Summary of AMBIENT CORP /NY

ITEM 7. RESTATED MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION.

Restatement

As discussed in the Explanatory Note to this Amended Filing and in Note 2 to the accompanying restated financial statements, we are amending and restating our audited consolidated financial statements and related disclosures for all periods presented in this Amended Filing. The following discussion and analysis of our financial condition and results of operations incorporates the restated amounts. For this reason, the data set forth in this section may not be comparable to the discussion and data in our previously filed Annual Report on Form 10-K for the fiscal year ended December 31, 2011.

The following discussion should be read in conjunction with our restated financial statements and the notes related to those statements. Some of our discussion is forward-looking and involves risks and uncertainties. For information regarding risk factors that could have a material adverse effect on our business, refer to the "risk factors" section of this Amended Filing.

Overview

We are a leading provider of a smart grid communications platform that enables utilities to effectively deploy, integrate and communicate with multiple devices creating smart grid applications within the electric power grid. Our smart grid communications platform significantly improves the ability of utilities to use advanced technologies to upgrade their electric power grids, effectively making the grids more intelligent.

Company History

We were incorporated in 1996 in the state of Delaware. Through the third quarter of 2008, we were a development stage company. We are focused on the development of a communications platform that meets the needs of utilities, including specifically for the implementation of smart grid applications.

On July 18, 2011, we implemented a reverse stock split of our issued and outstanding shares of common stock at a ratio of 1-for 100 shares (the "Reverse Split"). The Reverse Split became effective on July 18, 2011 and has been reflected in this Amended Filing. On August 3, 2011, our common stock began to trade on the NASDAQ Capital Market under our new ticker symbol "AMBT."

Duke Energy Relationship

Since 2005, we have maintained a strategic relationship with Duke Energy. The utility is actively deploying our communications nodes and is licensing our AmbientNMS® for its deployment in Ohio. We believe that we are the predominant provider of communications nodes and network management system software for Duke Energy's Ohio deployment. With what we believe is one of the most forward-looking smart grid initiatives in North America, Duke Energy has announced plans to invest $1 billion over the next five years in smart grid equipment for its service territories, including Ohio, Indiana, Kentucky and the Carolinas

We believe that we have demonstrated that our technology is secure, two-way, flexible, open, scalable, reliable and cost-effective through the total deployment of approximately 105,000 communications nodes in the field with Duke Energy, and we believe that Duke Energy will continue to predominantly use our communications platform for the remainder of its Ohio smart grid deployment. Furthermore, Duke Energy's pilot deployment of approximately 3,000 communications nodes in the Carolinas predominantly uses our communications platform as well. Throughout the past five years, we have worked with Duke Energy to develop our communications platform, which has enabled Duke Energy's ability to rapidly deploy its smart grid initiatives. Duke Energy has accelerated its historical deployment rates and is presently deploying thousands of our communications nodes each month.

We believe that we have an opportunity to grow our business with Duke Energy. In addition to the 130,000 communications nodes scheduled for deployment in Ohio, we estimate that Duke Energy could potentially require thousands of communications nodes if it implements a full deployment of smart grid communications nodes in Indiana, Kentucky or the Carolinas.

Since we established our relationship with Duke Energy, we have been focused on developing our technology to meet the needs of their smart grid communications platform. Based upon the success of the relationship and our ability to prove our technology, we have recently begun to expand our infrastructure to focus on new business development, marketing and sales programs and further technology development in order to expand our customer base, and we expect to increase investment in our marketing and sales efforts over the next twelve months.

In July 2011, Duke Energy and Progress Energy closed their merger. Together, Duke Energy and Progress Energy have committed to spend a combined $1.5 billion in smart grid initiatives, partially funded by approximately $400 million in total grants awarded to them in 2010 under the ARRA and required to be spent by 2013. If the combined company of Duke Energy and Progress Energy adopts Duke Energy's deployment strategy relating to smart grid initiatives, we believe there could be further opportunity with the combined entity

Revenue History

We have grown total revenue from $2.2 million in 2009 to $20.2 million in 2010 and to $62.1 million in 2011 due to increased sales of our communications nodes to Duke Energy. Our total revenue of $2.2 million in 2009 declined from $12.6 million in 2008 due mainly to the impact of the introduction of the ARRA. Although the ARRA was passed in September 2009, by late 2008 and early 2009, there was widespread speculation that a significant amount of funding would be made available for smart grid related initiatives. As a result, many utilities with smart grid projects underway, including Duke Energy, substantially slowed their spending until there was further clarity regarding the amount of funding available under the federal program. Furthermore, the language of the Smart Grid Investment Grants, which are part of the ARRA, also provided initial guidance regarding certain technical criteria required for grant eligibility. As such, utilities needed further clarity that the technology in their smart grid programs would qualify for funding. As soon as the ARRA was passed in September 2009, sales of our communications nodes to Duke Energy increased significantly as Duke Energy resumed its smart grid implementation in Ohio. Correspondingly, our total revenue realized for the end of 2009 also began to increase. This phenomenon impacted revenue trends across the entire smart grid sector.

Backlog

We define our backlog as products that we are obligated to deliver based on firm commitments relating to purchase orders received from customers, currently solely Duke Energy. As of December 31, 2011, we had backlog of approximately $35 million.

Critical Accounting Policies and Use of Estimates

The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, bad debts, investments, intangible assets and income taxes. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates.

We have identified the accounting policies below as critical to our business operations and the understanding of our results of operations.

Revenue Recognition

Total revenue consists primarily of sales of hardware, software, and maintenance services. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is reasonably assured. Product is considered delivered to the customer once it has been shipped and title and risk of loss have been transferred. For most of the Company's product sales, these criteria are met at the time the product is shipped. The Company records deferred revenue when it receives payments in advance of the delivery of products or the performance of services.

Hardware sales consist of our Ambient Smart Grid® communications nodes are physical boxes that contain the hardware and embedded software needed for communications and data collection in support of smart grid assets. The system software embedded in our communications nodes is used solely in connection with the operation of the physical boxes.

Our proprietary software AmbientNMS® is our smart grid network management system that controls the large numbers of communications nodes, devices and customers on a smart grid. NMS software is offered on a stand-alone basis.

We generally include a period of free maintenance services beginning from the sale of the communication nodes and NMS Software. As such, we recognize a portion of the revenue from the sales of our products upon delivery to the customer. The revenue allocated to the free period of maintenance services is deferred and recognized ratably over the period of performance.

We offer additional software maintenance service, on a fee basis, that entitles the purchasers of our products and AmbientNMS® software to postcontract customer support including help desk support, unspecified updates and upgrades to our products on a when-and-if available basis. Maintenance services are recognized ratably over the period of performance.

The Company recognizes revenue from the sale of (i) hardware products and (ii) software bundled with hardware that is essential to the functionality of the hardware in accordance with revenue recognition for multiple element arrangements. The Company recognizes revenue in accordance with applicable industry specific software accounting guidance for (i) standalone sales of software products, (ii) maintenance renewals, and (iii) sales of software bundled with hardware not essential to the functionality of the hardware.

Revenue Recognition for Arrangements with Multiple Deliverables

In October 2009, the FASB issued ASU No. 2009-13, Multiple-Deliverable Revenue Arrangements, (amendments to ASC Topic 605, Revenue Recognition) (''ASU 2009-13'') (formerly EITF Issue 08-1) and ASU No. 2009-14, Certain Arrangements That Include Software Elements, (amendments to FASB ASC Topic 985, Software) (''ASU 2009-14'') (formerly EITF 09-3). ASU 2009-13 eliminates the residual method and requires arrangement consideration to be allocated using the relative selling price method, which requires entities to allocate revenue in an arrangement using the best estimated selling price ("BESP") of each element when a vendor does not have vendor-specific objective evidence of selling price ("VSOE") or third party evidence of selling price ("TPE"). ASU 2009-14 removes tangible products from the scope of software revenue guidance and provides guidance on determining whether software deliverables in an arrangement that includes a tangible product are within the scope of the software revenue guidance. ASU 2009-13 and ASU 2009-14 are effective for arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. The Company adopted ASU 2009-13 and 2009-14 effective January 1, 2011

We evaluate each deliverable in an arrangement to determine whether it should be accounted for as a separate unit of accounting. The delivered item or items shall be considered a separate unit of accounting if it has standalone value to the customer and there is no customer-negotiated refunds or return rights.

We allocate the total arrangement consideration to each unit of accounting in a multiple-element arrangement based on its relative selling price, and include our bundled hardware and software component as one unit of accounting and the free period of maintenance as a separate unit of accounting. The Company uses a hierarchy to determine the selling price to be used for allocating revenue to each of the deliverables. We determine the selling price for each deliverable using vendor specific objective evidence (VSOE), if it exists or third party evidence (TPE) if VSOE does not exist. If neither VSOE nor TPE of selling price exists for a deliverable, we use our best estimate of selling price (BESP) for that deliverable. Revenue allocated to each element is then recognized when the basic revenue recognition criteria are met for each element.

We determine VSOE of a deliverable based on the price at which we sell the deliverable on a standalone basis to third parties or from the stated renewal rate for the elements contained in the initial arrangement. VSOE has been established for our software maintenance element. When VSOE cannot be established for all deliverables in an arrangement with multiple elements, we attempt to estimate the selling price of each element based on TPE. When we are unable to establish a selling price using VSOE or TPE, we establish the BESP in our allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the product or service were sold on a standalone basis. BESP has been established for our bundled hardware and software portion of the arrangement.

When establishing BESP the Company considers multiple factors including, but not limited to, the relative value of the features and functionality being delivered to the customer, and general pricing practices. Based on our analysis of pricing stated in contractual arrangements for our hardware products in historical multiple-element transactions, we have concluded that we typically price our hardware and embedded software at the contractually agreed upon amounts. Therefore, we have determined that, for our hardware and embedded software for which VSOE or TPE is not available, our BESP is generally comprised of prices based on our contractually agreed upon rates. We have established an annual review process around VSOE, TPE and BESP.

The Company accounts for multiple element arrangements that consist only of software or software-related products, including the sale of maintenance services to previously sold software, in accordance with industry specific software accounting guidance. For such multiple element software transactions, revenue is allocated to each element based on the residual method when VSOE has been established for the undelivered element. If the Company cannot objectively determine the VSOE of any undelivered element included in such multiple-element arrangements, the Company defers revenue until VSOE is established for any remaining undelivered elements, or all elements are delivered and services have been performed.

Inventory Valuation. We value inventory at the lower of cost or market determined on a first-in, first-out basis. Certain factors may impact the net realizable value of our inventory, including technological changes, market demand, new product introductions and significant changes to our cost structure. We make estimates of reserves for obsolescence based on the current product mix on hand and its expected net realizable value. If actual market conditions are less favorable or other factors arise that are significantly different than those anticipated by us, additional inventory write-downs or increases in obsolescence reserves may be required. We consider lower of cost or market adjustments and inventory reserves as an adjustment to the cost basis of the underlying inventory. Accordingly, we do not record favorable changes in market conditions to inventory in subsequent periods.

Software Development Costs. We have historically expensed costs incurred in the research and development of new software products and enhancements to existing software products as incurred. After we establish technological feasibility, we capitalize additional development costs. No software development costs have been capitalized as of December 31, 2010 or 2011.

Stock-Based Compensation. We account for stock-based compensation in accordance with accounting guidance now codified as Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or ASC, 718, "Compensation - Stock Compensation (formerly known as SFAS No. 123(R))." Under the fair value recognition provision of ASC 718, stock-based compensation cost is estimated at the grant date based on the fair value of the award. We estimate the fair value of stock options granted using the Black-Scholes option pricing model. Key input assumptions used to estimate the fair value of stock options include the exercise price of the award, the expected option term, the expected volatility of our stock price over the option's expected term, the risk-free interest rate over the stock option's expected term and the annual dividend yield.

On December 20, 2011, the Compensation Committee of the Board of Directors approved grants of options to purchase 960,000 shares of our common stock under the Company's 2000 Equity Incentive Plan to senior officers. Options as to one third of such shares vested upon grant at a per share exercise price of $6.30. Options as to the balance of such shares are scheduled to vest on a quarterly basis, in eight equal quarterly installments at the end of each quarter, beginning with the quarter ending March 31, 2013, with half of the option grants exercisable at a per share exercise price of $6.75 and the remaining half at $7.25. In addition, options to purchase 394,000 shares of our common stock were granted to the Board of Directors and Advisory Board members which immediately vested as well. As a result of the immediate vesting of a portion of the options granted to senior executives and the options granted to the Board of Directors and Advisory Board members, we recorded a stock based compensation charge of approximately $1.9 million during the fourth quarter of 2011.

Fair Value of Embedded Derivatives and Warrants. Embedded Derivatives and Warrants are recorded as liabilities at their estimated fair value at the date of issuance, with subsequent changes in estimated fair value recorded in other income (expense) in the statement of operations in each subsequent period.

Fair value of the Warrants is determined by management using a multiple scenario, probability-weighted option-pricing model using the following inputs:
the fair value of the underlying common stock at the valuation measurement date; the risk-free interest rates; the expected dividend rates; the remaining contractual terms of the warrants; the expected volatility of the price of the underlying common stock; and the probability of certain events occurring.

The fair value of Embedded Derivatives is determined by management using a Monte Carlo simulation analysis taking into account various inputs including the fair value of the underlying common stock at the valuation measurement date; the risk-free interest rates; the expected dividend rates; credit-risk spreads; time to maturity; the expected volatility of the price of the underlying common stock; and the probability of various events or other options occurring.

The assumptions used in calculating the estimated fair value of the Embedded Derivatives and Warrants represent our best estimates; however, these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and different assumptions are used, the Embedded Derivative and Warrant liabilities and the change in their estimated fair values could be materially different.

Debt Discount and Amortization of Debt Discount. Debt discount represents the fair value of Embedded Derivatives and Warrants. Debt discount is amortized over the term of the debt using the effective interest method where applicable. The amortization of debt discount is included as a component of other income (expense) in the accompanying statements of operations. Upon conversion of the Notes, the unamortized discount is recognized as part of the debt extinguishment gain or loss.

Deferred Income Taxes. We recognize deferred income taxes for the tax consequences of "temporary differences" by applying enacted statutory rates applicable to future years to differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities. At December 31, 2011, our deferred income tax assets consisted primarily of net operating loss carryforwards and stock-based compensation charges that have been fully offset with a valuation allowance due to the uncertainty that a tax benefit will be realized from the assets in the future. At December 31, 2011, we had available approximately $68.3 million of net operating loss carryforwards, for U.S. income tax purposes which expire in the years 2016 through 2030. However, due to changes in stock ownership resulting from historical investments, the use of the U.S. net operating loss carryforwards are significantly limited under Section 382 of the Internal Revenue Code. As such, approximately $61.4 million of our net operating loss carryforwards will expire and will not be available to use against future tax liabilities.

Warranties. We account for our warranties under the FASB ASC 450, "Contingencies." Our current standard product warranty includes a one-year warranty period for defects in material and workmanship. Due to the limited deployment of products, we had not historically accrued for the cost of warranty obligations and expensed any costs associated with repairing or replacing defective product as incurred. However, due to significantly increased sales volume during 2011, we began accruing a liability of approximately 0.2% of current communications node revenues for the estimated future costs of meeting our warranty obligation, based on our actual historical return rate of products within the one-year warranty period. We make and revise this estimate based on the number of communications nodes delivered and our historical experience with warranty claims. We continually monitor the rate of actual product returns and the quality of our products including the quality of the products produced by our U.S.-based contract manufacturer in China.

We engage in product quality programs and processes, including monitoring and evaluating the quality of component suppliers, in an effort to ensure the quality of our products and reduce our warranty exposure. The warranty obligation will be affected not only by product failure rates, but also the costs to repair or replace failed products and potential service and delivery costs incurred in correcting a product failure. If our actual product failure rates, repair or replacement costs, or service or delivery costs differ from these estimates, accrued warranty costs would be adjusted in the period that such events or costs become known.

Our software license agreements generally include provisions for indemnifying customers against liabilities if our software infringes upon a third party's intellectual property rights. We have not provided for any reserves for such warranty liabilities. Our software license agreements also generally include a warranty that our software will substantially operate as described in the applicable program documentation. We also warrant that we will perform services in a manner consistent with industry standards. To date, we have not incurred any material costs associated with these product and service performance warranties, and as such we have not provided for any reserves for any such warranty liabilities in our operating results.

RESULTS OF OPERATIONS

Comparison of the Year Ended December 31, 2011 and the Year Ended December 31, 2010

Total Revenue. Total revenue for 2011 was $62.1 million compared to $20.2 million in 2010, representing an increase of approximately 207%. The increase in total revenue for 2011 compared with 2010 primarily reflected an increase in sales volume of our communications nodes delivered as part of Duke Energy's Ohio smart grid initiative.

Costs of Goods Sold. Cost of goods sold for 2011 was $35.3 million compared to $12.0 million in 2010. The increase in cost of goods sold during 2011 primarily reflected an increase in sales volume to Duke Energy. Cost of goods sold includes all costs related to the manufacture of our products by our contract manufacturer, accruals for warranty and other overhead costs. Our contract manufacturer is responsible for substantially all aspects of manufacturing, including procuring most of the key components required for assembly. Included in cost of goods sold in 2011 was approximately $250,000 of stock-based compensation relating to immediately vesting stock options granted to certain employees.

Gross Profit. Gross profit for 2011 was $26.8 million compared to $8.2 million in 2010, an increase of approximately 227%. Gross margin for 2011 increased slightly to approximately 43% compared to approximately 41% for 2010. The increase in the gross margin for 2011 compared with 2010 was due to lower manufacturing costs resulting from increased volumes at our contract manufacturer and increased efforts in overall cost reduction programs.

Research and Development Expenses. Research and development expenses were approximately $11.7 million for 2011 compared to approximately $6.2 million in 2010. The increase in research and development during 2011 was primarily due to increased personnel and consultant expenses required for the continued development of our communications nodes, enhancements of our AmbientNMS®, and other product development efforts. In addition, included in research and development expenses in 2011 was approximately $341,000 of stock-based compensation relating to immediately vesting stock options granted to certain employees. We believe that our continued development efforts are critical to our strategic objectives of enhancing our technology while simultaneously reducing costs. We expect that our research and development expenses will increase in 2012 as we continue to develop and improve our communications platform.

Selling, General and Administrative Expenses. Selling, general and administrative expenses for 2011 were approximately $8.2 million compared to $5.1 million for 2010. The increase in selling, general and administrative expenses for 2011 compared with 2010 was due to an increase in personnel and related costs, increased efforts to market and commercialize our communications platform and increased costs associated with additional administrative personnel. In addition, included in selling, general and administrative expenses in 2011 was approximately $1.3 million of stock-based compensation relating to immediately vesting stock options granted to certain employees and the Board of Directors. Selling, general and administrative expenses consisted primarily of salaries and other related costs for personnel in executive and other administrative functions. Other significant costs included professional fees for legal, accounting and other services. In 2012, we expect our selling, general and administrative expenses to increase as we continue to increase our efforts to market and commercialize our communication platform.

Interest Income and Expense. Net interest income for 2011 was approximately $19,000 compared to net interest expense of approximately $30,000 in 2010. Interest expense in 2010 related primarily to our Notes, which were converted to common stock in January 2010.

Mark-to-Market Adjustment of Embedded Derivatives and Warrants. We recorded a non-cash gain of approximately $5.4 million representing the change in fair value of Embedded Derivatives immediately prior to their conversion during January 2010. In addition, we recorded a non-cash gain of approximately $2.7 million associated with the change in fair value of the Warrants for the year ended December 31, 2010.

As a result of the conversion of all the Notes in 2010, there was no impact . . .