The accompanying unaudited interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information. In the opinion of management, the interim financial statements reflect all adjustments of a normal recurring nature necessary for a fair presentation of the results for interim periods. The consolidated balance sheet as of September 30, 2007 was derived from the Company's most recent audited financial statements. Operating results for the nine month period are not necessarily indicative of the results that may be expected for the year. The interim financial statements and notes thereto should be read in conjunction with the Company's audited financial statements and notes thereto for the year ended September 30, 2007 included in the Company's Annual Report on Form 10-K.

The Company incurred net losses of $5,377,273 and $2,693,663 in the nine months ended June 30, 2008 and 2007, respectively. Management believes the Company has adequate financial resources to execute its fiscal 2008 and 2009 operating plan and to sustain operations for the next twelve months. Management's operating plan includes (a) growing revenues by focusing on direct sales to larger commercial and defense related companies, (b) improving product margins by reducing unit product costs and monitoring manufacturing overhead, and
(c) controlling research and development and selling, general and administrative costs. Nevertheless, the Company's operating results will depend on future product sales levels and other factors, some of which are beyond the Company's control. There can be no assurance the Company can achieve positive cash flow or profitability. If required, management has some flexibility to take remedial actions to adjust the level of research and development and selling, general and administrative expenses based on the availability of resources. However, the Company operates in a rapidly evolving and often unpredictable business environment that may change the timing or amount of expected future cash receipts and expenditures. Accordingly, there can be no assurance that the Company may not be required to raise additional funds through the sale of equity or debt securities or from credit facilities. Additional capital, if needed, may not be available on satisfactory terms, if at all.

3. RECENT ACCOUNTING PRONOUNCEMENTS

In March 2008, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 161, "Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133" ("SFAS No. 161"). SFAS No. 161 requires enhanced disclosures about an entity's derivative and hedging activities and thereby seeks to improve the transparency of financial reporting. Under SFAS No. 161, entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under SFAS 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity's financial position, financial performance, and cash flows. SFAS No. 161 will be effective for the Company beginning January 1, 2009. Early application is encouraged. SFAS No. 161 also encourages, but does not require, comparative disclosures for earlier periods at initial adoption. The Company is currently in the process of evaluating what impact SFAS No. 161 may have on the disclosures in its consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141(R), "Business Combinations" ("SFAS No. 141R"). SFAS 141R retains the fundamental requirements in SFAS 141 that the acquisition method of accounting (which SFAS 141 called the purchase method ) be used for all business combinations and for an acquirer to be identified for each business combination. SFAS 141R also establishes principles and requirements for how the acquirer: (a) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree; (b) improves the completeness of the information reported about a business combination by changing the requirements for recognizing assets acquired and liabilities assumed arising from contingencies; (c) recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and (d) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS No. 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008 (for acquisitions closed on or after October 1, 2009 for the Company). Early application is not permitted. Since the Company is not contemplating any business combinations after the effective date of SFAS No. 141R, it does not presently expect any impact of SFAS No. 141(R) on its consolidated financial statements.

In December 2007, the FASB issued SFAS No. 160, "Non-controlling Interests in Consolidated Financial Statements" ("SFAS No. 160"). SFAS No. 160 amends ARB 51 to establish accounting and reporting standards for the non-controlling (minority) interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a non-controlling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements and establishes a single method of accounting for changes in a parent's ownership interest in a subsidiary that do not result in deconsolidation. SFAS No. 160 is effective for fiscal years beginning on or after December 15, 2008 (as of October 1, 2009 for the Company). The Company has not yet determined the impact, if any, that SFAS No. 160 will have on its consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" ("SFAS No. 157"). This standard defines fair value, establishes a framework for measuring fair value in accounting principles generally accepted in the United States of America, and expands disclosure about fair value measurements. In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115" ("SFAS No. 159"), which will permit the option of choosing to measure certain eligible items at fair value at specified election dates and report unrealized gains and losses in earnings. SFAS Nos. 157 and 159 will become effective for the Company for fiscal year 2009, and interim periods within that fiscal year. The Company is currently evaluating the requirements of SFAS Nos. 157 and 159, and has not yet determined the likely, if any, impact on future financial statements.

Effective October 1, 2007, the Company adopted FASB Interpretation No. 48 ("FIN 48"), "Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109." See "Note 13-Income Taxes" for further discussion.

4. INVENTORIES

Inventories are stated at the lower of cost, which approximates actual costs on
a first in, first out cost basis, or market. Inventories consisted of the
following:



                                          June 30,        September 30,
                                            2008              2007
             Finished goods             $  1,629,265     $     1,664,914
             Work in process                 102,563                  -
             Raw materials                 3,297,746           3,475,655

                                           5,029,574           5,140,569
             Reserve for obsolescence     (1,303,599 )        (1,337,822 )

             Total, net                 $  3,725,975     $     3,802,747

5. PROPERTY AND EQUIPMENT

Property and equipment consisted of the following:



                                             June 30,        September 30,
                                               2008              2007
          Machinery and equipment          $    556,784     $       477,653
          Office furniture and equipment        906,708             912,248
          Leasehold improvements                260,591             260,591

                                              1,724,083           1,650,492
          Accumulated depreciation           (1,390,586 )        (1,228,465 )

          Property and equipment, net      $    333,497     $       422,027

Included in office furniture and equipment at both June 30, 2008 and September 30, 2007 was $497,049 for purchased software, which is being amortized over three years. The unamortized portion of software at June 30, 2008 and September 30, 2007 was $9,931 and $30,219, respectively.

Depreciation expense, excluding amortization of software, was $167,393 and $207,137 for the nine months ended June 30, 2008 and 2007, respectively. Amortization of purchased software was $20,288 and $68,026 for the nine months ended June 30, 2008 and 2007, respectively.

6. PATENTS

Patents consisted of the following:



                                          June 30,        September 30,
                                            2008              2007
              Cost                       $ 1,705,171     $     1,974,805
              Accumulated amortization      (585,034 )          (611,210 )

              Patents, net               $ 1,120,137     $     1,363,595

Amortization expense for the Company's patents was $93,283 and $98,527 for the nine months ended June 30, 2008 and 2007, respectively.

Each quarter, we review the ongoing value of our capitalized patent costs and in the first three quarters of fiscal 2008 identified some of these assets as being associated with patents that are no longer consistent with our business strategy. As a result of this review, we reduced the value of our previously capitalized patents by $310,347 during the nine months ended June 30, 2008, compared to a reduction of $24,695 from the disposal of patents in the nine months ended June 30, 2007.

7. SHARE-BASED COMPENSATION

Stock Option Plans

At June 30, 2008, the Company had two equity incentive plans. The 2005 Equity Incentive Plan ("2005 Equity Plan"), as amended, authorizes for issuance as stock options, stock appreciation rights, or stock awards an aggregate of 3,250,000 new shares of common stock to employees, directors or consultants. The total plan reserve, including the new shares and shares currently reserved under prior plans, allows for the issuance of up to 4,999,564 shares. At June 30, 2008, there were options outstanding covering 3,103,200 shares of common stock under the 2005 Equity Plan. The 2002 Stock Option Plan ("2002 Plan") reserved for issuance 2,350,000 shares of common stock. The 2002 Plan was terminated with respect to new grants in April 2005 but remains in effect for grants issued prior to that time. At June 30, 2008, there were options outstanding covering 135,500 shares of common stock under the 2002 Plan.

The Company has granted options outside the above plans as inducements to employment to new employees. At June 30, 2008, there were options outstanding covering 32,000 shares of common stock from grants outside the stock option plans. See Note 8 for summary stock option activity during the nine months ended June 30, 2008.

Share-Based Payments

The Company accounts for share-based payments under the provisions of SFAS No. 123(R) "Share-based payments" ("SFAS 123(R)"). Options or stock awards issued to non-employees who are not directors of the Company are recorded at their estimated fair value at the measurement date in accordance with SFAS No. 123(R) and EITF Issue No. 96-18, "Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction with Selling Goods or Services," and are periodically revalued as the options vest and are recognized as expense over the related service period. The Company's employee stock options have various restrictions that reduce option value, including vesting provisions and restrictions on transfer and hedging, among others, and are often exercised prior to their contractual maturity.

The Company recorded $1,669,035 and $912,083 of share-based compensation expense for the nine months ended June 30, 2008 and 2007, respectively. The amounts of share-based compensation expense are classified in the consolidated statements of operations as follows:

                                           Three months ended         Nine months ended
                                                June 30,                  June 30,
                                           2008          2007         2008         2007
   Cost of revenue                       $ (34,774 )   $  20,007   $     4,969   $  54,398
   Selling, general and administrative     366,363       424,541     1,350,718     763,559
   Research and development                193,042        54,196       313,348      94,126

   Total                                 $ 524,631     $ 498,744   $ 1,669,035   $ 912,083

The weighted-average estimated fair value of employee stock options granted during the nine months ended June 30, 2008 and 2007 was $1.00 and $2.06, per share, respectively, using the Black-Scholes option pricing model with the following weighted-average assumptions (annualized percentages):

                                         Nine months ended June 30,
                                            2008             2007
              Volatility                          71 %             71 %
              Risk-free interest rate   2.79% - 3.49 %   4.67% - 4.75 %
              Forfeiture rate                   20.0 %           20.0 %
              Dividend yield                     0.0 %            0.0 %
              Expected life in years       3.4 - 4.9        3.4 - 4.9

The dividend yield of zero is based on the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends. Expected volatility is based on the historical volatility of the Company's common stock over the period commensurate with the expected life of the options. The risk-free interest rate is based on rates published by the Federal Reserve Board. The expected life is based on observed and expected time to post-vesting exercise. The expected forfeiture rate is based on past experience and employee retention data. Forfeitures are estimated at the time of the grant and revised in subsequent periods if actual forfeitures differ from those estimates or if the Company updates its estimated forfeiture rate. Such amounts will be recorded as a cumulative adjustment in the period in which the estimate is changed. The Company recorded a cumulative favorable adjustment of $71,000 for the nine months ended June 30, 2008 based on actual forfeitures compared to prior estimates. We expect the future forfeiture rate to remain at 20%.

Since the Company has a net operating loss carryforward as of June 30, 2008, no excess tax benefit for the tax deductions related to share-based awards was recognized for the nine months ended June 30, 2008 and 2007. Additionally, as there were no options exercised in the nine months ended June 30, 2008 or 2007, there were no incremental tax benefits recognized. Such recognition would have resulted in a reclassification to reduce net cash provided by operating activities with an offsetting increase in net cash provided by financing activities.

As of June 30, 2008, there was $2.2 million of total unrecognized compensation cost related to non-vested share-based employee compensation arrangements. The cost is expected to be recognized over a weighted-average period of 1.5 years.