U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

x  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2009

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the transition period from __________ to __________.

Commission file number 001-31972

TELKONET, INC. 

(Exact Name of Registrant as Specified in Its Charter)

Utah
87-0627421
 (State or Other Jurisdiction of Incorporation or Organization)
 (I.R.S. Employer Identification No.)
   
20374 Seneca Meadows Parkway, Germantown, MD
20876
(Address of Principal Executive Offices)
(Zip Code)


(240) 912-1800
(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o   No ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

Large accelerated filer o
  
Accelerated filer o
     
Non-accelerated filer o
  
Smaller reporting company x
(Do not check if a smaller reporting company)
    

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

Indicate the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: 96,563,771 shares of Common Stock ($.001 par value) as of November 14, 2009.
 

 
 
 
 
 
TELKONET, INC.
FORM 10-Q for the Quarter Ended September 30, 2009

Index

 
Page
   
PART I. FINANCIAL INFORMATION
3
   
Item 1. Financial Statements (Unaudited)
3
   
Condensed Consolidated Balance Sheets:
September 30, 2009 and December 31, 2008
3
   
Condensed Consolidated Statements of Operations and Comprehensive Income (Loss):
Three And Nine Months Ended September 30, 2009 and 2008
 4
   
Condensed Consolidated Statement of Equity:
January 1, 2009 through September 30, 2009
 5
   
Condensed Consolidated Statements of Cash Flows:
Nine Months Ended September 30, 2009 and 2008
 6
   
Notes to Unaudited Condensed Consolidated Financial Statements:
September 30, 2009
 8
   
Item 2. Management’s Discussion and Analysis
 24
   
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
 35
   
Item 4. Controls and Procedures
 35
   
PART II. OTHER INFORMATION
 36
   
Item 1. Legal Proceedings
 36
   
Item 1A. Risk Factors
 36
   
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
 37
   
Item 3. Defaults Upon Senior Securities
 37
   
Item 4. Submission of Matters to a Vote of Security Holders
 37
   
Item 5. Other Information
 37
   
Item 6. Exhibits
 38
 

 
2
 

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

TELKONET, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
 
 
(Unaudited)
September 30,
    
December 31,
  
ASSETS
2009
    
2008
  
Current assets:
          
Cash and cash equivalents
  
$
38,449
    
$
168,492
  
Accounts receivable, net
    
687,056
      
836,336
  
Inventories
    
1,286,296
      
1,733,940
  
Other current assets
    
195,204
      
230,539
  
Current assets from discontinued operations
    
-
      
476,459
  
Total current assets
    
2,207,005
      
3,445,766
  
                 
Property and equipment, net
    
290,924
      
403,593
  
                 
Other assets:
                
Marketable securities
    
-
      
397,403
  
Deferred financing costs, net
    
287,178
      
432,136
  
Goodwill and other intangible assets, net
    
14,956,212
      
15,137,469
  
Other assets
    
8,890
      
98,807
  
Other assets from discontinued operations
    
-
      
6,593,169
  
Total other assets
    
15,252,280
      
22,658,984
  
                 
Total Assets
  
$
17,750,209
    
$
26,508,343
  
         
 
LIABILITIES AND EQUITY
        
Current liabilities:
                
Accounts payable and accrued liabilities
  
$
3,148,184
    
$
2,561,213
  
Accrued liabilities and expenses
    
1,968,910
      
1,996,044
  
Line of credit
    
449,741
      
574,005
  
Other current liabilities
    
141,059
      
278,033
  
Current Liabilities from discontinued operations
    
-
      
13,450,362
  
Total current liabilities
    
5,707,894
      
18,859,657
  
                 
Long-term liabilities:
                
Convertible debentures, net of debt discounts of $538,305 and $825,585, respectively
    
1,067,718
      
1,311,065
  
Derivative liability
    
1,870,113
      
2,573,126
  
Note payable
    
300,000
      
-
  
Deferred lease liability and other
    
50,791
      
50,791
  
Total long-term liabilities
    
3,288,622
      
3,934,982
  
                 
Commitments and contingencies
    
-
      
-
  
                 
Equity
                
Preferred stock, par value $.001 per share; 15,000,000 shares authorized; none issued and outstanding at September 30, 2009 and December 31, 2008
    
-
      
-
  
Common stock, par value $.001 per share; 155,000,000 shares authorized; 96,563,771 and 87,525,495  shares issued and outstanding at September 30, 2009 and December 31, 2008, respectively
    
96,564
      
87,526
  
Additional paid-in-capital
    
119,296,304
      
118,197,450
  
Accumulated deficit
    
(110,639,175
)
    
(114,801,318
)
Accumulated comprehensive loss
    
-
      
(32,750
) 
        Total stockholders’ equity
    
8,753,693
      
3,450,908
  
Non-controlling interest
    
-
      
262,795
  
Total equity
    
8,753,693
      
3,713,703
  
                 
Total Liabilities and Equity
  
$
17,750,209
    
$
26,508,343
  
 
See accompanying notes to the unaudited condensed consolidated financial statements
 
3
 
TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)

   
For The Three Months Ended
September 30,
    
For The Nine Months Ended
September 30,
  
   
2009
    
2008
    
2009
    
2008
  
Revenues, net:
                        
Product
  
$
1,445,888
    
$
3,837,728
    
$
5,462,955
    
$
10,821,179
  
Recurring
    
991,130
      
897,482
      
2,982,384
      
2,559,728
  
Total Revenue
    
2,437,018
      
4,735,210
      
8,445,339
      
13,380,907
  
                                 
Cost of Sales:
                                
Product
    
833,926
      
2,076,776
      
2,942,748
      
6,800,627
  
Recurring
    
348,321
      
416,723
      
957,668
      
1,274,786
  
Total Cost of Sales
    
1,182,247
      
2,493,499
      
3,900,416
      
8,075,413
  
                                 
Gross Profit
    
1,254,771
      
2,241,711
      
4,544,923
      
5,305,494
  
                                 
Operating Expenses:
                                
Research and Development
    
263,672
      
509,418
      
761,950
      
1,667,229
  
Selling, General and Administrative
    
1,732,053
      
2,123,035
      
5,089,221
      
7,268,375
  
Impairment write-down in investment in affiliate
    
-
      
-
      
-
      
380,000
  
Stock Based Compensation
    
65,746
      
194,483
      
243,366
      
704,613
  
Depreciation and Amortization
    
86,223
      
103,056
      
266,740
      
318,210
  
Total Operating Expense
    
2,147,694
      
2,929,992
      
6,361,277
      
10,338,427
  
                                 
Loss from Operations
    
(892,923
)
    
(688,281
)
    
(1,816,354
)
    
(5,032,933
)
                                 
Other Income (Expenses):
                                
Financing Expense, net
    
(228,730
)
    
(243,424
)
    
(710,266
)
    
(2,191,431
)
Gain (Loss) on Derivative Liability
    
(650,338
)
    
(576,156
)
    
788,936
      
(1,594,609
)
Impairment of Investment in Marketable Securities
    
(367,653
)
    
-
      
(367,653
)
    
-
  
(Loss) on Sale of Investment
    
-
      
-
      
(29,371
)
    
-
  
Total Other Income (Expenses)
    
(1,246,721
) 
    
(819,580
)
    
(318,354
)
    
(3,786,040
) 
                                 
Income (Loss) Before Provision for Income Taxes
    
(2,139,644
) 
    
(1,507,861
)
    
(2,134,708
)
    
(8,818,973
)
Provision for Income Taxes
    
-
      
-
      
-
      
-
  
                                 
Income (Loss) from Continuing Operations
  
$
(2,139,644
) 
  
$
(1,507,861
)
  
$
(2,134,708
)
  
$
(8,818,973
)
                                 
Discontinued Operations
                                
Income (Loss) from Discontinued Operations
    
-
      
(1,370,896
)
    
(635,735
)
    
(3,412,656
)
Gain on Deconsolidation
    
-
      
-
      
6,932,586
      
-
  
                                 
Net Income (Loss)
  
$
(2,139,644
) 
  
$
(2,878,757
) 
  
$
4,162,143
    
$
(12,231,629
) 
                                 
Net income (loss) per share:
                                
Income (loss) per share from continuing operations - basic
  
$
(0.02
)
  
$
(0.04
)
  
$
(0.02
)
  
$
(0.16
)
Income (loss) per share from continuing operations - diluted
  
$
(0.02
) 
  
$
(0.04
)
  
$
(0.02
)
  
$
(0.16
)
Income (loss) per share from discontinued operations – basic
  
$
0.00
    
$
(0.02
)
  
$
0.07
    
$
(0.04
)
Income (loss) per share from discontinued operations – diluted
  
$
0.00
    
$
(0.02
)
  
$
0.07
    
$
(0.04
)
Net income (loss) per share – basic
  
$
(0.02
)
  
$
(0.04
)
  
$
0.04
    
$
(0.16
)
Net income (loss) per share - diluted
  
$
(0.02
) 
  
$
(0.04
)
  
$
0.04
    
$
(0.16
)
                                 
Weighted Average Common Shares Outstanding - basic
    
96,220,386
      
81,422,404
      
93,787,069
      
76,880,047
  
Weighted Average Common Shares Outstanding - diluted
    
96,220,386
      
81,422,404
      
93,787,069
      
76,880,047
  
                                 
Comprehensive Income (Loss): 
                                
Net Income (Loss) 
  
$ 
(2,139,644
) 
  
$ 
(2,878,757
) 
  
$ 
4,162,143
    
$ 
(12,231,629
) 
Unrecognized Gain (Loss) on Investment 
    
-
      
(1,218,100
) 
    
32,750
      
(2,776,304
) 
                                 
Comprehensive Income (Loss)
  
$ 
(2,139,644
) 
  
$ 
(4,096,857
) 
  
$ 
4,194,893
    
$ 
(15,007,933
) 
 
See accompanying notes to the unaudited condensed consolidated financial statements
 
4
 


TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENT OF EQUITY (UNAUDITED)
FOR THE PERIOD FROM JANUARY 1, 2009 THROUGH SEPTEMBER 30, 2009
 
   
Preferred Shares
    
Preferred
 Stock
Amount
    
Common
 Shares
    
Common
Stock
Amount
    
Additional
 Paid in
Capital
    
Accumulated Deficit
    
Comprehensive Income (Loss)
    
Noncontrolling Interest
    
Total
  
Balance at January 1, 2009
                
87,525,495
    
$
87,526
    
$
118,197,450
    
$
(114,801,318
)
  
$
(32,750
)
  
$
262,795
    
$
3,713,703
  
                                                                     
Shares issued in exchange for services rendered at approximately $0.12 per share
    
-
      
-
      
83,333
      
83
      
9,917
      
-
      
-
      
-
      
10,000
  
                                                                         
Shares issued for warrants exercised at $0.09 per share
    
-
      
-
      
780,000
      
780
      
70,746
      
-
      
-
      
-
      
71,526
  
                                                                         
Shares issued in exchange for convertible debentures
    
-
      
-
      
8,174,943
      
8,175
      
714,339
      
-
      
-
      
-
      
722,514
  
                                                                         
Stock-based compensation expense related to employee stock options
    
-
      
-
      
-
      
-
      
233,366
      
-
      
-
              
233,366
  
                                                                         
Stock-based compensation expense related to the re-pricing of investor warrants
    
-
      
-
      
-
      
-
      
70,486
      
-
      
-
      
-
      
70,486
  
                                                                         
Unrealized Gain on available for sale securities
    
-
      
-
      
-
      
-
      
-
      
-
      
32,750
      
-
      
32,750
  
                                                                         
Reclass of non-controlling interest
    
-
      
-
      
-
      
-
      
-
      
-
      
-
      
(262,795
) 
    
(262,795
) 
                                                                         
Income from discontinued operations
    
-
      
-
      
-
      
-
      
-
      
6,296,851
      
-
      
-
      
6,296,851
  
                                                                         
Income from continuing operations
  
-
    
-
      
-
    
-
      
-
      
(2,134,708
) 
    
-
    
-
    
(2,134,708
) 
                                                                         
Balance at September 30, 2009
  
-
    
$  -
    
96,563,771
    
$
96,564
    
$
119,296,304
    
$
(110,639,175
)
  
$
-
    
$
-
    
$
8,753,693
  

See accompanying notes to the unaudited condensed consolidated financial statements 

 
5
 

TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

   
For the Nine Months
Ended September 30,
  
   
2009
    
2008
  
Increase (Decrease) In Cash and Equivalents
            
Cash Flows from Operating Activities:
            
Net income (loss) attributable to common shareholders
  
$
4,162,143
    
$
(12,231,639
)
Net (income) loss from discontinued operations
    
(6,296,851
)
    
3,082,656
  
Net income (loss) from continuing operations
    
(2,134,708
) 
    
(9,148,983
)
                 
Adjustments to reconcile net income (loss) from operations to cash  (used in) operating activities:
                
Amortization of debt discounts and financing costs
    
543,161
      
364,374
  
Loss on sale of investment
    
29,371
      
-
  
Impairment of investment in marketable securities
    
367,653
          
(Gain) loss on derivative liability
    
(788,936
) 
    
1,594,609
  
Impairment write-down on fixed assets and goodwill
    
-
      
710,000
  
Stock based compensation
    
243,366
      
704,613
  
Fair value of issuance of warrants and re-pricing  (financing expense)
    
70,486
      
1,798,662
  
Depreciation and amortization
    
266,740
      
350,163
  
                 
Increase / decrease in:
                
Accounts receivable, trade and other
    
766,598
      
455,162
  
Inventories
    
447,644
      
572,088
  
Prepaid expenses and deposits
    
117,019
      
345,520
  
Deferred revenue
    
(20,536
) 
    
(28,008
) 
Other Assets
    
(62,595
) 
    
157,654
  
Accounts payable, net
    
(90,088
)
    
(803,822
)
Accrued expenses, net
    
172,319
      
(305,398
) 
Cash used in continuing operations
    
(72,506
) 
    
(3,233,366
)
Cash used in discontinued operations
    
(287,997
)
    
(861,542
)
Net Cash Used In Operating Activities
    
(360,503
)
    
(4,094,908
)
                 
Cash Flows From Investing Activities:
                
Purchase of property and equipment
    
(2,675
)
    
(14,375
)
Advances to unconsolidated subsidiary
    
(305,539
)
    
-
  
Proceeds from sale of investment
    
33,129
      
-
  
Cash used in continuing operations
    
(275,085
)
    
(14,375
)
Cash used in discontinued operations
    
(5,979
)
    
(994,344
)
Net Cash Used In Investing Activities
    
(281,064
) 
    
(1,008,719
) 
                 
Cash Flows From Financing Activities:
                
Proceeds from issuance of convertible debentures
    
-
      
3,500,000
  
Proceeds from sale of common stock, net of costs and fees
    
-
      
1,500,000
  
Proceeds from issuance of notes payable
    
300,000
      
60,000
  
Proceeds (repayments) from line of credit
    
(124,264
) 
    
475,000
  
Financing fees
    
(25,000
)
    
 (462,566
) 
Repayment of notes payable
    
-
      
(1,500,000
) 
Proceeds from the exercise of warrants
    
71,526
      
-
  
Repayment of capital lease and other
    
(4,714
) 
    
(4,625
) 
Cash provided by continuing operations
    
217,548
      
3,567,809
  
Cash provided by discontinued operations
    
293,976
      
56,228
  
Net Cash Provided By Financing Activities
    
511,524
      
3,624,037
  
                 
Net Decrease In Cash and Equivalents
    
(130,043
)
    
(1,479,590
)
Cash and cash equivalents at the beginning of the period
    
168,492
      
1,629,583
  
Cash and cash equivalents at the end of the period
  
$
38,449
    
$
149,993
  



 
6
 


TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(UNAUDITED)

 
For the Nine Months Ended
September 30,
  
 
2009
  
2008
  
Supplemental Disclosures of Cash Flow Information:
        
         
Cash transactions:
        
Cash paid during the period for financing expenses
  
$
355,340
    
$
257,403
  
Income taxes paid
    
-
      
-
  
Non-cash transactions:
                
Stock based compensation to employees and consultants in exchange for services
  
$ 
243,366
    
 $
704,613
  
Fair value of issuance of warrants and re-pricing  (financing expense)
    
70,486
      
1,798,662
  
(Gain) loss on derivative liability
    
(788,936
 )
    
1,594,609
  
Impairment write-down on goodwill and fixed assets
    
-
      
710,000
  
Amortization of debt discount on convertible debentures and financing costs
    
543,161
      
364,374
  
Accrued interest re classified as convertible debenture principal
    
191,887
      
-
  
Value of common stock issued in exchange for conversion of debenture principal
    
722,514
      
710,000
  
 
 

 
See accompanying notes to the unaudited condensed consolidated financial statements


 
7
 
 
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2009
(UNAUDITED)
 
NOTE A-SUMMARY OF ACCOUNTING POLICIES

A summary of the significant accounting policies applied in the preparation of the accompanying consolidated financial statements follows.

Business and Basis of Presentation

Telkonet, Inc., formed in 1999 and incorporated under the laws of the state of Utah, has evolved into a Clean Technology company that develops and manufactures proprietary energy efficiency and SmartGrid networking technology.  Prior to January 1, 2007, the Company was primarily engaged in the business of developing, producing and marketing proprietary equipment enabling the transmission of voice and data communications over a building’s existing internal electrical wiring.

In January 2006, of the Company acquired 90% of Microwave Satellite Technologies, Inc. (MST), and through this subsidiary, the Company began offering complete sales, installation, and service of VSAT and business television networks, and became a full-service national Internet Service Provider (ISP).  In 2009, the Company completed the deconsolidation of MST by reducing its ownership percentage and board membership.  Financial statements and accompanying notes included in this report include disclosure of the results of operations for MST, for all periods presented, as discontinued operations.  

In March 2007, the Company acquired substantially all of the assets of Smart Systems International (SSI), a leading provider of energy management products and solutions to customers in the United States and Canada.

In March 2007, the Company acquired 100% of the outstanding membership units of EthoStream, LLC, a network solutions integration company that offers installation, sales and service to the hospitality industry.  The EthoStream acquisition enables Telkonet to provide installation and support for PLC products and third party applications to customers across North America.

The unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Telkonet Communications, Inc. and EthoStream, LLC.  Significant intercompany transactions have been eliminated in consolidation.

Going Concern

The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplate continuation of the Company as a going concern.  The Company has reported a net income available to common shareholders of $4,162,143 for the nine months ended September 30, 2009.  However, the Company has reported operating losses of $1,816,354, excluding gains on derivative liabilities, impairment of marketable securities and discontinued operations, for the nine months ended September 30, 2009.  In addition, the Company has reported an accumulated deficit of $110,639,175 and a working capital deficit of $3,500,889 as of September 30, 2009.

The Company believes that anticipated revenues from operations will be insufficient to satisfy its ongoing capital requirements for at least the next 12 months.  If the Company’s financial resources from operations are insufficient, the Company will require additional financing in order to execute its operating plan and continue as a going concern.  The Company cannot predict whether this additional financing will be in the form of equity or debt, or be in another form.  The Company may not be able to obtain the necessary additional capital on a timely basis, on acceptable terms, or at all.  In any of these events, the Company may be unable to implement its current plans for expansion, repay its debt obligations as they become due, or respond to competitive pressures, any of which circumstances would have a material adverse effect on its business, prospects, financial condition and results of operations.
 
Management intends to raise capital through asset-based financing and/or the sale of its stock in private placements.  Management believes that with this financing, the Company will be able to generate additional revenues that will allow the Company to continue as a going concern.  There can be no assurance that the Company will be successful in obtaining additional funding.

 
 
8
 

TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2009
(UNAUDITED)

 
Goodwill and Other Intangibles

Goodwill represents the excess of the cost of businesses acquired over fair value or net identifiable assets at the date of acquisition.  Goodwill is subject to a periodic impairment assessment by applying a fair value test based upon a two-step method.  The first step of the process compares the fair value of the reporting unit with the carrying value of the reporting unit, including any goodwill.  The Company utilizes a discounted cash flow valuation methodology to determine the fair value of the reporting unit.  If the fair value of the reporting unit exceeds the carrying amount of the reporting unit, goodwill is deemed not to be impaired in which case the second step in the process is unnecessary.  If the carrying amount exceeds fair value, the Company performs the second step to measure the amount of impairment loss.  Any impairment loss is measured by comparing the implied fair value of goodwill, calculated per SFAS No. 142, with the carrying amount of goodwill at the reporting unit, with the excess of the carrying amount over the fair value recognized as an impairment loss.

Fair Value of Financial Instruments
 
In January 2008, the Company adopted the provisions under FASB for Fair Value Measurements, which define fair value for accounting purposes, establishes a framework for measuring fair value and expands disclosure requirements regarding fair value measurements.  The Company’s adoption of these provisions did not have a material impact on its consolidated financial statements. Fair value is defined as an exit price, which is the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date.  The degree of judgment utilized in measuring the fair value of assets and liabilities generally correlates to the level of pricing observability.  Financial assets and liabilities with readily available, actively quoted prices or for which fair value can be measured from actively quoted prices in active markets generally have more pricing observability and require less judgment in measuring fair value.  Conversely, financial assets and liabilities that are rarely traded or not quoted have less price observability and are generally measured at fair value using valuation models that require more judgment.  These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency of the asset, liability or market and the nature of the asset or liability.  The Company has categorized its financial assets and liabilities measured at fair value into a three-level hierarchy in accordance with these provisions.
 
Investments

Telkonet maintained investments in two publicly-traded companies for the period ended September 30, 2009.  The Company has classified these securities as available for sale.  Such securities are carried at fair market value.  Unrealized gains and losses on these securities, if any, are reported as accumulated other comprehensive income (loss), which is a separate component of stockholders’ equity.  Unrealized gains on the sale of one investment resulted in a gain of $32,750 recorded for the nine months ended September 30, 2009 and unrealized losses of $2,776,304 were recorded for the nine months ended September 30, 2008.  Realized gains and losses and declines in value judged to be other than temporary on securities available for sale, if any, are included in operations.   Realized losses of $397,024 were recognized for the nine months ended September 30, 2009, of which, a $29,371 loss was recorded in February 2009 for the sale of the Company’s investment in Multiband, and a $367,653 loss was recorded in September 2009 for the write-off of the Company’s remaining investment in Geeks on Call America, Inc.  There were no realized gains or losses for the nine months ended September 30, 2008.

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect certain reported amounts and disclosures.  Accordingly, actual results could differ from those estimates.
 
 
9
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2009
(UNAUDITED)
 
Revenue Recognition

For revenue from product sales, the Company recognizes revenue in accordance with FASB’s Accounting Standards Codification (“ASC”) 605-10, and ASC Topic 13 guidelines that require that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the selling price is fixed and determinable; and (4) collectibility is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the selling prices of the products delivered and the collectibility of those amounts. Provisions for discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period the related sales are recorded.  The Company defers any revenue for which the product has not been delivered or is subject to refund until such time that the Company and the customer jointly determine that the product has been delivered or no refund will be required.  The guidelines also address the accounting for arrangements that may involve the delivery or performance of multiple products, services and/or rights to use assets.

For equipment under lease, revenue is recognized over the lease term for operating lease and rental contracts. All of the Company’s leases are accounted for as operating leases.  At the inception of the lease, no lease revenue is recognized and the leased equipment and installation costs are capitalized and appear on the balance sheet as “Equipment Under Operating Leases.”  The capitalized cost of this equipment is depreciated from two to three years, on a straight-line basis down to the Company’s original estimate of the projected value of the equipment at the end of the scheduled lease term. Monthly lease payments are recognized as rental income.
     
Revenue from sales-type leases for EthoStream products is recognized at the time of lessee acceptance, which follows installation.  The Company recognizes revenue from sales-type leases at the net present value of future lease payments. Revenue from operating leases is recognized ratably over the lease period

Reclassifications

Certain reclassifications have been made in prior year's financial statements to conform to classifications used in the current year.

Non-controlling Interest

As a result of adopting FASB ASC 810-10 Consolidations – Variable Interest Entities, on January 1, 2009, we present non-controlling interests (previously shown as minority interest) as a component of equity on our Consolidated Balance Sheets and Consolidated Statement of Equity (Deficit).  The adoption of this guidance did not have any other material impact on our financial position, results of operations or cash flow.
 
New Accounting Pronouncements

Accounting Standards Codification and GAAP Hierarchy — Effective for interim and annual periods ending after September 15, 2009, the Accounting Standards Codification and related disclosure requirements issued by the FASB became the single official source of authoritative, nongovernmental GAAP. The ASC simplifies GAAP, without change, by consolidating the numerous, predecessor accounting standards and requirements into logically organized topics. All other literature not included in the ASC is non-authoritative. We adopted the ASC as of September 30, 2009, which did not have any impact on our results of operations, financial condition or cash flows as it does not represent new accounting literature or requirements.   All references to pre-codified U.S. GAAP have been removed from this Form 10-Q.

Financial Instruments — Effective for interim and annual periods ending after June 15, 2009, GAAP established new disclosure requirements for the fair value of financial instruments in both interim and annual financial statements. Previously, the disclosure was only required annually. We adopted the new requirements as of July 4, 2009, which resulted in no change to our accounting policies, and had no effect on our results of operations, cash flows or financial position, but did result in the addition of interim disclosure of the fair values of our financial instruments.
 
 
10
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2009
(UNAUDITED)
 
Consolidation — Effective for interim and annual periods beginning after November 15, 2009, with earlier application prohibited, GAAP amends the current accounting standards for determining which enterprise has a controlling financial interest in a VIE and amends guidance for determining whether an entity is a VIE. The new standards will also add reconsideration events for determining whether an entity is a VIE and will require ongoing reassessment of which entity is determined to be the VIE’s primary beneficiary as well as enhanced disclosures about the enterprise’s involvement with a VIE. We are currently assessing the future impact these new standards will have on our results of operations, financial position or cash flows.

Transfers and Servicing – Effective for interim and annual periods beginning after November 15, 2009, GAAP eliminates the concept of a qualifying special purpose entity, changes the requirements for derecognizing financial assets and requires additional disclosures. We are currently assessing the future impact these new standards will have on our results of operations, financial position or cash flows.
 
NOTE B- INTANGIBLE ASSETS AND GOODWILL

Total identifiable intangible assets acquired and their carrying values at December 31, 2008 are:

   
Gross
Carrying
Amount
    
Accumulated Amortization
    
Net
    
Residual
Value
    
Weighted
Average
Amortization
Period (Years)
  
Amortized Identifiable Intangible Assets:
                              
Subscriber lists - EthoStream
  
$
2,900,000
    
$
(432,986
)
  
$
2,467,014
    
$
-
      
12.0
  
Total Amortized Identifiable Intangible Assets
    
2,900,000
      
(432,986
)
    
2,467,014
      
-
      
9.6
  
Goodwill - EthoStream
  
8,796,439
      
(2,000,000
)
    
6,796,439
      
-
          
Goodwill - SSI
  
5,874,016
      
-
      
5,874,016
      
   -
          
Total
  
$
17,570,455
    
$
(2,432,985
)
  
$
15,137,469
    
$
-
          

Total identifiable intangible assets acquired and their carrying values at September 30, 2009 are:
 
   
Gross
Carrying
Amount
    
Accumulated Amortization
    
Net
    
Residual
Value
    
  Weighted
Average
Amortization Period (Years)
Amortized Identifiable Intangible Assets:
                                    
Subscriber lists - EthoStream
  
$
2,900,000
    
$
(614,243
)
  
$
2,285,757
    
$
-
    
   
12.0
Total Amortized Identifiable Intangible Assets
    
2,900,000
      
(614,243
)
    
2,285,757
      
-
    
   
12.0
Goodwill - EthoStream
    
8,796,439
      
(2,000,000
)
    
6,796,439
      
-
        
Goodwill - SSI
    
5,874,016
      
-
      
5,874,016
      
  -
        
Total
  
$
17,570,455
    
$
(2,614,243
)
  
$
14,956,212
    
$
-
        
 
Total amortization expense charged to operations for the three and nine months ended September 30, 2009 and 2008 was $60,424 and $181,257, and $60,417 and $120,833, respectively.
 
 
11
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2009
(UNAUDITED)
 
NOTE C – ACCOUNTS RECEIVABLE

Components of accounts receivable as of September 30, 2009 and December 31, 2008 are as follows:

   
September 30,
2009
    
December 31,
2008
  
Accounts receivable  (factored)
  
$
1,087,086
    
$
1,961,535
  
Advances from factor
    
(342,876
)
    
(1,075,879
) 
Due from factor
    
744,210
      
885,656
  
Accounts receivable  (non-factored)
    
85,846
      
127,080
  
Allowance for doubtful accounts
    
(143,000
) 
    
(176,400
) 
Total
  
$
687,056
    
$
836,336
  
 
In February 2008, the Company entered into a factoring agreement to sell, without recourse, certain receivables to an unrelated third party financial institution in an effort to accelerate cash flow.  Under the terms of the factoring agreement the maximum amount of outstanding receivables at any one time is $2.5 million.  Proceeds on the transfer reflect the face value of the account less a discount.  The discount is recorded as interest expense in the Consolidated Statement of Operations in the period of the sale.  Net funds received reduced accounts receivable outstanding while increasing cash.  Fees paid pursuant to this arrangement are included in “Operating expenses” in the Consolidated Statement of Operations and amounted to $156,582 for the period ended September 30, 2009.  The amounts borrowed are collateralized by the outstanding accounts receivable, and are reflected as a reduction to accounts receivable in the accompanying consolidated balance sheets.

NOTE D - INVENTORIES
 
Components of inventories as of September 30, 2009 and December 31, 2008 are as follows:

   
September 30,
2009
    
December 31,
2008
  
Raw Materials
   $ 737,752     $ 843,978  
Finished Goods
     748,544       1,089,962  
Reserve for Obsolescence
     (200,000       (200,000 ) 
Total
   $ 1,286,296     $ 1,733,940  
 
 
12
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2009
(UNAUDITED)
 
NOTE E - - PROPERTY AND EQUIPMENT

The Company’s property and equipment at September 30, 2009 and December 31, 2008 consists of the following:

   
September 30,
 2009
    
December 31,
 2008
  
Telecommunications and related equipment
  
$
117,637
    
$
117,493
  
Development Test Equipment
    
153,484
      
153,484
  
Computer Software
    
160,894
      
160,894
  
Leasehold Improvements
    
228,017
      
248,778
  
Office Equipment
    
371,251
      
377,851
  
Office Fixtures and Furniture
    
249,604
      
265,315
  
Total
    
1,280,887
      
1,328,818
  
Accumulated Depreciation
    
(989,966
)
    
(925,225
)
   
$
290,924
    
$
403,593
  
 
Depreciation expense included as a charge to income was $25,803 and $90,364 and $54,120 and $168,911 for the three and nine months ended September 30, 2009 and 2008, respectively.

NOTE F – MARKETABLE SECURITIES

Multiband Corporation

In connection with a payment of $75,000 of accounts receivable, the Company received 30,000 shares of common stock of Multiband Corporation, a Minnesota-based communication services provider to multiple dwelling units.  The Company classifies this security as available for sale, and it is carried at fair market value.  The Company sold its remaining investment in Multiband and recorded a loss of $29,371 in January 2009.

Geeks on Call America, Inc

As of September 30, 2009, the Company maintained an investment in a publicly traded company which was approximately 18% of the outstanding shares of common stock of Geeks on Call Holdings, Inc. (“GOCA”), a provider of on-site computer services to residential and commercial customers.  As of December 31, 2008, the Company determined that a significant portion of this investment was permanently impaired and wrote-off $4,098,514.  Management has determined that the entire investment in GOCA is impaired and the remaining value of $367,653 has been written off during the period ended September 30, 2009.
 
 
13
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2009
(UNAUDITED)
 
NOTE G – LINE OF CREDIT

In September 2008, the Company entered into a two-year line of credit facility with a third party financial institution.  The line of credit has an aggregate principal amount of $1,000,000 and is secured by the Company’s inventory.  The outstanding principal balance bears interest at the greater of (i) the Wall Street Journal Prime Rate plus nine (9%) percent per annum, adjusted on the date of any change in such prime or base rate, or (ii) sixteen percent (16%).  Interest, computed on a 365/360 simple interest basis, and fees on the credit facility are payable monthly in arrears on the last day of each month and continuing on the last day of each month until the maturity date.  The Company may prepay amounts outstanding under the credit facility in whole or in part at any time.  In the event of such prepayment, the lender will be entitled to receive a prepayment fee of four percent (4.0%) of the highest aggregate loan commitment amount if prepayment occurs before the end of the first year and three percent (3.0%) if prepayment occurs thereafter.  The outstanding borrowing under the agreement at September 30, 2009 was $449,741.  The Company has incurred interest expense of $103,881 related to the line of credit for the nine months ended September 30, 2009.  The Prime Rate was 3.25% at September 30, 2009.

On November 11, 2009, the Company received a notice of waiver of the “minimum cash flow to debt service ratio” and the “tangible net worth” requirements under the line of credit facility, as such terms are defined in items D(10)a and D(10)b, respectively, of the line of credit agreement.  The waiver is in effect as of September 30, 2009 and continues for the 90 day period thereafter.

NOTE H - - SENIOR CONVERTIBLE DEBENTURES
 
Senior Convertible Debenture

A summary of convertible debentures payable at September 30, 2009 and December 31, 2008 is as follows:

   
September 30,
2009
    
December 31,
2008
  
Senior Convertible Debentures, accrue interest at 13% per annum and mature on May 29, 2011
  
$
1,606,023
    
$
2,136,650
  
Debt Discount - beneficial conversion feature, net of accumulated amortization of $514,381 and $295,508 at September 30, 2009 and December 31, 2008, respectively.
    
(292,508
)
    
(425,458
) 
Debt Discount - value attributable to warrants attached to notes, net of accumulated amortization of $432,243 and $277,913 at September 30, 2009 and December 31, 2008, respectively.
    
(245,797
)
    
(400,127
) 
                 
Total
  
$
1,067,718
    
$
1,311,065
  
Less: current portion
    
-
      
-
  
   
$
1,067,718
    
$
1,311,065
  
 
As of September 30, 2009, the Company has $1,606,023 outstanding in convertible debentures. During the nine months ended September 30, 2009, $722,514 of convertible debentures was converted into 8,174,943 shares of common stock.

The Company amortized the beneficial conversion feature and the value of the attached warrants, and recorded non-cash interest expense in the amount of $218,873 and $154,330, respectively, and $146,251 and $137,545, respectively, for the nine months ended September 30, 2009, and 2008.
 
On February 20, 2009, the Company and YA Global entered into an Agreement of Clarification pursuant to which the parties agreed that interest accrued as of December 31, 2008, in the amount of $191,887 shall be added to the principal amount outstanding under the Debentures and that each Debenture be amended to reflect the applicable increase in principal amount.  In connection with this increase in the principal value of the debenture, the Company has recognized an additional $85,923 of debt discount attributed to the beneficial conversion feature of the debenture for the period ended September 30, 2009.
 
14

TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2009
(UNAUDITED)
 
 
On May 28, 2009, the Company’s shareholders voted against a proposal to remove the Exchange Cap, allowing YA Global to potentially acquiring in excess of 19.99% of the outstanding shares of the Company’s common stock, as of May 30, 2008, upon conversion of debentures and/or the exercise of warrants, pursuant to NYSE Amex LLC regulations.  In the Agreement of Clarification, the Company agreed to seek approval of the share issuance at the 2009 annual meeting of stockholders, which was held on May 28, 2009.  On May 12, 2009, YA Global met the Exchange Cap for the conversion of its debentures, and cannot receive additional shares of the Company’s common stock for the conversion of debentures or exercise of warrants, under NYSE Amex rules.
 
At September 30, 2009, the Senior Convertible Debenture had an estimated fair value of $1.1 million.

Business Loan

On September 11, 2009, the Company entered into a Loan Agreement in the aggregate principal amount of $300,000 with the Wisconsin Department of Commerce (the “Department”).  The outstanding principal balance bears interest at the annual rate of two (2.00) percent. Payment of interest and principal is to be made in the following manner:   (a) payment of any and all interest that accrues from the date of disbursement commences on January 1, 2010 and continues on the first day of each consecutive month thereafter through and including December 31, 2010; (b) commencing on January 1, 2011 and continuing on the first day of each consecutive month thereafter through and including November 1, 2016, the Company shall pay equal monthly installments of $4,426 each; followed by a final installment on December 1, 2016 which shall include all remaining principal, accrued interest and other amounts owed by the Company to the Department under the Loan Agreement.  The Company may prepay amounts outstanding under the credit facility in whole or in part at any time without penalty.  The credit facility is secured by the Company’s assets and the proceeds from this loan will be used for the working capital requirements of the Company.  The outstanding borrowing under the agreement at September 30, 2009 was $300,000.

Aggregate maturities of long-term debt as of September 30, 2009 are as follows:

For the twelve months ended December 31,
  
Amount
  
2009
  
$
-
  
2010
    
-
  
2011
    
1,606,023
  
2012 and thereafter
    
300,000
  
   
$
1,906,023
  


NOTE I - - CAPITAL STOCK

The Company has authorized 15,000,000 shares of preferred stock, with a par value of $.001 per share. As of September 30, 2009 and December 31, 2008, the Company has no preferred stock issued and outstanding.  The Company has authorized 155,000,000 shares of common stock, with a par value of $.001 per share. As of September 30, 2009 and December 31, 2008, the Company has 96,563,771 and 87,525,495, respectively, shares of common stock issued and outstanding.

During the nine months ended September 30, 2009, the Company issued 83,333 shares of common stock to consultants for services performed and services accrued in fiscal 2008.  These shares were valued at $10,000, which approximated the fair value of the shares when they were issued.
 
During the nine months ended September 30, 2009, the Company issued 780,000 shares of common stock at approximately $0.09 per share to warrant holders in exchange for the exercise of their stock purchase warrants.

During the nine months ended September 30, 2009, the Company issued 8,174,943 shares of common stock at approximately $0.09 per share to its senior convertible debenture holders in exchange for $722,514 of debentures.
 
 
15
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2009
(UNAUDITED)
 
NOTE J - - STOCK OPTIONS AND WARRANTS

Employee Stock Options
 
The following table summarizes the changes in options outstanding and the related prices for the shares of the Company’s common stock issued to employees of the Company under a non-qualified employee stock option plan.

Options Outstanding
    
Options Exercisable
  
Exercise Prices
    
Number
Outstanding
    
Weighted
Average
Remaining
Contractual
Life
 (Years)
    
Weighted
Average
Exercise
Price
    
Number
Exercisable
    
Weighted
Average
Exercise
Price
  
$
1.00 - $1.99
      
4,417,133
      
3.93
    
$
1.02
      
4,273,550
    
$
1.01
  
$
2.00 - $2.99
      
997,500
      
5.48
    
$
2.52
      
957,250
    
$
2.51
  
$
3.00 - $3.99
      
536,250
      
6.08
    
$
3.23
      
413,500
    
$
3.28
  
$
4.00 - $4.99
      
70,000
      
5.83
    
$
4.33
      
58,500
    
$
4.33
  
$
5.00 - $5.99
      
100,000
      
5.57
    
$
5.17
      
88,000
    
$
5.16
  
         
6,120,883
      
4.42
    
$
1.56
      
5,790,800
    
$
1.52
  

Transactions involving stock options issued to employees are summarized as follows:

   
Number of
Shares
    
Weighted
Average
Price
Per Share
  
Outstanding at January 1, 2008
    
8,105,429
    
$
1.98
  
Granted
    
185,000
      
1.00
  
Exercised
    
-
      
-
  
Cancelled or expired
    
(1,296,500
)
    
2.71
  
Outstanding at December 31, 2008
    
6,993,929
    
$
1.82
  
Granted
    
320,000
      
1.00
  
Exercised
    
-
      
-
  
Cancelled or expired
    
(1,193,046
)
    
2.91
  
Outstanding at September 30, 2009
    
6,120,883
    
$
1.56
  
 
 
16
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2009
(UNAUDITED)
 
 
The weighted-average fair value of stock options granted to employees during the period ended September 30, 2009 and 2008 and the weighted-average significant assumptions used to determine those fair values, using a Black-Scholes option pricing model are as follows:

   
September 30, 2009
    
September 30, 2008
  
Significant assumptions (weighted-average):
            
Risk-free interest rate at grant date
    
3.5%
      
3.0%
  
Expected stock price volatility
    
81%
      
74%
  
Expected dividend payout
    
-    
      
-    
  
Expected option life (in years)
    
5.0 
      
5.0 
  
Expected forfeiture rate
    
12%
      
12%
  
Fair value per share of options granted
  
$
0.30
    
$
0.62
  

The expected life of awards granted represents the period of time that they are expected to be outstanding.  We determine the expected life based on historical experience with similar awards, giving consideration to the contractual terms, vesting schedules, exercise patterns and pre-vesting and post-vesting forfeitures.  We estimate the volatility of our common stock based on the calculated historical volatility of our own common stock using the trailing 60 months of share price data prior to the date of the award.  We base the risk-free interest rate used in the Black-Scholes-Merton option valuation model on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term equal to the expected life of the award.  We have not paid any cash dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future.  Consequently, we use an expected dividend yield of zero in the Black-Scholes-Merton option valuation model. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation for those awards that are expected to vest. In accordance with Share Based Payments, we adjust share-based compensation for changes to the estimate of expected equity award forfeitures based on actual forfeiture experience.
 
There were no options exercised during the period ended September 30, 2009 or 2008.  

The total fair value of shares vested during the period ended September 30, 2009 and 2008 was $233,366 and $623,113, respectively.

Total stock-based compensation expense recognized in the consolidated statement of earnings for the three and nine months ended September 30, 2009 and 2008 was $65,746 and $243,366, and $194,483 and $704,613, respectively, net of tax effect. Additionally, the aggregate intrinsic value of options outstanding and unvested as of September 30, 2009 is $0.

Non-Employee Stock Options

The following table summarizes the changes in options outstanding and the related prices for the shares of the Company’s common stock issued to the Company consultants.  These options were granted in lieu of cash compensation for services performed.

Options Outstanding
  
Options Exercisable
  
Exercise Prices
    
Number
Outstanding
    
Weighted Average
Remaining Contractual
Life (Years)
    
Weighted Average
Exercise Price
  
Number
Exercisable
    
Weighted Average
Exercise Price
  
                                           
$
1.00
      
740,000
      
2.84
    
$
1.00
    
740,000
    
$
1.00
  
 
 
17
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2009
(UNAUDITED)
 
 
Transactions involving options issued to non-employees are summarized as follows: