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

FORM 10-Q /A
(Amendment No.1)

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

OR

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

For the transition period from __________ to __________.

For the period ended June 30, 2009

Commission file number 001-31972

TELKONET, INC. 

(Exact name of Issuer 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
Issuer's Telephone Number

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.       Yes x  No o
 
Indicate by check mark 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: 95,884,001 shares of Common Stock ($.001 par value) as of August 14, 2009.
 

 
TELKONET, INC.
FORM 10-Q /A for the Quarter Ended June 30, 2009

Index

 
Page
   
EXPLANATORY NOTE
2
   
PART I. FINANCIAL INFORMATION
3
   
Item 1. Financial Statements (Unaudited)
3
   
Condensed Consolidated Balance Sheets:
3
June 30, 2009 and December 31, 2008
  
   
Condensed Consolidated Statements of Operations and Comprehensive Income:
 4
Three And Six Months Ended June 30, 2009 and 2008
  
   
Condensed Consolidated Statement of Equity
 5
January 1, 2009 through June 30, 2009
  
   
Condensed Consolidated Statements of Cash Flows:
 6
Six Months Ended June 30, 2009 and 2008
  
   
Notes to Unaudited Condensed Consolidated Financial Statements:
 8
June 30, 2009
  
   
Item 2. Management’s Discussion and Analysis
 21
   
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
 30
   
Item 4. Controls and Procedures
 31
   
PART II. OTHER INFORMATION
 31
   
Item 1. Legal Proceedings
 31
   
Item 1A. Risk Factors
 31
   
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
 31
   
Item 3. Defaults Upon Senior Securities
 32
   
Item 4. Submission of Matters to a Vote of Security Holders
 32
   
Item 5. Other Information
 32
   
Item 6. Exhibits
 33

 

 
1
 
 
EXPLANATORY NOTE

This Amendment No. 1 on Form 10-Q/A (the “Amendment”) amends our quarterly report on Form 10-Q for the fiscal quarter ended June 30, 2009 as filed with the Securities and Exchange Commission on August 14, 2009 (the “Original Report”).  The Company is filing this Amendment in response to comments received from the SEC. This Amendment corrects errors and provides additional disclosure information in Item 1 of Part I, Note N Discontinued Operations in the notes to the unaudited financial statements for the period ended June 30, 2009, and Item 6 of Part II as permitted by the rules and regulations of the SEC. The amendment did not have any material impact on our financial results.

For convenience and ease of reference, we are filing the quarterly report in its entirety with the applicable changes.   Except for the amendment named above and the updated certifications, this Amendment continues to speak as of the date of our Original Report, and we have not updated the disclosures contained herein to reflect any events that have occurred thereafter. For a discussion of events and developments thereafter, please see our reports filed with the Securities and Exchange Commission since August 14, 2009.
 
 

 
2
PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

TELKONET, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
 
 
(Unaudited)
June 30,
    
December 31,
  
ASSETS
2009
    
2008
  
Current assets:
          
Cash and cash equivalents
  
$
120,173
    
$
168,492
  
Accounts receivable, net
    
782,283
      
836,336
  
Inventories
    
1,374,493
      
1,733,940
  
Other current assets
    
163,985
      
230,539
  
Current assets from discontinued operations
    
-
      
476,459
  
Total current assets
    
2,440,934
      
3,445,766
  
                 
Property and equipment, net
    
321,273
      
403,593
  
                 
Other assets:
                
Marketable securities
    
367,653
      
397,403
  
Deferred financing costs, net
    
340,588
      
432,136
  
Goodwill and other intangible assets, net
    
15,016,632
      
15,137,469
  
Other assets
    
95,179
      
98,807
  
Other assets from discontinued operations
    
-
      
6,593,169
  
Total other assets
    
15,820,052
      
22,658,984
  
                 
Total Assets
  
$
18,582,259
    
$
26,508,343
  
         
LIABILITIES AND EQUITY
        
Current liabilities:
                
Accounts payable and accrued liabilities
  
$
4,665,453
    
$
4,557,257
  
Line of credit
    
714,020
      
574,005
  
Other current liabilities
    
252,563
      
278,033
  
Current Liabilities from discontinued operations
    
-
      
13,450,362
  
Total current liabilities
    
5,632,036
      
18,859,657
  
                 
Long-term liabilities:
                
Convertible debentures, net of debt discounts of $619,050 and $825,585, respectively
    
986,973
      
1,311,065
  
Derivative liability
    
1,219,775
      
2,573,126
  
Deferred lease liability and other
    
50,791
      
50,791
  
Total long-term liabilities
    
2,257,539
      
3,934,982
  
                 
Commitments and contingencies
    
-
      
-
  
                 
Equity
                
Preferred stock, par value $.001 per share; 15,000,000 shares authorized; none issued and outstanding at June 30, 2009 and December 31, 2008
    
-
      
-
  
Common stock, par value $.001 per share; 155,000,000 shares authorized; 95,833,871 and 87,525,495  shares issued and outstanding at June 30, 2009 and December 31, 2008, respectively
    
95,834
      
87,526
  
Additional paid-in-capital
    
119,096,381
      
118,197,450
  
Accumulated deficit
    
(108,499,531
)
    
(114,801,318
)
Accumulated comprehensive loss
    
-
      
(32,750
) 
        Total stockholders’ equity
    
10,692,684
      
3,450,908
  
Non-controlling interest
    
-
      
262,795
  
Total equity
    
10,692,684
      
3,713,703
  
                 
Total Liabilities and Equity
  
$
18,582,259
    
$
26,508,343
  
 
See accompanying notes to the unaudited condensed consolidated financial statements

 
3
 

TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE (LOSS)
(UNAUDITED)

   
For The Three Months Ended
June 30,
    
For The Six Months Ended
June 30,
  
   
2009
    
2008
    
2009
    
2008
  
Revenues, net:
                        
Product
  
$
2,098,640
    
$
3,781,214
    
$
4,017,067
    
$
6,983,451
  
Recurring
    
1,011,729
      
826,917
      
1,991,254
      
1,662,246
  
Total Revenue
    
3,110,369
      
4,608,131
      
6,008,321
      
8,645,697
  
                                 
Cost of Sales:
                                
Product
    
1,032,183
      
2,265,073
      
2,108,822
      
4,723,851
  
Recurring
    
303,513
      
422,680
      
609,347
      
858,063
  
Total Cost of Sales
    
1,335,696
      
2,687,753
      
2,718,169
      
5,581,914
  
                                 
Gross Profit
    
1,774,673
      
1,920,378
      
3,290,152
      
3,063,783
  
                                 
Operating Expenses:
                                
Research and Development
    
222,316
      
492,689
      
498,278
      
1,157,811
  
Selling, General and Administrative
    
1,737,376
      
2,619,897
      
3,357,168
      
5,145,340
  
Impairment write-down in investment in affiliate
    
-
      
380,000
      
-
      
380,000
  
Stock Based Compensation
    
83,810
      
206,432
      
177,620
      
510,130
  
Depreciation and Amortization
    
93,683
      
107,577
      
180,517
      
215,154
  
Total Operating Expense
    
2,137,185
      
3,806,595
      
4,213,583
      
7,408,435
  
                                 
Loss from Operations
    
(362,512
)
    
(1,886,217
)
    
(923,431
)
    
(4,344,652
)
                                 
Other Income (Expenses):
                                
Financing Expense, net
    
(212,720
)
    
(152,832
)
    
(481,536
)
    
(1,948,007
)
Gain (Loss) on Derivative Liability
    
1,175,573
      
(1,018,453
) 
    
1,439,274
      
(1,018,453
) 
(Loss) on Sale of Investment
    
-
      
-
      
(29,371
)
    
-
  
Total Other Income (Expenses)
    
962,853
      
(1,171,285
)
    
928,367
      
(2,966,460
) 
                                 
Income (Loss) Before Provision for Income Taxes
    
600,341
      
(3,057,502
)
    
4,936
      
(7,311,112
)
Provision for Income Taxes
    
-
      
-
      
-
      
-
  
                                 
Income (Loss) from Continuing Operations
  
$
600,341
    
$
(3,057,502
)
  
$
4,936
    
$
(7,311,112
)
                                 
Discontinued Operations
                                
Income (Loss) from Discontinued Operations
    
(123,438
)
    
(1,174,339
)
    
(635,735
)
    
(2,041,760
)
Gain on Deconsolidation
    
6,932,586
      
-
      
6,932,586
      
-
  
                                 
Net Income (Loss)
  
$
7,409,489
  
  
$
(4,231,841
) 
  
$
6,301,787
    
$
(9,352,872
) 
                                 
Net income (loss) per share:
                                
Income (loss) per share from continuing operations - basic
  
$
0.01
    
$
(0.04
)
  
$
0.00
    
$
(0.10
)
Income (loss) per share from continuing operations - diluted
  
$
0.01
    
$
(0.04
)
  
$
0.00
    
$
(0.10
)
Income (loss) per share from discontinued operations – basic
  
$
0.07
    
$
(0.01
)
  
$
0.07
    
$
(0.03
)
Income (loss) per share from discontinued operations – diluted
  
$
0.07
    
$
(0.01
)
  
$
0.07
    
$
(0.03
)
Net income (loss) per share – basic
  
$
0.08
    
$
(0.05
)
  
$
0.07
    
$
(0.13
)
Net income (loss) per share - diluted
  
$
0.08
    
$
(0.05
)
  
$
0.07
    
$
(0.13
)
                                 
Weighted Average Common Shares Outstanding - basic
    
94,765,021
      
77,319,806
      
92,550,245
      
74,583,911
  
Weighted Average Common Shares Outstanding - diluted
    
94,765,021
      
77,319,806
      
92,550,245
      
74,583,911
  
                                 
Comprehensive Income (Loss): 
                                
Net Income (Loss) 
  
$ 
7,409,489
    
$ 
(4,231,841
) 
  
$ 
6,301,787
    
$ 
(9,352,872
) 
Unrecognized Gain (Loss) on Investment 
    
-
      
(1,019,237
) 
    
32,750
      
(1,558,204
) 
                                 
Comprehensive Income (Loss)
  
$ 
7,409,489
    
$ 
(5,251,078
) 
  
$ 
6,334,537
    
$ 
(10,911,076
) 

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 JUNE 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
    
-
      
-
      
50,100
      
50
      
4,545
      
-
      
-
      
-
      
4,595
  
                                                                         
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
    
-
      
-
      
-
      
-
      
167,620
      
-
      
-
              
167,620
  
                                                                         
Stock-based compensation expense related to the re-pricing of investor warrants
    
-
      
-
      
-
      
-
      
2,510
      
-
      
-
      
-
      
2,510
  
                                                                         
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
  
-
    
-
      
-
    
-
      
-
      
4,936
      
-
    
-
    
4,936
  
                                                                         
Balance at June 30, 2009
  
-
    
$                         -
    
95,833,871
    
$
95,834
    
$
119,096,381
    
$
(108,499,531
)
  
$
-
    
$
-
    
$
10,692,684
  

See accompanying notes to the unaudited condensed consolidated financial statements 

 
5
 

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

   
For the Six Months
Ended June 30,
  
   
2009
    
2008
  
Increase (Decrease) In Cash and Equivalents
            
Cash Flows from Operating Activities:
            
Net income (loss) attributable to common shareholders
  
$
6,301,787
    
$
(9,352,872
)
Net (income) loss from discontinued operations
    
(6,296,851
)
    
2,041,760
  
Net income (loss) from continuing operations
    
4,936
      
(7,311,112
)
                 
Adjustments to reconcile net income (loss) from operations to cash provided by (used in) operating activities:
                
Amortization of debt discounts and financing costs
    
409,006
      
12,794
  
Loss on sale of investment
    
29,371
      
-
  
(Gain) loss on derivative liability
    
(1,439,274
) 
    
1,018,453
  
Impairment write-down on goodwill
    
-
      
380,000
  
Stock based compensation
    
177,620
      
769,037
  
Fair value of issuance of warrants and re-pricing  (financing expense)
    
2,510
      
1,837,612
  
Depreciation and amortization
    
180,517
      
215,154
  
                 
Increase / decrease in:
                
Accounts receivable, trade and other
    
671,371
      
769,325
  
Inventories
    
359,447
      
290,436
  
Prepaid expenses and deposits
    
63,975
      
(125,756
) 
Deferred revenue
    
(61,095
) 
    
(29,335
) 
Other Assets
    
82,840
 
    
274,121
  
Accounts payable, accrued expenses, net
    
(369,354
) 
    
539,110
  
Cash provided by (used in) continuing operations
    
111,870
      
(1,360,161
)
Cash used in discontinued operations
    
(287,997
)
    
(761,944
)
Net Cash Used In Operating Activities
    
(176,127
)
    
(2,122,105
)
                 
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
)
    
(766,586
)
Net Cash Used In Investing Activities
    
(281,064
) 
    
(780,961
) 
                 
Cash Flows From Financing Activities:
                
Proceeds from issuance of convertible debentures
    
-
      
1,500,000
  
Proceeds from sale of common stock, net of costs and fees
    
-
      
1,500,000
  
Proceeds from issuance of notes payable
    
-
      
400,000
  
Proceeds from line of credit
    
140,015
      
-
  
Financing fees
    
(25,000
)
    
 (462,511
) 
Repayment of notes payable
    
-
      
(1,500,000
) 
Proceeds from the exercise of warrants
    
4,595
      
-
  
Repayment of capital lease and other
    
(4,714
) 
    
(3,422
) 
Cash provided by continuing operations
    
114,896
      
1,434,067
  
Cash provided by discontinued operations
    
293,976
      
64,204
  
Net Cash Provided By Financing Activities
    
408,872
      
1,498,271
  
                 
Net (Decrease) In Cash and Equivalents
    
(48,319
)
    
(1,404,795
)
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
  
$
120,173
    
$
224,788
  

See accompanying notes to the unaudited condensed consolidated financial statements

 
6
 

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

 
For the Six Months Ended
June 30,
  
 
2009
  
2008
  
Supplemental Disclosures of Cash Flow Information:
        
         
Cash transactions:
        
Cash paid during the period for financing expenses
  
$
114,739
    
$
175,532
  
Income taxes paid
    
-
      
-
  
Non-cash transactions:
                
Stock based compensation to employees and consultants in exchange for services
  
$ 
170,130
    
 $
769,037
  
Fair value of issuance of warrants and re-pricing  (financing expense)
    
2,510
      
1,837,612
  
(Gain) loss on derivative liability
    
(1,439,274
) 
    
1,018,453
  
Impairment write-down on goodwill
    
-
      
380,000
  
Amortization of debt discount on convertible debentures and financing costs
    
409,006
      
12,794
  
Accrued interest re classified as convertible debenture principal
    
191,887
      
-
  
Value of common stock issued in exchange for conversion of debenture principal
    
722,514
      
-
  
 
 
 
 

 
See accompanying notes to the unaudited condensed consolidated financial statements
 

 
 
 
 
 
 

 
7
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 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 $6,301,787 for the six months ended June 30, 2009.  However, the Company has reported operating losses of $923,431, excluding gains on derivative liabilities and discontinued operations, for the six months ended June 30, 2009.  In addition, the Company has reported an accumulated deficit of $108,499,531 and a working capital deficit of $3,191,101 as of June 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
JUNE 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 of SFAS No. 157, “Fair Value Measurements” (“FAS 157”), which defines 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 FAS 157 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 FAS 157.
 
Investments

Telkonet maintained investments in two publicly-traded companies for the period ended June 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 period ended June 30, 2009 and unrealized losses of $1,558,204 were recorded for the period ended June 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 $29,371 were recorded for the sale of the Company’s investment in Multiband during the period ended June 30, 2009.  There were no realized gains or losses for the period ended June 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.
 
Revenue Recognition

For revenue from product sales, the Company recognizes revenue in accordance with Staff Accounting Bulletin No. 104, Revenue Recognition (“SAB104”), which includes the provisions of Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (“SAB101”).  SAB 101 requires 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.  SAB 104 incorporates Emerging Issues Task Force 00-21 (“EITF 00-21”), Multiple-Deliverable Revenue Arrangements.  EITF 00-21 addresses accounting for arrangements that may involve the delivery or performance of multiple products, services and/or rights to use assets.


 
9
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2009
(UNAUDITED)

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.

Noncontrolling Interest

As a result of adopting Statement of Financial Accounting Standards (“SFAS”) No. 160, Noncontrolling Interests in Consolidated Statements, an amendment of ARB No. 51 , 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 SFAS 160 did not have any other material impact on our financial position, results of operations or cash flow.

New Accounting Pronouncements

FSP FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly, provides guidelines for making fair value measurements more consistent with the principles presented in FASB Statement No. 157 (“SFAS 157”), Fair Value Measurements. FSP FAS 157-4 reaffirms what SFAS 157 states is the objective of fair value measurement, to reflect how much an asset would be sold for in an orderly transaction at the date of the financial statements under current market conditions.  Specifically, it reaffirms the need to use judgment to ascertain if a formerly active market has become inactive and in determining fair values when markets have become inactive.  The Company does not expect this pronouncement to have a material impact on its results of operations, financial position, or cash flows.

FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments, enhances consistency in financial reporting by increasing the frequency of fair value disclosures.  This relates to fair value disclosures for any financial instruments that are not currently reflected on the consolidated balance sheet at fair value. FSP FAS 107-1 and APB 28-1 now require that fair value disclosures be made on a quarterly basis, providing qualitative and quantitative information about fair value estimates for all those financial instruments not measured on the balance sheet at fair value.  The Company does not expect this pronouncement to have a material impact on its results of operations, financial position, or cash flows.

FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments, provides additional guidance designed to create greater clarity and consistency in accounting for and presenting impairment losses on securities. This FSP is intended to bring greater consistency to the timing of impairment recognition and to provide greater clarity to investors about the credit and noncredit components of impaired debt securities that are not expected to be sold.  This FSP also requires increased and timelier disclosures sought by investors regarding expected cash flows, credit losses, and an aging of securities with unrealized losses.  The Company does not expect this pronouncement to have a material impact on its results of operations, financial position, or cash flows.



 
10
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2009
(UNAUDITED)

 
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 June 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
    
$
(553,823
)
  
$
2,346,177
    
$
-
      
12.0
  
Total Amortized Identifiable Intangible Assets
    
2,900,000
      
(553,823
)
    
2,346,177
      
-
      
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
    
$
(2,553,823
)
  
$
15,016,632
    
$
-
          

Total amortization expense charged to operations for the three and six months ended June 30, 2009 and 2008 was $60,417 and $120,833, and $60,417 and $120,833, respectively.

NOTE C – ACCOUNTS RECEIVABLE

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

   
June 30,
2009
    
December 31,
2008
  
Accounts receivable  (factored)
  
$
1,603,973
    
$
1,961,535
  
Advances from factor
    
(739,277
)
    
(1,075,879
) 
Due from factor
    
864,696
      
885,656
  
Accounts receivable  (non-factored)
    
93,916
      
127,080
  
Allowance for doubtful accounts
    
(176,329
) 
    
(176,400
) 
Total
  
$
782,283
    
$
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 “Financing expense” in the Consolidated Statement of Operations and amounted to $105,189 for the period ended June 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.

 
11
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2009
(UNAUDITED)


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

   
June 30,
2009
    
December 31,
2008
  
Raw Materials
  
$
751,357
    
$
843,978
  
Finished Goods
    
823,136
      
1,089,962
  
Reserve for Obsolescence
    
(200,000
) 
    
(200,000
) 
Total
  
$
1,374,493
    
$
1,733,940
  

NOTE E - - PROPERTY AND EQUIPMENT

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

   
June 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
    
377,851
      
377,851
  
Office Fixtures and Furniture
    
265,315
      
265,315
  
Total
    
1,303,201
      
1,328,818
  
Accumulated Depreciation
    
(981,928
)
    
(925,225
)
   
$
321,273
    
$
403,593
  
 

Depreciation expense included as a charge to income was $35,432 and $64,561 and $43,117 and $88,227 for the three and six months ended June 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.

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 June 30, 2009 was $714,020.  The Company has incurred interest expense of $78,069 related to the line of credit for the six months ended June 30, 2009.  The Prime Rate was 3.25% at June 30, 2009.

 
12
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2009
(UNAUDITED)


On August 13, 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 June 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 June 30, 2009 and December 31, 2008 is as follows:

   
June 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 $470,506 and $295,508 at June 30, 2009 and December 31, 2008, respectively.
    
(336,383
)
    
(425,458
) 
Debt Discount - value attributable to warrants attached to notes, net of accumulated amortization of $395,373 and $277,913 at June 30, 2009 and December 31, 2008, respectively.
    
(282,667
)
    
(400,127
) 
                 
Total
  
$
986,973
    
$
1,311,065
  
Less: current portion
    
-
      
-
  
   
$
986,973
    
$
1,311,065
  
 
As of June 30, 2009, the Company has $1,606,023 outstanding in convertible debentures. During the six months ended June 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 $174,998 and $117,460, and $20,027, and $15,716, respectively, for the six months ended June 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 June 30, 2009.
 
On July 8, 2009, the Company and YA Global amended the Debentures to provide for monthly payments of interest, as opposed to quarterly payments.  The Company and YA Global agreed that the Company shall pay $72,008 representing accrued and unpaid interest through June 30, 2009 upon the earlier to occur of (i) August 15, 2009 or (ii) the date the Company receives the proceeds of financing from the Wisconsin Department of Commerce.  On August 13, 2009, YA Global agreed to defer the August 15, 2009 interest payment until September 15, 2009.

At June 30, 2009, the Senior Convertible Debenture had an estimated fair value of $1.0 million.


 
13
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2009
(UNAUDITED)

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

For the twelve months ended December 31,
  
Amount
  
2009
  
$
-
  
2010
    
-
  
2011
    
1,606,023
  
   
$
1,606,023
  

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 June 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 June 30, 2009 and December 31, 2008, the Company has 95,833,871 and 87,525,495, respectively, shares of common stock issued and outstanding.

During the six months ended June 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 six months ended June 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.


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
      
4.18
    
$
1.02
      
4,266,883
    
$
1.01
  
$
2.00 - $2.99
      
997,500
      
5.73
    
$
2.52
      
951,250
    
$
2.51
  
$
3.00 - $3.99
      
540,000
      
6.33
    
$
3.23
      
400,500
    
$
3.29
  
$
4.00 - $4.99
      
70,000
      
6.08
    
$
4.33
      
55,000
    
$
4.34
  
$
5.00 - $5.99
      
100,000
      
5.82
    
$
5.17
      
83,000
    
$
5.16
  
         
6,124,633
      
4.67
    
$
1.56
      
5,756,633
    
$
1.53
  

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
    
(1,189,296
)
    
2.91
  
Outstanding at June 30, 2009
    
6,124,633
    
$
1.56
  
 

 
14
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2009
(UNAUDITED)


The weighted-average fair value of stock options granted to employees during the period ended June 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:

   
June 30, 2009
    
June 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 SFAS No. 123R, 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 June 30, 2009 or 2008.  

The total fair value of shares vested during the period ended June 30, 2009 and 2008 was $167,620 and $428,630, respectively.

Total stock-based compensation expense recognized in the consolidated statement of earnings for the three and six months ended June 30, 2009 and 2008 was $83,810 and $177,670, and $206,432 and $510,130, respectively, net of tax effect. Additionally, the aggregate intrinsic value of options outstanding and unvested as of June 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
      
1,815,937
      
2.84
    
$
1.00
    
1,815,937
    
$
1.00
  
 

 
15
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2009
(UNAUDITED)

 
 
Transactions involving options issued to non-employees are summarized as follows:

   
Number of
Shares
    
Weighted
Average Price
Per Share
  
Outstanding at January 1, 2008
    
1,815,937
    
$
1.00
  
Granted
    
-
      
-
  
Exercised
    
-
      
-
  
Canceled or expired
    
-
      
-
  
Outstanding at December 31, 2008
    
1,815,937
    
$
1.00
  
Granted
    
-
      
-
  
Exercised
    
-
      
-
  
Canceled or expired
    
-
      
-
  
Outstanding at June 30, 2009
    
1,815,937
    
$
1.00
  

There were no non-employee stock options vested during the period ended June 30, 2009 and 2008, respectively.

Warrants

The following table summarizes the changes in warrants outstanding and the related prices for the shares of the Company’s common stock issued to non-employees of the Company.  These warrants were granted in lieu of cash compensation for services performed or financing expenses and in connection with placement of convertible debentures.
 
     
Warrants Outstanding
          
Warrants Exercisable
  
Exercise Prices
    
Number
Outstanding
    
Weighted Average
Remaining Contractual
Life (Years)
    
Weighed
Average
Exercise Price
    
Number
Exercisable
    
Weighted
Average
Exercise Price
  
$
0.58
      
806,639
      
2.59
    
$
0.58
      
856,639
    
$
0.58
  
$
0.60
      
800,000
      
3.85
    
$
0.60
      
800,000
    
$
0.60
  
$
0.61
      
2,500,000
      
3.92
    
$
0.61
      
2,500,000
    
$
0.61
  
$
2.59
      
862,452
      
2.12
    
$
2.59
      
862,452
    
$
2.59
  
$
3.98
      
3,078,864
      
2.29
    
$
3.98
      
3,078,864
    
$
3.98
  
$
4.17
      
359,712
      
3.06
    
$
4.17
      
359,712
    
$
4.17
  
         
8,407,667
      
2.97
    
$
2.19
      
8,457,667
    
$
2.19
  


Transactions involving warrants are summarized as follows:

   
Number of
Shares
    
Weighted
Average Price
Per Share
  
Outstanding at January 1, 2008
    
7,673,627
    
$
4.15
  
Issued
    
4,164,140
      
1.31
  
Exercised
    
(3,380,000
) 
    
0.70
*
Canceled or expired
    
-
      
-
  
Outstanding at December 31, 2008
    
8,457,767
    
$
2.19
  
Issued
    
-
      
-
  
Exercised
    
(50,100
) 
    
0.10
  
Canceled or expired
    
-
      
-
  
Outstanding at June 30, 2009
    
8,407,667
    
$
2.19
  
______________

 
16
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2009
(UNAUDITED)
 
 

*The warrants were issued to Enable Capital and originally priced at $4.17 per share.  In February 2008, these warrants were re-priced to $0.6978258 per share and the holders exercised the warrants on a cashless basis and received 1,000,000 shares
 
The Company did not issue any warrants during the period ended June 30, 2009.  During the period ended June 30, 2008, the Company granted 645,632 warrants to Convertible Senior Notes holders, 2,100,000 to a Convertible Debenture holder and 800,000 to a Note holder.  The Company did not issue any compensatory warrants during the period ended June 30, 2009 and 2008.  

The purchase price of the warrants issued to Convertible Senior Note holders was adjusted from $4.70 to $4.39 per share and approximately 79,000 additional warrants were issued during the period ended June 30, 2008 in accordance with the anti-dilution protection provision of the Convertible Senior Notes Payable Agreement (the “Agreement”) dated October 27, 2005, upon the occurrence of certain events as defined in the Agreement.

In February 2008, the Company amended certain stock purchase warrants held by private placement investors to reduce the exercise price under such warrants from $4.17 per share to $0.6978258 per share.  The warrants entitled the holders to purchase an aggregate of up to 3,380,000 shares of Telkonet’s common stock.   Subsequently, these private placement investors exercised all of their warrants on a cashless basis using the five day volume average weighted price (VWAP) as of January 31, 2008 of $.99 resulting in the issuance of 1,000,000 shares of Company common stock.  The Company has accounted for the amended warrants issued, valued at $1,224,236, as other expense using the Black-Scholes pricing model and the following assumptions: contractual term of 5 years, an average risk-free interest rate of 3.5% a dividend yield of 0% and volatility of 70%.  In addition, during the period ended June 30, 2008, the Company recorded non-cash expenses of $574,426 for issuing additional warrants and the re-pricing of outstanding warrants in accordance with the anti-dilution provision of the warrant agreements.

NOTE K - COMMITMENTS AND CONTINGENCIES

Employment and Consulting Agreements

On August 1, 2007, the Company entered into an agreement with Barry Honig, President of GRQ Consultants, Inc. (“GRQ”). Telkonet has agreed to pay Mr. Honig 50,000 shares of common stock per month for six (6) months, to provide the Company with transaction advisory services.  As of December 31, 2007, GRQ held a Senior Promissory Note issued by Telkonet on July 24, 2007, in the principal amount of $1,500,000 (Note J).  On February 8, 2008, this note was repaid in full including $49,750 in accrued but unpaid interest from the issuance date through the date of repayment.
 
Litigation

The Company is subject to legal proceedings and claims which arise in the ordinary course of its business.  Although occasional adverse decisions or settlements may occur, the Company believes that the final disposition of such matters should not have a material adverse effect on its financial position, results of operations or liquidity.

Senior Convertible Noteholder Claim

The August 14, 2006 Settlement Agreement with the Senior Convertible Debenture Noteholders provided that the number of shares issued to the Noteholders shall be adjusted based upon the arithmetic average of the weighted average price of the Company’s common stock on the American Stock Exchange for the twenty trading days immediately following the settlement date.  The Company has concluded that, based upon the weighted average of the Company's common stock between August 16, 2006 and September 13, 2006, the Company is entitled to a refund from the two Noteholders.  One of the Noteholders has informed the Company that it does not believe such a refund is required.  As a result, the Company has declined to deliver to the Noteholders certain stock purchase warrants issued to them pursuant to the Settlement Agreement pending resolution of this disagreement.  The Noteholder has alleged that the Company has failed to satisfy its obligations under the Settlement Agreement by failing to deliver the warrants.  In addition, the Noteholder maintains that the Company has breached certain provisions of the Registration Rights Agreement and, as a result of such breach, such Noteholder claims that it is entitled to receive liquidated damages from the Company. In the Company’s opinion, the ultimate disposition of these matters will not have a material adverse effect on the Company’s results of operations or financial position.

 
17
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2009
(UNAUDITED)


Purchase Price Contingency

In conjunction with the acquisition of MST on January 31, 2006, the stock portion of the purchase price was price protected for the benefit of the former owner of MST. In the event the Company’s common stock price is below $4.50 per share upon the achievement of thirty three hundred (3,300) subscribers during the three (3) year period following the closing (as extended) a pro rata adjustment in the number of shares will be required to support the aggregate consideration of $5.4 million.  The issuance of additional shares or distribution of other consideration upon resolution of the contingency based on the Company’s common stock prices will not affect the cost of the acquisition.  When the contingency is resolved or settled, and additional consideration is distributable, the Company will record the current fair value of the additional consideration and the amount previously recorded for the common stock issued will be simultaneously reduced to the lower current value of the Company’s common stock.  In addition, the Company agreed to fully fund the MST three year business plan, established on January 31, 2006.  The parties originally agreed, in the event, for any reason, the Company materially fails to satisfy its funding obligations under the acquisition agreement, that the former owners of MST shall be entitled to the release of any and all consideration held in reserve.  However the parties deleted this provision in a May, 2008 agreement wherein the Company made a minimum commitment of $2.3 million to fund MST's business plan in accordance with Section 11.1 of the Stock Purchase Agreement between Telkonet and Frank T. Matarazzo.  In addition, the adjustment date for the achievement of MST's 3,300 subscribers was extended an additional six months from January 31, 2009 to July 31, 2009.  In April 2008 the Company issued from escrow 200,000 shares of the reserve shares and advanced 400,000 of such shares in June 2008 in exchange for Mr. Matarazzo’s agreement to a debt covenant restricting the use of proceeds in the Company’s debenture financing with YA Global Investments LP.

NOTE L- BUSINESS CONCENTRATION

Revenue from one major customer approximated $785,649 or 13% of total revenues for the period ended June 30, 2009. Revenue from two (2) major customers approximated $4,233,118 or 49% of total revenues for the period ended June 30, 2008.  Total accounts receivable of $80,776, or 4% of total accounts receivable, were due from these customers as of June 30, 2009. Total accounts receivable of $532,190, or 29% of total accounts receivable, was due from these customers as of June 30, 2008.

Purchases from one major supplier approximated $698,482, or 62% of purchases during the period ended June 30, 2009, and $1,395,828, or 47% of purchases, for the period ended June 30, 2008, respectively. Total accounts payable of approximately $92,507, or 3% of total accounts payable, was due to this supplier as of June 30, 2009, and $1,167,254, or 18% of total accounts payable, was due to this supplier as of June 30, 2008.

NOTE M- FAIR VALUE MEASUREMENTS

The financial assets of the Company measured at fair value on a recurring basis are cash equivalents, and long-term marketable securities.  The Company’s cash equivalents and long term marketable securities are generally classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency.  The Company’s long-term investments are classified within Level 3 of the fair value hierarchy because they are valued using unobservable inputs, due to the fact that observable inputs are not available, or situations in which there is little, if any, market activity for the asset or liability at the measurement date.  The Company’s derivative liabilities are classified within Level 2 of the fair value hierarchy because they are valued using inputs which are not actively observable, either directly or indirectly.
 
 
•
  
Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

 
•
  
Level 2: Quoted prices in markets that are not active, or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability; or
 
 
•
  
Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and are unobservable.
 

 
18
 
TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2009
(UNAUDITED)

The following table sets forth the Company’s short- and long-term investments as of June 30, 2009 which are measured at fair value on a recurring basis by level within the fair value hierarchy. As required by SFAS No. 157, these are classified based on the lowest level of input that is significant to the fair value measurement, (in thousands):

(in thousands)
  
Level 1
    
Level 2
    
Level 3
    
Assets at
 fair value
  
Cash and cash equivalents
  
$
120