initial advance of approximately $1,633,000, of which we used approximately $715,000 to repay all of our outstanding indebtedness to DMRJ pursuant to the bridge note issued to DMRJ in August 2009, and approximately $548,000 to retire certain obligations owed to other parties. We used the balance of the initial advance for working capital and ordinary course general corporate purposes.

We failed to pay an aggregate of $7,505,678 in principal, together with approximately $149,292 of interest, due to DMRJ in December 2009, the maturity of each of the promissory notes described above.  On December 20, 2009, we received written notice from DMRJ, stating that we were in default of our obligations under each of the notes.

As a result of these defaults, effective December 11, 2009, (i) the interest rate that we were obligated to pay to DMRJ under the promissory note issued in March 2009 automatically increased from 11% per annum to 2.5% per month (or the maximum applicable legal interest rate, if less); (ii) the interest rate that we were obligated to pay to DMRJ under the promissory note issued in July 2009 automatically increased from 2.5% per month to 3.0% per month (or the maximum applicable legal interest rate, if less); and (iii) the interest rate that we were obligated to pay to DMRJ under the promissory note issued in September 2009 increased from 25% per annum to 30% per annum (or the maximum applicable legal interest rate, if less). All such default interest is payable upon demand by DMRJ.

On December 31, 2009, we received further written notice from DMRJ, withdrawing its default notice. Also, on December 31, 2009, DMRJ elected to convert $120,000 of the principal amount owed by us under the senior secured convertible promissory note into 1,500,000 shares of our common stock, at an adjusted conversion price of $.08 per share. DMRJ has subsequently converted additional portions of our indebtedness on similar terms. Under the promissory notes and related agreements, however, DMRJ may not convert any portion of the notes if the number of shares of common stock to be issued pursuant to such conversion, when aggregated with all other shares of common stock owned by DMRJ at such time, would result in DMRJ beneficially owning in excess of 4.99% of the then issued and outstanding shares of common stock. DMRJ may waive such limitation by providing us with 61 days’ prior written notice.

16

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

In January 2010, we amended each of our credit instruments with DMRJ. Pursuant to those amendments: (i) our line of credit under the September 2009 credit agreement was increased from $3,000,000 to $5,000,000; (ii) the maturity of all of our indebtedness to DMRJ under each of the notes described above was extended from December 10, 2009 to June 10, 2010; (iii) DMRJ waived all existing defaults under all of these promissory notes and all related credit agreements through the new maturity date of June 10, 2010; (iv) the interest rate payable on our obligations under each of the promissory notes was reduced to 15% per annum; (v) all arrangements pursuant to which we were to share with DMRJ any profits resulting from certain transactions were removed from the credit documents; (vi) we agreed to certain limitations on equity financings without DMRJ’s prior consent; and (vii) we agreed that we will not prepay more than $3,600,000 of the $5,600,000 of indebtedness owed to DMRJ under the March 2009 amended and restated promissory note without DMRJ’s prior consent.

In April 2010, we further amended each of our credit instruments with DMRJ. Pursuant to those amendments: (i) our line of credit under the September 2009 credit agreement was increased from $5,000,000 to $10,000,000; and (ii) the maturity of all of our indebtedness to DMRJ, including indebtedness under each of the promissory notes described in the preceding paragraphs, was extended from June 10, 2010 to September 30, 2010.

In September 2010, we further amended each of our credit instruments with DMRJ. Pursuant to those amendments, the maturity of all of the our indebtedness to DMRJ, including indebtedness in the preceding paragraphs, was extended from September 30, 2010 to March 31, 2011.

In March 2011, we further amended each of our credit instruments with DMRJ. Pursuant to those amendments, the maturity of all of our indebtedness to DMRJ was extended to April 7, 2011 and our line of credit under the September 2009 credit agreement was increased from $10,000,000 to $15,000,000.

In April 2011, we further amended each of our credit instruments with DMRJ. Those amendments: (i) extended the maturity our all our indebtedness to DMRJ from April 7, 2011 to September 30, 2011; (ii) waived our compliance with certain financial covenants in the notes and all related credit agreements through maturity; (iii) removed the reset provisions from both the senior secured convertible promissory note and the amended and restated warrant; (iv) fixed the conversion and exercise price of the senior secured convertible promissory note and the amended and restated warrant at $0.08 per share; (v) established the order in which our prepayments of the notes would be applied; (vi) required that we authorize a new series of Series G Convertible Preferred Stock, with terms identical  to the Series F Preferred Stock except that the Series G Preferred Stock would not contain the reset antidilution provision; (vii) required that we issue DMRJ 0.1 share of Series G Preferred Stock in exchange for each share of Series F Preferred Stock held by it; and (viii) provided DMRJ with the right of first refusal on any new securities we may issue to any third party.

The Series G Preferred Stock is convertible into that number of shares of common stock which equals the original issue price of the Series G Preferred Stock ($0.08 per share) divided by the “Series G Conversion Price” (originally $0.08 per share), multiplied by 100. All of the 164,667 shares of Series G Preferred Stock held by DMRJ were originally convertible into 16,466,700 shares of common stock, or 25% of our common stock, calculated on a fully diluted basis. The Series G Preferred Stock is entitled to participate on an “as converted” basis in all dividends or distributions declared or paid on our common stock. In the event of any liquidation, dissolution or winding up of our company, the holders of the Series G Preferred Stock will be entitled to be paid an amount equal to $.08 per share of Series G Preferred Stock, multiplied by 100, plus any declared but unpaid dividends, prior to the payment of any amounts to the holders of our common stock by reason of their ownership of such stock.

The holders of the Series G Preferred Stock have no voting rights except as required by applicable law. However, without the consent of the holders of a majority of the Series G Preferred Stock, we may not (i) amend, alter or repeal any provision of our Restated Articles of Organization or By-laws in a manner that adversely affects the powers, preferences or rights of the Series G Preferred Stock; (ii) authorize or issue any equity securities (or any equity or debt securities convertible into equity securities) ranking prior and superior to the Series G Preferred Stock with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up; or (iii) consummate any capital reorganization or reclassification of any of our equity securities (or debt securities convertible into equity securities) into equity securities ranking prior and superior to the Series G Preferred Stock with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up.

17

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

In addition, for as long as the July 2009 note or the amended and restated senior secured convertible promissory note issued to DMRJ in March 2009 remain outstanding, we may not issue additional shares of common stock, or other securities convertible into or exercisable for common stock, if such securities would increase the number of shares of our common stock, calculated on a fully diluted basis, unless we simultaneously issue to DMRJ that number of additional shares of Series G Preferred Stock which is necessary to result in the number of shares of common stock into which all Series G Preferred Stock held by DMRJ may be converted representing the same percentage ownership of our common stock on a fully diluted basis after such issuance as immediately prior thereto.  

We considered the guidance in ASC 470-50-40-15, “Debt-Modifications and Extinguishments,” and have concluded that the April 2011 amendment to the DMRJ credit facility was a debt modification, not an extinguishment, and have not recognized a gain or loss on this transaction in our statements of operations.  Further, we did not recognize a beneficial conversion feature or reassess an existing beneficial conversion feature as a result of this amendment.

In September 2011, we further amended each of our credit instruments with DMRJ. Pursuant to those amendments: (i) the maturity of our indebtedness to DMRJ was extended from  September 30, 2011 to March 31, 2012; (ii) DMRJ waived our compliance with certain financial covenants in the notes and all related credit agreements through maturity; (iii) our line of credit under the September 2009 credit agreement was increased from $15,000,000 to $23,000,000; and (iv) we were required to repay sufficient amounts of our outstanding indebtedness under the notes and related credit agreements and other amounts owing to DMR such that as of December 31, 2011, the outstanding obligations to DMRJ shall not exceed $15,000,000.

In October 2011, we further amended each of our credit instruments with DMRJ, to eliminate the obligation repay any portion of our outstanding indebtedness to DMRJ by December 31, 2011 .

On February 21, 2012, we amended each of our credit instruments with DMRJ, pursuant to which the maturity of all of our indebtedness to DMRJ was extended to September 30, 2012.

The failure to refinance this indebtedness or otherwise negotiate extensions of our obligations to DMRJ would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.

Our ability to comply with our debt covenants in the future depends on our ability to generate sufficient sales and to control expenses, and will require us to seek additional capital through private financing sources.  There can be no assurances that we will achieve our forecasted financial results or that we will be able to raise additional capital to operate our business.  Any such failure would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.  Further, upon the occurrence of an event of default under certain provisions of our agreements with DMRJ, we could be required to pay default rate interest equal to the lesser of 3.0% per month and the maximum applicable legal rate per annum on the outstanding principal balance outstanding.

As of March 31, 2012, our obligation to DMRJ under the amended senior secured convertible promissory note, the senior secured promissory note and under the credit facility approximated $3,440,000, $1,000,000 and $23,079,000, respectively. Further, as of March 31, 2012, our obligation to DMRJ for accrued interest under the amended senior secured convertible promissory note, the senior secured promissory note and the line of credit approximated $2,053,000 and is included in current liabilities in the condensed consolidated balance sheet.

As of April 30, 2012, our obligations to DMRJ under the amended senior secured convertible promissory note, the senior secured promissory note and the credit facility approximated $3,440,000, $1,000,000 and $23,907,000, respectively.  Further, as of April 30, 2012, our obligation to DMRJ for accrued interest under the amended senior secured convertible promissory note, the senior secured promissory note and the line of credit approximated $2,205,000 and is included in current liabilities.

18

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

14.

Note Conversion Option Liability

ASC 815-40-15 “Derivatives and Hedging” requires issuers to record as liabilities financial instruments that provide for reset provisions as an adjustment mechanism to the relevant exercise or conversion price, since they are not deemed to be indexed to our common stock. Under the provisions of ASC 815-40-15, a contract designated as an asset or a liability must be carried at fair value until exercised or expired, with any changes in fair value recorded in the results of operations. In our December 2008 financing transaction with DMRJ, we issued a senior secured promissory note in the principal amount of $5,600,000. The promissory note contained reset terms, providing that, in the event that we issued additional shares of common stock (or securities convertible into or exercisable for additional shares of common stock) at a price below the note conversion price, the conversion price would be automatically adjusted to equal the price per share at which such shares are issued or deemed to be issued. The conversion option liability was initially and subsequently measured at fair value with changes in fair value recorded in earnings in each reporting period. For the three months ended March 31, 2012 and 2011, we recorded non-cash benefits of $0 and $1,667,000, respectively, in our condensed consolidated statements of operations to record the change in fair value of the note conversion option liability. For the nine months ended March 31, 2012 and 2011, we recorded non-cash charges of $0 and $5,345,000, respectively, in our condensed consolidated statements of operations to record the change in fair value of the note conversion option liability. Fair value was estimated using a binomial option pricing model, which included variables such as the expected volatility of our share price, interest rates, and dividend yields. These variables were projected based on our historical data, experience, and other factors.  The note conversion option liability was valued using a binomial option pricing model, with the following assumptions on the following dates:

The fair value of the note conversion option liability was measured at the end of each reporting period and the change in fair value was reported in our condensed consolidated statement of operations.  Upon adoption of ASC 815-40-15 at July 1, 2009, we recorded a fair value note conversion option liability of $1,183,000. On April 7, 2011, we amended the note and warrant purchase agreement. As amended on April 7, 2011, the conversion price of the senior secured convertible promissory note was fixed at $0.08 per share and subsequent changes in fair value were no longer required to be recorded in our statements of operations. As of that date, the note conversion feature was no longer subject to adjustment and was no longer required to be recorded as a separate liability under ASC 815-40-15. On April 7, 2011, we reclassified the note conversion liability of $17,845,000 to stockholders’ deficit. As of March 31, 2012 and June 30, 2011, the note conversion liability was $0.

19

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

15.

Warrant Derivative Liability

ASC 815-40-15 “Derivatives and Hedging” requires freestanding contracts that are settled in our own stock, including common stock warrants, to be designated as an equity instrument, asset or liability. Under the provisions of ASC 815-40-15, a contract designated as an asset or a liability must be carried at fair value until exercised or expired, with any changes in fair value recorded in the results of operations. In our December 2008 financing transaction with DMRJ, we issued a warrant to purchase 1,000,000 shares of our common stock. The warrant contained reset terms, providing that, in the event that we issued additional shares of common stock (or securities convertible into or exercisable for additional shares of common stock) at a price below the exercise price, the warrant would be automatically adjusted to equal the price per share at which such shares are issued or deemed to be issued. The warrant derivative liability was initially and subsequently measured at fair value with changes in fair value recorded in earnings in each reporting period. For the three months ended March 31, 2012 and 2011, we recorded non-cash benefits of $0 and $35,000, respectively, in our condensed consolidated statements of operations to record the change in fair value of the warrant derivative liability. For the nine months ended March 31, 2012 and 2011, we recorded non-cash charges of $0 and $121,000, respectively, in our condensed consolidated statements of operations to record the change in fair value of the warrant derivative liability. Fair value was estimated using a binomial option pricing model, which included variables such as the expected volatility of our share price, interest rates, and dividend yields. These variables were projected based on our historical data, experience, and other factors. The warrant derivative liability was valued using a binomial option pricing model, with the following assumptions on the following dates:

We originally recorded the fair value of this warrant of approximately $160,000 as an increase to additional paid in capital.  Upon adoption of ASC 815-40-15 at July 1, 2009, we reclassified $160,000 from additional paid in capital to the warrant derivative liability. On April 7, 2011, we amended the note and warrant purchase agreement. As amended on April 7, 2011, the conversion price of the warrant was fixed at $0.08 per share and subsequent changes in fair value were no longer required to be recorded in our statements of operations. As of that date, warrant was no longer subject to adjustment and was no longer required to be recorded as a separate liability under ASC 815-40-15. On April 7, 2011, we reclassified the warrant derivative liability of $438,000 to stockholders’ deficit. As of March 31, 2012 and June 30, 2011, the warrant derivative liability was $0.

20

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

16.

Series F Convertible Preferred Stock

In connection with the July 2009 amendment to the December 2008 note and warrant purchase agreement with DMRJ, pursuant to which we issued a senior secured promissory note to DMRJ in the principal amount of $1,000,000, we issued 1,646,663 shares of our Series F Convertible Preferred Stock to DMRJ.  The Series F Preferred Stock was originally convertible into that number of shares of common stock which equaled the original issue price of the Series F Preferred Stock ($0.08 per share) divided by the “Series F Conversion Price.” All of the 1,646,663 shares of Series F Preferred Stock held by DMRJ were convertible into 16,466,630 shares of common stock, or 25% of our common stock, calculated on a fully diluted basis.  In addition, for as long as the promissory note issued in July 2009 or the amended and restated promissory note issued in March 2009 remain outstanding, we were prohibited from issuing additional shares of common stock, or other securities convertible into or exercisable for common stock, if such securities would increase the number of shares of our common stock, calculated on a fully diluted basis, unless we simultaneously issued to DMRJ that number of additional shares of Series F Preferred Stock which is necessary to result in the number of shares of common stock into which all Series F Preferred Stock held by DMRJ would be converted representing the same percentage ownership of our common stock on a fully diluted basis after such issuance as immediately prior thereto.

On April 7, 2011, in connection with the amendments to our credit instruments with DMRJ, we issued shares of a new series of Series G Convertible Preferred Stock to DMRJ in exchange for the Series F Preferred Stock (see Note 13).

17.

Series G Convertible Preferred Stock

On April 7, 2011, in connection with the amendment to the December 2008 note and warrant purchase agreement with DMRJ, we issued 164,667 shares of our Series G Convertible Preferred Stock to DMRJ in exchange for 1,646,663 shares of our Series F Preferred Stock (see Notes 13 and 16).

The Series G Preferred Stock is convertible into that number of shares of common stock which equals the original issue price of the Series G Preferred Stock ($0.08 per share) divided by the “Series G Conversion Price.” All of the 164,667 shares of Series G Preferred Stock held by DMRJ were convertible into 16,466,700 shares of common stock, or 25% of our common stock, calculated on a fully diluted basis.  We have concluded that the April 7, 2011 amendment to the DMRJ credit facility was a debt modification, not an extinguishment, and have not recognized a gain or loss on this transaction in our statements of operations.  Further, we did not recognize a beneficial conversion feature on the Series G Preferred Stock or reassess an existing beneficial conversion feature as a result of this amendment.

21

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

18.

Stockholders’ Deficit

Common Stock Options and Warrants

In connection with various financing agreements and services provided by consultants, we have issued warrants to purchase shares of our common stock.  The fair value of warrants issued is determined using a binomial option pricing model.  In December 2008, in conjunction with the issuance of the senior secured convertible note to DMRJ, we issued a five-year warrant to purchase 1,000,000 shares of common stock at an initial exercise price of $0.26 per share.  The warrant is exercisable between December 10, 2008 and December 10, 2013.  We recorded the fair value of this warrant of approximately $160,000 against the senior secured convertible promissory note, which was accreted to the note and interest expense was recorded over the life of the note. In March 2009, we issued DMRJ an amended and restated warrant to purchase shares of common stock, to reduce the initial exercise price of the warrant from $0.26 to $0.18. As a result of the issuance of the Series F Preferred Stock, in July 2009, the exercise price of the warrant was automatically reduced under its reset provisions to $0.08.  We adopted ASC 815-40-15 on July 1, 2009 and reclassified $160,000 from additional paid in capital to the “Warrant Derivative Liability.” The warrant derivative liability was initially and subsequently measured at fair value with changes in fair value recorded in earnings in each reporting period. On April 7, 2011, we amended our credit instruments with DMRJ. As amended on April 7, 2011, the conversion price of the warrant was fixed at $0.08 per share.  As of that date, the warrant was deemed to be indexed to our common stock and subsequent changes in fair value were no longer required to be recorded in our results of operations. For the three months ended March 31, 2012 and 2011, we recorded non-cash benefits of $0 and $35,000, respectively, in our condensed consolidated statements of operations to record the change in fair value of the warrant derivative liability. For the nine months ended March 31, 2012 and 2011, we recorded non-cash charges of $0 and $121,000, respectively, in our condensed consolidated statements of operations to record the change in fair value of the warrant derivative liability (see Note 15).

In May 2011, we entered into two advisory and consulting services agreements, pursuant to which we agreed to issue up to an aggregate of 4,000,000 shares of our common stock.  In June 2011, we issued 1,000,000 shares of common stock, having a value of approximately $800,000, under these agreements. We have agreed to issue the balance of the 4,000,000 shares in monthly installments of 166,667 shares to each of the two advisors, beginning in August 2011 and ending upon the earlier of the ninth such installment or the termination of each advisor’s respective agreement.  During the three months ended March 31, 2012, we issued 1,000,000 shares of common stock, having a value of approximately $587,000 and during the nine months ended March 31, 2012 we issued 2,333,336 shares of common stock, having a value of $1,386,000, to the two advisors, in consideration of services rendered to us under two advisory and consulting services agreements.

As of March 31, 2012, there were warrants outstanding to purchase 2,455,352 shares of our common stock at exercise prices ranging from $0.08 to $1.14 expiring at various dates between December 10, 2013 and April 1, 2021.

We issued 200,000 and 27,133 shares of common stock during the nine months ended March 31, 2012 and 2011, respectively, as a result of the exercise of options by employees.

22

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

19.

Income Taxes

We are required to file federal and state income tax returns in the United States.  The preparation of these tax returns requires us to interpret the applicable tax laws and regulations in effect in such jurisdictions, which could affect the amount of tax paid by us. In consultation with our tax advisors, we base our tax returns on interpretations that are believed to be reasonable under the circumstances. The tax returns, however, are subject to routine reviews by the various federal and state taxing authorities in the jurisdictions in which we file tax returns. As part of these reviews, a taxing authority may disagree with respect to the income tax positions taken by us (“uncertain tax positions”) and, therefore, may require us to pay additional taxes. As required under applicable accounting rules, we accrue an amount for our estimate of additional income tax liability, including interest and penalties, which we could incur as a result of the ultimate or effective resolution of the uncertain tax positions. We account for income taxes using the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributed to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences and carry-forwards are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.  A valuation allowance is established when necessary to reduce deferred tax assets to amounts expected to be realized.

We account for uncertain income tax positions by accruing for the estimated additional amount of taxes for the uncertain tax positions when the uncertain tax position does not meet the more likely than not standard for sustaining the position. We review and update our accrual as more definitive information becomes available from taxing authorities, upon completion of tax audits, upon expiration of statutes of limitation, or upon occurrence of other events.  This requires significant judgment, the use of estimates, and the interpretation and application of complex tax laws. Significant judgment is required in assessing the timing and amounts of deductible and taxable items and the probability of sustaining uncertain tax positions. The benefits of uncertain tax positions are recorded in our condensed consolidated financial statements only after determining a more-likely-than-not probability that the uncertain tax positions will withstand challenge, if any, from tax authorities. When facts and circumstances change, we reassess these probabilities and record any changes in the consolidated financial statements as appropriate.

Potential 382 Limitation

As of June 30, 2011, the  we had the following unused net operating loss and tax credit carry forwards available to offset future federal and state taxable income, both of which expire at various times as noted below:

We have recorded a full valuation allowance against our net deferred tax assets of $20,136,000 as of June 30, 2011, due to uncertainties related to our ability to utilize these assets. The valuation allowance is based on our estimates of taxable income and the period over which our deferred tax assets will be recoverable.

Our net operating loss carry forwards are subject to review and possible adjustment by the Internal Revenue Service.  Our ability to utilize our net operating loss (“NOL”) and alternative minimum tax (“AMT”) and research and development credit (“R&D”) carryforwards may be substantially limited due to ownership changes that may have occurred or that could occur in the future, as required by Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”), as well as similar state provisions.  These ownership changes may limit the amount of NOL, AMT and R&D credit carryforwards that can be utilized annually to offset future taxable income and tax, respectively.  In general, an ownership change, as defined in Section 382 of the Code, results from a transaction or series of transactions over a three-year period resulting in an ownership change of more than 50% of the outstanding stock of a company by certain stockholders or public groups.

23

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

We have not completed a study to assess whether one or more ownership changes have occurred since we became a loss corporation as defined in Section 382 of the Code, but we believe that it is likely than an ownership change has occurred.  If we have experienced an ownership change, utilization of the NOL, AMT and R&D credit carryforwards would be subject to an annual limitation, which is determined by first multiplying the value of our common stock at the time of the ownership change by the applicable long-term, tax-exempt rate, and then could be subject to additional adjustments, as required.  Any such limitation may result in the expiration of a portion of the NOL, AMT or R&D credit carryforwards before utilization.  Until a study is completed and any limitation known, no amounts are being considered as an uncertain tax position or disclosed as an unrecognized tax benefit under FIN No. 48.  Any carryforwards that expire prior to utilization as a result of such limitations will be removed from deferred tax assets with a corresponding adjustment to the valuation allowance.  Due to the existence of the valuation allowance, it is not expected that any potential limitation will have a material impact on our operating results.

From time to time we may be assessed interest or penalties by major tax jurisdictions, namely the states of Massachusetts and California.  At the adoption date and as of March 31, 2012, we had no material unrecognized tax benefits and no adjustments to liabilities or operations were required. No interest and penalties have been recognized by the Company to date.

For the nine months ended March 31, 2012 and 2011, we provided for no taxes in our condensed consolidated statement of operations as we have significant net loss carryforwards.

20.

Commitments and Contingencies

We lease manufacturing, research and office space in Wilmington, Massachusetts, the lease of which expires on January 31, 2015.  Under the terms of the lease, we are responsible for our proportionate share of real estate taxes and operating expenses relating to this facility.  As a result of the Ion Metrics acquisition, we assumed a lease for research and office space in San Diego, California, which lease was renewed and expires on March 31, 2013.  Total rent expense, including assessments for maintenance and real estate taxes for the nine months ended March 31, 2012 and 2011, was $254,000 and $251,000, respectively.

In April 2007, in conjunction with our plans to conduct research, development and minor manufacturing work in New Mexico, we executed an operating lease which was initially to expire on May 1, 2010.  The lease allowed for early termination, which we elected in February 2008.  As a result of the early termination, we are responsible for reimbursing the landlord for certain leasehold improvements over a 24-month period.  As of March 31, 2012 and June 30, 2011, the balance due is approximately $27,000 and is included in current liabilities in the condensed consolidated balance sheets.

21.

Financial Information By Segment

Operating segments are defined as components of an enterprise about which separate financial information is available that is regularly evaluated by the chief operating decision maker or decision making group, in determining how to allocate resources and in accessing performance.  Our chief operating decision making group is composed of the chief executive officer and members of senior management.  Based on qualitative and quantitative criteria, we have determined that we operate within one reportable segment, which is the Security Products Segment.

22.

Legal Proceedings

In January 2011, Fulong Integrated Technique, Ltd. (“Fulong”) filed a complaint against us in the Middlesex Superior Court of the Commonwealth of Massachusetts, alleging non-payment of amounts owed for services provided to us in connection with the sale of handheld explosives detection equipment to a customer in China in the first quarter of fiscal 2009. Fulong seeks general monetary damages, other statutory damages, attorneys’ fees and costs. We believe the case is without merit and that we have substantial defenses against the Fulongs claims. We have filed counterclaims against Fulong, and are contesting the matter vigorously. If, however, Fulong is ultimately successful, it could have a material adverse effect on our business and financial condition.

We are not currently a party to any other legal proceedings, other than routine litigation incidental to our business that which we believe will not have a material effect on our business, assets or results of operations.  From time to time, we are subject to various claims, legal proceedings and investigations covering a wide range of matters that arise in the ordinary course of our business activities.  Each of these matters may be subject to various uncertainties.

24

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q contains certain statements that are “forward-looking” within the meaning of the federal securities laws. These forward looking statements and other information are based on our beliefs as well as assumptions made by us using information currently available.

The words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “will,” “should” and similar expressions, as they relate to us, are intended to identify forward-looking statements.  Such statements reflect our current views with respect to future events, are subject to certain risks, uncertainties and assumptions, and are not guaranties of future performance.  Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated, expected, intended or using other similar expressions.

We are making investors aware that such forward-looking statements, because they relate to future events, are by their very nature subject to many important factors that could cause actual results to differ materially from those contemplated by the forward-looking statements contained in this Report. Important factors that could cause actual results to differ from our predictions include those discussed under this “Management’s Discussion and Analysis” and under “Risk Factors,” as well as those discussed under “Risk Factors,” “Management’s Discussion and Analysis” and “Business” in our Annual Report on Form 10-K, for the fiscal year ended June 30, 2011. Although we have sought to identify the most significant risks to our business, we cannot predict whether, or to what extent, any of such risks may be realized, nor can there be any assurance that we have identified all possible issues which we might face.  In addition, assumptions relating to budgeting, marketing, product development and other management decisions are subjective in many respects and thus susceptible to interpretations and periodic revisions based on actual experience and business developments, the impact of which may cause us to alter our marketing, capital expenditure or other budgets, which may in turn affect our financial position and results of operations.  For all of these reasons, the reader is cautioned not to place undue reliance on forward-looking statements contained herein, which speak only as of the date hereof.  We assume no responsibility to update any forward-looking statements as a result of new information, future events, or otherwise except as required by law.  We urge readers to review carefully the risk factors described in this Quarterly Report, in our Annual Report on Form 10-K for the fiscal year ended June 30, 2011 and in the other documents that we file with the Securities and Exchange Commission.  You can read these documents at www.sec.gov.

Overview

We develop, manufacture and sell sophisticated sensors and systems for the security, safety and defense industries.  A variety of technologies are currently used worldwide in security and inspection applications.  In broad terms, the technologies focus on detection in two major categories: (i) the detection of “bulk” contraband, which includes materials that would be visible to the eye, such as weapons, explosives, narcotics and chemical agents; and (ii) the detection of “trace” amounts of contraband, which includes trace particles or vapors of explosives, narcotics and chemical agents.  Technologies used in the detection of “bulk” materials include computed tomography, transmission and backscatter x-ray, metal detection, trace detection and x-ray, gamma-ray, passive millimeter wave, and neutron analysis.  Trace detection techniques used include mass spectrometry, gas chromatography, chemical luminescence, and ion mobility spectrometry.

We have developed proprietary technologies used in explosives trace detection (ETD) applications and market and sell handheld and benchtop ETD systems that use our proprietary technologies.  Our products are marketed and sold to a growing number of locations domestically and internationally.  These systems are used by private companies and government agencies to screen baggage, cargo, other objects and people for the detection of trace amounts of explosives. Please see our Annual Report on Form 10-K for the fiscal year ended June 30, 2011 for a complete description of our business.

25

Critical Accounting Policies

Our significant accounting policies are summarized in Note 2 to our consolidated financial statements included in Item 7 of our Annual Report on Form 10-K, for the fiscal year ended June 30, 2011.  However, certain of our accounting policies require the application of significant judgment by our management, and such judgments are reflected in the amounts reported in our condensed consolidated financial statements.  In applying these policies, our management uses our judgment to determine the appropriate assumptions to be used in the determination of estimates.  Those estimates are based on our historical experience, terms of existing contracts, our observance of market trends, information provided by our strategic partners and information available from other outside sources, as appropriate.  Actual results may differ significantly from the estimates contained in our condensed consolidated financial statements.  

Results of Operations

Three Months Ended March 31, 2012 vs. March 31, 2011

Revenues

Security product revenues for the three months ended March 31, 2012 were $686,000 as compared with $734,000 for the comparable prior year period, a decrease of $48,000, or 6.5%.  The decrease in security revenue is primarily a result of a 17.6% decrease in unit volume of our explosives detection products sold, partially offset by a 10.4% increase in average unit sell prices, during the three months ended March 31, 2012 as compared to the comparable prior year period. The revenue decrease and higher average unit sell prices are predominantly due to lower sales of our explosives detection products into China.

Cost of Revenues

Cost of revenues for the three months ended March 31, 2012 were $504,000 as compared with $534,000 for the comparable prior year period, a decrease of $30,000, or 5.6%.  The decrease in cost of revenues is primarily due to decreased unit sales of security product in the three months ended March 31, 2012, as compared to the comparable prior period and a decrease in our warranty costs.

Gross Margin

Gross margin for the three months ended March 31, 2012 was $182,000, or 26.5% of security revenues as compared with gross margin of $200,000 or 27.2% of security revenues for the comparable prior year period.  The decrease in gross margin is a result of lower unit volume of our explosives detection products sold, resulting in increased unabsorbed manufacturing overhead, partially offset by a decrease in our warranty costs.

Research and Development Expense

Research and development expense for the three months ended March 31, 2012 was $799,000 as compared with $829,000 for the comparable prior year period, a decrease of $30,000, or 3.6%.  The decrease in research and development expense is due primarily to decreased direct material costs incurred in the development of the QS-B220 benchtop explosives and narcotics detector, partially offset by increased payroll and related fringe benefit costs. We continue to expend funds to further the development of new products in the areas of explosives detection, as well as to prepare for certain government laboratory acceptance testing, including our participation in the Cooperative Research and Development Agreement with the Department of Homeland Security’s Science and Technology Directorate. Spending on research and development will increase in the next six to twelve months due to the ongoing development of the QS-B220 benchtop explosives and narcotics detector and the QS-Hx portable explosives detector.

Selling, General and Administrative Expenses

Selling, general and administrative expenses for the three months ended March 31, 2012 were $2,258,000 as compared with $1,078,000 for the comparable prior year period, an increase of $1,180,000, or 109.5%.  The increase in selling, general and administrative expenses is due primarily to increased consulting expense, due to the issuance of our common stock to certain consultants and the retention of consultants to assist with our efforts to advance our interests with the U.S. government, increased payroll, related fringe benefits costs and travel expense resulting from the addition of sales, marketing and administrative personnel, increased legal fees, increased stock-based expense on warrants and employee stock options.

26

Other Income and Expense, Net

For the three months ended March 31, 2012, other expense, net was $1,015,000 as compared with other income, net of $1,066,000, for the comparable prior year period, a decrease of $2,081,000. The decrease was primarily due to decreases in the fair value of the note conversion option liability of $1,667,000 and warrant derivative liability of $35,000, in the three months ended March 31, 2011, both of which are related to our financing with DMRJ. On April 7, 2011, we entered into an amendment to our credit facility with DMRJ. As amended, the conversion price of the senior secured convertible promissory note and warrant to purchase shares of our common stock were both fixed at $0.08 per share. As of that date, the note conversion feature and warrant were no longer subject to adjustment and were no longer required to be recorded as a separate liability under ASC 815-40-15. Interest expense increased to $1,016,000, compared to $637,000, for the comparable prior period, an increase of $379,000, due to higher borrowings under our credit facility with DMRJ. Interest income was $1,000 for the three months ended March 31, 2012 and 2011.

Net Loss

Our net loss for the three months ended March 31, 2012 was $3,890,000 as compared with a net loss of $641,000 for the comparable prior year period, an increase of $3,249,000, or 506.9%.  The increase in the net loss is primarily due to the non-cash fair value adjustments recorded in the three months ended March 31, 2011 on the note conversion option liability and warrant derivative liability, both of which are related to our financing with DMRJ, lower revenues, a $1,150,000 increase in operating expenses and increased interest expense due to higher borrowings under our credit facility with DMRJ.

Nine Months Ended March 31, 2012 vs. March 31, 2011

Revenues

Security product revenues for the nine months ended March 31, 2012 were $2,854,000 as compared with $4,885,000 for the comparable prior year period, a decrease of $2,031,000, or 41.6%.  The decrease in security revenue is primarily a result of a 47.5% decrease in the number of units sold during the nine months ended March 31, 2012 and decreased sales of accessories, as compared to the comparable prior year period, partially offset by 11.5% increase in average unit sell prices on sales our explosives detection products. The revenue decrease and higher average unit sell prices are predominantly due to lower sales of our explosives detection products into China.

Cost of Revenues

Cost of revenues for the nine months ended March 31, 2012 were $1,908,000 as compared with $2,895,000 for the comparable prior year period, a decrease of $987,000, or 34.1%.  The decrease in cost of revenues is primarily due to a decrease in the number of units sold during the nine months ended March 31, 2012, as compared to the comparable prior year period and decreased warranty costs, partially offset by the cost incurred to remediate certain defective component parts, increased manufacturing overhead spending and an increase in a minimum guaranteed royalty.

Gross Margin

Gross margin for the nine months ended March 31, 2012 was $946,000, or 33.1% of security revenues as compared with gross margin of $1,990,000, or 40.7% of security revenues for the comparable prior year period.  The decrease in gross margin is a result of lower unit volume of our explosives detection products sold, resulting in increased unabsorbed manufacturing overhead, costs incurred to remediate certain defective component parts  and an increase in a minimum guaranteed royalty, partially offset by a decrease in our warranty costs.

27

Research and Development Expense

Research and development expense for the nine months ended March 31, 2012 was $2,365,000 as compared with $1,949,000 for the comparable prior year period, an increase of $416,000, or 21.3%.  The increase in research and development expense is due primarily to increased payroll and related fringe benefit costs, increased contracted engineering and direct material costs incurred in the development of the QS-B220 benchtop explosives and narcotics detector. We continue to expend funds to further the development of new products in the areas of explosives detection, as well as to prepare for certain government laboratory acceptance testing including our participation in the Cooperative Research and Development Agreement with the Department of Homeland Security’s Science and Technology Directorate. Spending on research and development will increase in the next nine to twelve months due to the ongoing development of the QS-B220 benchtop explosives and narcotics detector and the QS-Hx portable explosives detector.

Selling, General and Administrative Expenses

Selling, general and administrative expenses for the nine months ended March 31, 2012 were $6,053,000 as compared with $3,530,000 for the comparable prior year period, an increase of $2,523,000, or 71.5%.  The increase in selling, general and administrative expenses is due primarily to increased consulting expense, due to the issuance of our common stock to certain consultants and the retention of consultants to assist with our efforts to advance our interests with the U.S. government, increased payroll, related fringe benefits costs and travel expense resulting from the addition of sales, marketing and administrative personnel, increased stock-based expense on warrants and employee stock options, increased legal fees, partially offset by the early termination payment discount of $201,000 recorded in the comparable prior period with respect to the note receivable from Core Systems Incorporated and decreased vendor late payment fees. In December 2010, we entered into a payoff agreement with Core Systems Incorporated, pursuant to which we agreed to reduce the amount due under the note by $201,000, from $688,000 to $487,000 in exchange for accelerated payment of the note.

Other Income and Expense, Net

For the nine months ended March 31, 2012, other expense, net was $2,780,000 as compared with other expense, net of $7,190,000, for the comparable prior year period, a decrease of $4,410,000. The decrease was primarily due to increases in the fair value of the note conversion option liability of $5,345,000 and warrant derivative liability of $121,000, in the nine months ended March 31, 2011, both of which are related to our financing with DMRJ. On April 7, 2011, we entered into an amendment to our credit facility with DMRJ. As amended, the conversion price of the senior secured convertible promissory note and warrant to purchase shares of our common stock were both fixed at $0.08 per share. As of that date, the note conversion feature and warrant were no longer subject to adjustment and were no longer required to be recorded as a separate liability under ASC 815-40-15. Interest expense increased to $2,783,000, compared to $1,739,000, for the comparable prior period, an increase of $1,044,000, due to higher borrowings under our credit facility with DMRJ. Interest income decreased $12,000 to $3,000, in the nine months ended March 31, 2012 from $15,000, for the comparable prior year period, due to decreased interest income associated with the note receivable issued to us as part of the Core asset sale.

Net Loss

Our net loss for the nine months ended March 31, 2012 was $10,252,000 as compared with a net loss of $10,679,000 for the comparable prior year period, a decrease of $427,000, or 4.0%.  The decrease in the net loss is primarily due to the non-cash fair value adjustments recorded in the nine months ended March 31, 2011 on the note conversion option liability and warrant derivative liability, both of which are related to our financing with DMRJ,  lower revenues, a $2,939,000 increase in operating expenses and increased interest expense due to higher borrowings under our credit facility with DMRJ.

28

Liquidity and Capital Resources

As of March 31, 2012 and June 30, 2011, we had cash and cash equivalents of $2,000 and $264,000, respectively. On September 30, 2012, we must repay in full our obligations to DMRJ under the amended and restated senior secured promissory note issued to DMRJ in March 2009, under a second secured promissory note issued in July 2009 and under a revolving credit facility established in September 2009.  As of March 31, 2012, our obligations under the two promissory notes and under the revolving credit facility were $3,440,000, $1,000,000 and $23,079,000, respectively. Each of these notes and the credit facility are described in Note 13 of the Notes to Condensed Consolidated Financial Statements, accompanying this Quarterly Report. Further, as of March 31, 2012, our obligation to DMRJ for accrued interest under the amended senior secured convertible promissory note,  the senior secured promissory note and the line of credit approximated $2,053,000.

As of April 30, 2012, our obligation to DMRJ under the two senior notes and under the revolving credit facility were $3,440,000, $1,000,000 and $23,907,000, respectively, reflecting increased borrowing under the revolving credit facility to fund working capital. Further, as of April 30, 2012, our obligation to DMRJ for accrued interest under the senior secured convertible promissory note, the senior secured promissory note and the credit facility approximated $2,205,000.

During the nine months ended March 31, 2012, we had net cash outflows of $7,358,000 from operating activities as compared to net cash outflows from operating activities of $5,687,000 for the comparable prior year period.  The $1,671,000 increase in net cash used in operating activities during the nine months ended March 31, 2012, as compared to the comparable prior year period, was primarily a result of (i) the increased net loss of $10,252,000, compared to the adjusted net loss of $5,213,000, adjusting for the non-cash fair value adjustments recorded in the nine months ended March 31, 2011 on the note conversion option liability and warrant derivative liability in the prior period, due to lower revenues, increased operating expenses and increased interest expense; (ii) an increase in accounts payable of $40,000, compared to a decrease in accounts payable of $337,000 in the prior period due to increased operating expenses; (iii) an increase of $71,000 in deferred revenue, compared to a $760,000 increase in deferred revenue in the prior period due primarily to the receipt in July 2010 of the $893,000 advance deposit under our contract with the India Ministry of Defence; (iv) a $4,000 decrease in prepaid expenses, compared to a $1,052,000 increase in prepaid expenses in the prior period, due to the receipt of inventory which had been prepaid in the comparable prior period; (v) a $565,000 increase in accrued expenses compared to a $305,000 increase in accrued expenses in the prior period, due to increased interest expense and consulting fees, partially offset by reduced warranty costs; (vi) a $904,000 decrease in accounts receivable, compared to a $316,000 increase in accounts receivable in the prior period, due to higher revenues and shipment timing in the comparable prior period; and (vii), an $654,000 increase in inventories, compared to a $223,000 increase in the prior period, due to the receipt of inventory purchased to fulfill our contract  with the India Ministry of Defence and increased raw materials procured for the initial production of the B-220 benchtop explosives and narcotics trace detector.

During the nine months ended March 31, 2012, we had net cash outflows of $178,000 from investing activities as compared to net cash inflows of $561,000 from investing activities for the comparable prior year period.  The $739,000 decrease in net cash provided by investing activities during the nine months ended March 31, 2012, as compared to the comparable prior year period, was primarily due to the  increase in Core note receivable payments received of $583,000, in the prior period, due to the payoff agreement entered into with Core Systems, Inc., a $39,000 decrease in restricted funds, compared to a $21,000 increase in the comparable prior period and a $96,000 increase in cash used to  purchase property and equipment.

During the nine months ended March 31, 2012 we had net cash inflows of $7,274,000 from financing activities as compared to net cash inflows of $5,136,000 from financing activities for the comparable prior year period.  The $2,138,000 increase in net cash from financing activities during the nine months ended March 31, 2012, as compared to the comparable prior year period, was primarily a result of increased borrowings under our  credit facility with DMRJ. During the nine months ended March 31, 2011, we received proceeds of $5,000 due to the exercise of employee stock options.

29

Our ability to comply with our debt covenants in the future depends on our ability to generate sufficient sales and to control expenses, and will require us to seek additional capital through private financing sources.  In addition, we will require substantial funds for further research and development, regulatory approvals, and the marketing of our explosives detection products.  Our capital requirements depend on numerous factors, including but not limited to the progress of our research and development programs; the cost of filing, prosecuting, defending and enforcing any intellectual property rights; competing technological and market developments; changes in our development of commercialization activities and arrangements; and the hiring of additional personnel, and acquiring capital equipment.  There can be no assurances that we will achieve our forecasted financial results or that we will be able to raise additional capital to operate our business.  

Any failure to comply with our debt covenants, to achieve our projections and/or obtain sufficient capital on acceptable terms would have a material adverse impact on our liquidity, financial condition and operations and could force us to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.  Further, upon the occurrence of an event of default under certain provisions of our agreements with DMRJ, we could be required to pay default rate interest equal to the lesser of 3.0% per month and the maximum applicable legal rate per annum on the outstanding principal balance outstanding.

Based on current sales, operating expense and cash flow projections, and the cash available from our line of credit, management believes there are plans in place to sustain operations for the next several months. Because there can be no assurances that sales will materialize as forecasted, and/or that management will be successful in refinancing or extending our obligations with DMRJ, management will continue to closely monitor and attempt to control our costs and will continue to actively seek the needed capital through government grants and awards, strategic alliances, private financing sources, and through its lending institutions.  Future expenditures for research and product development are discretionary and can be adjusted as can certain selling, general and administrative expenses, based on the availability of cash.  The financial statements do not include any adjustments relating to the recoverability and classification of asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue as a going concern.

Off-Balance Sheet Arrangements

As of March 31, 2012, we had three irrevocable standby letters of credit outstanding in the approximate amount of $1,488,000.  These letters of credit (1) provide performance security equal to 5% of the amount of our contract with the India Ministry of Defence; (2) provide warranty performance security equal to 5% of the contract amount; and (3) provide security equal to 15% of the contract amount against an advance deposit under the terms of the contract.  In May 2012, we amended each of the letters of credit, extending the expiration dates. As amended, the letters of credit expire between February 4, 2013 and December 15, 2014.

As of March 31, 2012, we did not have any other off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our consolidated financial condition, results of operations, liquidity, capital expenditures or capital resources.

New Accounting Pronouncements

In May 2011, the FASB issued Accounting Standards Update 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS” (“ASU 2011-04”). The adoption of ASU 2011-04 gives fair value the same meaning between U.S. generally accepted accounting principles (“U.S. GAAP”) and International Financial Reporting Standards (“IFRS”), and improves consistency of disclosures relating to fair value. The provisions of ASU 2011-04 will be effective for fiscal years and interim periods beginning after December 15, 2011 and can be applied prospectively. However, changes in valuation techniques shall be treated as changes in accounting estimates.  The adoption of this update did not have a material effect on our consolidated financial position and results of operations.

30

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

Not required pursuant to Item 305(e) of Regulation S-K.

Item 4.

Controls and Procedures

The certifications of our Chief Executive Officer and Chief Financial Officer attached as Exhibits 31.1 and 31.2 to this Quarterly Report on Form 10-Q include, in paragraph 4 of such certifications, information concerning our disclosure controls and procedures, and internal control over financial reporting.  Such certifications should be read in conjunction with the information contained in this Item 4 for a more complete understanding of the matters covered by such certifications.

Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2012.  The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by the company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported, within the time periods specified in the rules and forms of the Securities and Exchange Commission.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions to be made regarding required disclosure.  It should be noted that any system of controls and procedures, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met and that management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Our Chief Executive Officer and Chief Financial Officer, concluded that we did maintain effective internal control over financial reporting as of March 31, 2012 and further concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control Over Financial Reporting

Except as described above, there were no changes to our internal control over financial reporting during the quarter ended March 31, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

31

PART II.

OTHER INFORMATION

Item 1.

Legal Proceedings

From time to time, we are subject to various claims, legal proceedings and investigations covering a wide range of matters that arise in the ordinary course of our business activities. Each of these matters is subject to various uncertainties.

Except as disclosed under Item 3 of our Annual Report on Form 10-K, for the fiscal year ended June 30, 2011, we are not a party to any other legal proceedings, other than ordinary routine litigation incidental to our business, which we believe will not have a material affect on our business, assets or results of operations.

Item 1A.

Risk Factors

Other than as set forth below, there have not been any material changes from the risk factors previously disclosed under Item 1A of our Annual Report on Form 10-K, for the fiscal year ended June 30, 2011.

We will be required to repay our borrowings from DMRJ Group LLC on September 30, 2012.  

We will be required to repay all of our borrowings from DMRJ on September 30, 2012.  Our obligations to DMRJ are secured by a security interest in substantially all of our assets.  As of March 31, 2012, the outstanding balances due to DMRJ under an amended senior secured convertible promissory note, a second secured promissory note and a revolving credit facility were $3,440,000, $1,000,000 and $23,079,000, respectively.  As of April 30, 2012, the outstanding balances due to DMRJ under these instruments were $3,440,000, $1,000,000 and $23,907,000, respectively.  If we are unable to repay these amounts as required, refinance our obligations to DMRJ, or negotiate extensions of these obligations, DMRJ may seize our assets and we may be forced to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.

We will require additional capital to fund operations and continue the development, commercialization and marketing of our product.  Our failure to raise capital could have a material adverse effect on the business.

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

During the three months ended March 31, 2012, we issued 1,000,000 shares of common stock, having a value of approximately $587,000, to two advisors, in consideration of services rendered to us under two advisory and consulting services agreements. The issuance of these shares was exempt from registration under the Securities Act pursuant to an exemption provided by Section 4(2) of the Securities Act.

Item 3.

Defaults Upon Senior Securities

None.

Item 4.

Mine Safety Disclosures

None.

Item 5.

Other Information

None.

32

Item 6.

Exhibits

Exhibit No.

______________________

33

SIGNATURES

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

Dated: May 15, 2012

34