10-Q 1 v139369_10q.htm Unassociated Document


 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended December 31, 2008

Commission File Number 0-20734

e.Digital Corporation
(Exact name of registrant as specified in its charter)


Delaware
33-0591385
(State or other jurisdiction of
(I.R.S. Empl. Ident. No.)
incorporation or organization)
 
   
16770 West Bernardo Drive, San Diego, California
92127
(Address of principal executive offices)
    (Zip Code)

(858) 304-3016
(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 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.
   
Large Accelerated Filer o
Accelerated filer o
Non-accelerated filer o  (Do not check if a smaller reporting company)
Smaller reporting company x
   
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o   No  x
As of February 6, 2009 a total of 281,376,657 shares of the Registrant’s Common Stock, par value $0.001, were issued and outstanding.

 



 
 

 

e.DIGITAL CORPORATION

INDEX
       
     
Page
PART I.
FINANCIAL INFORMATION
 
       
 
Item 1.
Financial Statements (unaudited):
 
       
   
Consolidated Balance Sheets as of December 31, 2008 and
 
   
and March 31, 2008
 3
       
   
Consolidated Statements of Operations for the three and nine
 
   
months ended December 31, 2008 and 2007
 4
       
   
Consolidated Statements of Cash Flows for the nine
 
   
months ended December 31, 2008 and 2007
 5
       
   
Notes to Interim Consolidated Financial Statements
 6
       
 
Item 2.
Management's Discussion and Analysis of Financial
 
   
  Condition and Results of Operations
19
       
 
Item 4.
Controls and Procedures
26
       
       
PART II.
OTHER INFORMATION
 
       
 
Item 1.
Legal Proceedings
27
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
28
 
Item 3.
Defaults Upon Senior Securities
28
 
Item 4.
Submission of Matters to a Vote of Security Holders
28
 
Item 5.
Other Information
28
 
Item 6.
Exhibits
28
SIGNATURES
   
29


 
2

 
 
 
Part I. Financial Information
     
Item 1. Financial Statements:
     
e.Digital Corporation and subsidiary
     
CONSOLIDATED BALANCE SHEETS
   
December 31,
   
March 31,
 
   
2008
   
2008
 
   
(Unaudited)
$
     
$
 
ASSETS
             
Current
             
Cash and cash equivalents
    742,740       122,116  
Accounts receivable, trade
    2,137,965       174,905  
Inventories
    516,034       489,238  
Deposits and prepaid expenses
    31,758       34,717  
    Total current assets
    3,428,497       820,976  
Property and equipment, net of accumulated depreciation of
               
   $497,212 and $485,037, respectively
    27,886       40,061  
Total assets
    3,456,383       861,037  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
               
Current
               
Accounts payable, trade
    523,457       836,217  
Other accounts payable and accrued liabilities
    874,774       198,210  
Accrued employee benefits
    104,849       149,483  
Customer deposits
    80,000       80,000  
Deferred revenue
    68,953       36,500  
Current maturity of convertible term note, less $11,241 and $25,842 of debt discount
    516,967       366,989  
Secured promissory note, less $2,868 and $4,131 of note discount
    297,132       445,869  
Promissory note, less $1,173 and $-0- of note discount
    38,827       -  
    Total current liabilities
    2,504,959       2,113,268  
                 
Long-term convertible term note, less $-0- and $6,141 of debt discount
    -       381,093  
Deferred revenue-long term
    32,000       72,000  
    Total long-term liabilities
    32,000       453,093  
    Total liabilities
    2,536,959       2,566,361  
                 
Commitments and Contingencies
               
                 
Stockholders' equity (deficit)
               
Series AA Convertible Preferred stock, $0.001 par value, 100,000
               
  shares designated: 75,000 and -0- issued and outstanding, respectively
         
  Liquidation preference of $769,212 and $-0-, respectively
    568,432       -  
Common stock, $0.001 par value, authorized 350,000,000,
               
   280,062,704 and 272,494,867 shares outstanding, respectively
    280,063       272,495  
Additional paid-in capital
    81,302,762       80,103,769  
Accumulated deficit
    (81,231,833 )     (82,081,588 )
Total stockholders' equity (deficit)
    919,424       (1,705,324 )
                 
Total liabilities and stockholders' equity (deficit)
    3,456,383       861,037  

See notes to interim consolidated financial statements
 
3


e.Digital Corporation and subsidiary
     
               
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
               

   
For the three months ended
   
For the nine months ended
 
   
December 31,
   
December 31,
 
    2008    
2007
      2008    
2007
 
      $     
(as restated)
$
     
$
   
(as restated)
$
 
Revenues:
                         
   Products
    120,463       1,006,485       356,444       4,304,197  
   Services
    135,570       184,362       451,746       507,065  
   Patent license
    3,650,000       -       5,250,000       -  
      3,906,033       1,190,847       6,058,190       4,811,262  
                                 
Cost of revenues:
                               
   Products
    96,334       748,529       303,793       3,455,058  
   Services
    57,230       45,967       169,438       116,340  
   Patent license
    1,465,919       -       2,027,245       -  
      1,619,483       794,496       2,500,476       3,571,398  
Gross profit
    2,286,550       396,351       3,557,714       1,239,864  
                                 
Operating expenses:
                               
   Selling and administrative
    576,997       484,252       1,743,389       1,427,344  
   Research and related expenditures
    111,922       243,345       387,672       739,592  
          Total operating expenses
    688,919       727,597       2,131,061       2,166,936  
                                 
Operating income (loss)
    1,597,631       (331,246 )     1,426,653       (927,072 )
                                 
Other income (expense):
                               
   Interest expense
    (38,717 )     (56,115 )     (129,425 )     (187,783 )
   Other income and expense
    (11,119 )     (10,010 )     (183,473 )     (33,662 )
          Other income (expense)
    (49,836 )     (66,125 )     (312,898 )     (221,445 )
                                 
Income (loss) before provision for income taxes
    1,547,795       (397,371 )     1,113,755       (1,148,517 )
Provision for income taxes
    -       -       (264,000 )     -  
Income (loss) for the period
    1,547,795       (397,371 )     849,755       (1,148,517 )
Accrued and deemed dividends on preferred stock
    (43,284 )     (27,225 )     (87,978 )     (81,975 )
Income (loss) attributable to common stockholders
    1,504,511       (424,596 )     761,777       (1,230,492 )
Income (loss) per common share - basic and diluted
    0.01       (0.00 )     0.00       (0.00 )
                                 
Weighted average common shares outstanding
                         
  Basic
    279,143,996       249,097,860       276,916,733       246,631,374  
  Diluted
    281,454,506       249,097,860       277,912,376       246,631,374  

See notes to interim consolidated financial statements

 
4

 

       
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

   
For the nine months ended
 
   
December 31,
 
     
2008
   
2007
 
     
$
     
$
 
OPERATING ACTIVITIES
               
Income (loss) for the period
    849,755       (1,148,517 )
Adjustments to reconcile income (loss) to net cash used in operating activities:
 
     Depreciation and amortization
    12,175       12,616  
     Accrued interest and accretion of discount relating to promissory notes
    32,632       21,893  
     Interest paid with common stock
    29,500       77,381  
    Warranty provision
    (41,615 )     185,602  
    Stock-based compensation
    31,526       129,209  
    Warrant modification and warrant derivative revaluation
    174,667       -  
Changes in assets and liabilities:
               
     Accounts receivable, trade
    (1,963,060 )     (131,800 )
     Inventories
    (26,796 )     51,723  
Deposits and prepaid expenses
    2,959       9,756  
     Accounts payable
    (262,760 )     (165,837 )
     Other accounts payable and accrued liabilities
    758,251       (57,246 )
     Customer deposits
    -       (38,850 )
     Accrued employee benefits
    (44,634 )     49,562  
     Deferred revenue
    (7,547 )     112,000  
     Warranty reserve
    (43,072 )     (81,904 )
Cash used in operating activities
    (498,019 )     (974,412 )
INVESTING ACTIVITIES
               
Purchase of property and equipment
    -       (7,167 )
Cash used in investing activities
    -       (7,167 )
FINANCING ACTIVITIES
               
Sale of common stock
    580,000       640,000  
Proceeds from sale of preferred stock
    700,000       -  
Proceeds from exercise of warrants
    -       214,480  
Proceeds from exercise of stock options
    -       11,310  
Payment on convertible term note
    (51,357 )     -  
Payment on secured promissory note
    (150,000 )     (300,000 )
Proceeds from unsecured promissory note
    40,000       -  
Cash provided by financing activities
    1,118,643       565,790  
Net increase (decrease) in cash and cash equivalents
    620,624       (415,789 )
Cash and cash equivalents, beginning of period
    122,116       694,757  
Cash and cash equivalents, end of period
    742,740       278,968  
                 
Supplemental disclosures of cash flow information:
               
   Cash paid for interest
    64,893       88,509  
Supplemental schedule of noncash investing and financing activities:
         
   Accounts payable exchanged for preferred stock
    50,000       -  
   Common stock issued on conversion of preferred stock
    -       1,456,000  
   Accrued and deemed dividends on preferred stock
    87,978       81,975  
   Term note payments paid in common stock
    230,000       120,000  
   Financing fees paid in common stock
    8,800       21,500  
  Warrant derivative liability reclassified to equity
    132,315       -  

See notes to interim consolidated financial statements

 
5

 

1. NATURE OF OPERATIONS AND BASIS OF PRESENTATION
e.Digital Corporation is a holding company incorporated under the laws of Delaware that operates through a wholly-owned California subsidiary of the same name. The Company has innovated a proprietary secure digital video/audio technology platform ("DVAP") and markets the eVU™ mobile entertainment device for the travel and recreational industries. The Company also obtains revenue from licensing and enforcing its Flash-R™ portfolio of patents related to the use of flash memory in portable devices.

Unaudited Interim Financial Statements
These unaudited consolidated financial statements have been prepared by management in accordance with accounting principles generally accepted in the United States and with the instructions to Form 10-Q and Article 10 of Regulation S-X on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future. These interim consolidated financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, the unaudited consolidated financial statements reflect all adjustments considered necessary for a fair statement of the Company's financial position at December 31, 2008, and the results of operations and cash flows for the periods presented, consisting only of normal and recurring adjustments. All significant intercompany transactions have been eliminated in consolidation. Operating results for the three and nine months ended December 31, 2008 are not necessarily indicative of the results that may be expected for the fiscal year ending March 31, 2009. For further information, refer to the Company's consolidated financial statements and footnotes thereto for the year ended March 31, 2008 filed on Form 10-K.

Prior Period Presentation
As more fully described in Note 15 to the Company’s consolidated financial statements and footnotes thereto for the year ended March 31, 2008 filed on Form 10-K, the Company restated the two quarters ended September 30, 2007 and December 31, 2007 due to an overstatement of both revenues and cost of revenues of $104,000 and $62,400 for the quarters, respectively, due to a misclassification of supplier material transfers with no effect on gross profit, operating loss or net loss in either quarter or for the fiscal year ended March 31, 2008. The results for December 31, 2007 included herein reflect such restatement. Certain other amounts reported in prior periods have been reclassified to be consistent with the current period presentation.

Going Concern
These consolidated financial statements have been prepared assuming that the Company will continue as a going concern. The Company has experienced significant operating losses and negative cash flow from operations in each of the last three years and has an accumulated deficit of $81.2 million at December 31, 2008. The Company’s recent profitability has resulted from one-time patent licensing revenues and there is no assurance of future licensing revenues from new licensees. Accordingly, the Company could incur losses in the future until product, service and/or licensing revenues are sufficient to sustain continued profitability. The Company's ability to continue as a going concern is in doubt and is dependent upon achieving a profitable level of operations and if necessary obtaining additional financing. In the event the Company is unable to continue as a going concern, it may elect or be required to seek protection from creditors by filing a voluntary petition in bankruptcy or may be subject to an involuntary petition in bankruptcy. To date, management has not considered this alternative, nor does management view it as a likely occurrence.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. These consolidated financial statements do not give effect to any adjustments which would be necessary should the Company be unable to continue as a going concern and therefore be required to realize its assets and discharge its liabilities in other than the normal course of business and at amounts different from those reflected in the accompanying consolidated interim financial statements.

2. RECENT ACCOUNTING PRONOUNCEMENTS
On April 1, 2008, the Company adopted certain provisions of Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”), which establishes a single authoritative definition of fair value, sets out a framework for measuring fair value and expands on required disclosures about fair value measurement. The provisions of SFAS 157 adopted on April 1, 2008 relate to financial assets and liabilities as well as other assets and liabilities carried at fair value on a recurring basis and did not have a material impact on the Company’s consolidated financial statements. The provisions of SFAS 157 related to other nonfinancial assets and liabilities will be effective for the Company on April 1, 2009, and will be applied prospectively. The Company is currently evaluating the impact that these additional SFAS 157 provisions will have on the Company’s consolidated financial statements. See Note 10 - Fair Value Measurements.


 
6

 


In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” Under SFAS No. 159, companies may elect to measure certain financial instruments and certain other items at fair value. The standard requires that unrealized gains and losses on items for which the fair value option has been elected be reported in earnings. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company adopted SFAS No. 159 for fiscal 2009. However the Company did not elect to apply the fair value option to any financial instruments or other items upon adoption of SFAS No. 159 or during the nine months ended December 31, 2008. Therefore, the adoption of SFAS No. 159 did not impact the Company’s consolidated financial position, results of operations or cash flows.

In December 2007, the Financial Accounting Standards Board (“ FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 141(R), “Business Combinations” (“SFAS No. 141R”). SFAS No. 141R retains the fundamental requirements in SFAS No. 141 that the acquisition method of accounting (which SFAS No. 141 called the purchase method) be used for all business combinations and for an acquirer to be identified for each business combination. SFAS No. 141R also establishes principles and requirements for how the acquirer: (a) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; (b) improves the completeness of the information reported about a business combination by changing the requirements for recognizing assets acquired and liabilities assumed arising from contingencies; (c) recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and (d) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS No. 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008 (for acquisitions closed on or after April 1, 2009 for the Company). Early application is not permitted. Since the Company is not contemplating any business combinations after its effective date it does not presently expect any impact of SFAS No. 141R on its consolidated financial statements.
 
In December 2007, the FASB issued SFAS No. 160, “Non-Controlling Interests in Consolidated Financial Statements an amendment of ARB No. 51” (“SFAS 160”). SFAS 160 establishes new standards for the accounting for and reporting of non-controlling interests (formerly minority interests) and for the loss of control of partially owned and consolidated subsidiaries. SFAS 160 does not change the criteria for consolidating a partially owned entity. SFAS 160 is effective for fiscal years beginning after December 15, 2008. The provisions of SFAS 160 will be applied prospectively upon adoption except for the presentation and disclosure requirements which will be applied retrospectively. The Company does not expect the adoption of SFAS 160 will have a material impact on its consolidated financial statements.

On March 19, 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133 (“SFAS No. 161”). SFAS No. 161 requires enhanced disclosures about an entity’s derivative and hedging activities. These enhanced disclosures will discuss (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under Statement 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The Company has not determined the impact, if any SFAS No. 161 will have on its consolidated financial statements.
 
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS 162”). SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (the GAAP hierarchy). SFAS 162 will become effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles.” The Company does not currently expect the adoption of SFAS 162 to have a material effect on its consolidated results of operations and financial condition.

 
7

 


3. INCOME (LOSS) PER SHARE
Basic earnings per common share is computed by dividing income (loss) attributable to common shareholders by the weighted-average number of shares of common stock outstanding during the period. The income attributable to common stockholders is reduced by accrued and deemed dividends on preferred stock during the three and nine months ended December 31, 2008 of $43,284 and $87,978, respectively. The loss attributable to common stockholders is increased by accrued and deemed dividends on preferred stock during the three and nine months ended December 31, 2007 of $27,225 and $81,975, respectively. Diluted earnings per common share is computed by dividing income (loss) attributable to common shareholders by the weighted-average number of shares of common stock outstanding during the period increased to include the number of additional shares of common stock that would have been outstanding if the potentially dilutive securities had been issued. Potentially dilutive securities include outstanding convertible preferred stock, stock options, warrants, and convertible debt. The dilutive effect of potentially dilutive securities is reflected in diluted earnings per share by application of the treasury stock method. Under the treasury stock method, an increase in the fair market value of the Company’s common stock can result in a greater dilutive effect from potentially dilutive securities.
  
 The following table sets forth the computation of basic and diluted earnings per share:
             
   
Three Months Ended
   
Nine Months Ended
 
   
December 31,
   
December 31,
 
   
2008
   
2007
   
2008
   
2007
 
         
(as restated)
         
(as restated)
 
Basic
                       
Income (loss) attributable to common stockholders
  $ 1,504,511     $ (424,596 )   $ 761,777     $ (1,230,492 )
Weighted average common shares outstanding (basic)
    279,143,996       249,097,860       276,916,733       246,631,374  
Basic income (loss) per common share
  $ 0.01     $ (0.00 )   $ 0.00     $ (0.00 )
                                 
Diluted
                               
Income (loss) attributable to common stockholders
  $ 1,504,511     $ (424,596 )   $ 761,777     $ (1,230,492 )
Plus:
                               
Accrued and deemed dividends on preferred stock (1)
    -       -       -       -  
Income (loss) for diluted
  $ 1,504,511     $ (424,596 )   $ 761,777     $ (1,230,492 )
Common and potential common shares:
                               
Weighted average common shares outstanding
    279,143,996       249,097,860       276,916,733       246,631,374  
Assumed conversion of  preferred stock (1)
    -       -       -       -  
Assumed exercise of options and warrants
    2,310,510       -       995,643       -  
Common and potential common shares
    281,454,506       249,097,860       277,912,376       246,631,374  
Diluted income (loss) per common share
  $ 0.01     $ (0.00 )   $ 0.00     $ (0.00 )
                                 
Potentially dilutive securities outstanding at period end excluded from diluted computation as they were antidilutive
    18,597,387       16,440,925       18,897,387       16,440,925  
                                 
(1) The convertible preferred stock and convertible term note were antidilutive for the respective periods.
 
4. INVENTORIES
 
Inventories are stated at the lower of cost, which approximates actual costs on a first in, first out cost basis, or market.
Inventories consisted of the following:
   
December 31,
   
March 31,
 
   
2008
   
2008
 
     
$
     
$
 
Raw materials
    32,957       41,354  
Work in process
    321,673       217,820  
Finished goods
    161,404       230,064  
      516,034       489,238  
                 


 
8

 


5. STOCK-BASED COMPENSATION COSTS
The Company accounts for stock-based compensation under the provisions of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment (SFAS 123R). SFAS 123R requires measurement of all employee stock-based awards using a fair-value method and recording of related compensation expense in the consolidated financial statements over the requisite service period. Further, as required under SFAS 123R, the Company estimates forfeitures for share based awards that are not expected to vest. The Company recorded stock-based compensation in its consolidated statements of operations for the relevant periods as follows:
             
   
Three Months Ended
   
Nine Months Ended
 
   
December 31,
   
December 31,
 
   
2008
   
2007
   
2008
   
2007
 
         
(as restated)
         
(as restated)
 
   
$
   
$
   
$
   
$
 
Cost of revenues
    -       4,310       -       13,442  
Research and development
    8,918       15,282       8,918       30,349  
Selling and administrative
    (731 )     37,445       31,526       85,418  
Total stock-based compensation expense
    8,187       57,037       40,444       129,209  

Stock-based compensation expense for the three and nine months ended December 31, 2008 includes $8,918 for stock appreciation rights of three former employees in lieu of cash severance.  The value of such rights is recognized at fair value, remeasured at each reporting date and recorded as an accrued liability. Outstanding rights covered an aggregate of 437,500 shares with exercise prices ranging from $0.145 to $0.22 and a term ranging from 0.7 to 1.25 years. The rights were valued using the Black-Scholes option pricing model with the following assumptions: no dividend yield; weighted average risk free rate of 0.56%; volatility of 63% to 78% and a term equal to the term of the rights.

As of December 31, 2008 total estimated compensation cost of stock options granted but not yet vested was approximately $60,404 and is expected to be recognized over the weighted average period of 1.3 years.

The following table sets forth the weighted-average key assumptions and fair value results for stock options granted during the nine-month periods ended December 31, 2008 and 2007 (annualized percentages):

   
Nine Months Ended
 
   
December 31,
 
   
2008
   
2007
 
Volatility
    71 %     78 %
Risk-free interest rate
    2.3 %     4.1%-5.0 %
Forfeiture rate
    0.0 %     5.0 %
Dividend yield
    0.0 %     0.0 %
Expected life in years
    3.5       3  
Weighted-average fair value of options granted
  $ 0.05     $ 0.10  

The dividend yield of zero is based on the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends. Expected volatility is based on the historical volatility of the common stock over the period commensurate with the expected life of the options. The Company has a small number or option grants and limited exercise history and accordingly has for all new option grants applied the simplified method prescribed by SEC Staff Accounting Bulletin 110 to estimate expected life (computed as vesting term plus contractual term divided by two). The expected forfeiture rate is estimated based on historical experience for each option group. Additional expense is recorded when the actual forfeiture rates are lower than estimated and a recovery of prior expense will be recorded if the actual forfeitures are higher than estimated.

See Note 8 for further information on outstanding stock options.

 
9

 

6. WARRANTY RESERVE

Details of the estimated warranty liability included in other accounts payable and accrued liabilities are as follows:

   
Three Months Ended
   
Nine Months Ended
 
   
December 31,
   
December 31,
 
   
2008
   
2007
   
2008
   
2007
 
   
$
   
$
   
$
   
$
 
Beginning balance
    33,875       137,900       109,138       40,072  
Warranty provision
    (7,472 )     52,638       (43,072 )     185,602  
Warranty deductions
    (1,952 )     (46,768 )     (41,615 )     (81,904 )
Ending balance
    24,451       143,770       24,451       143,770  

7. PROMISSORY NOTES
The following table summarizes outstanding promissory notes at December 31, 2008:
                                   
       
Principal
Due at
December 31,
   
Less Unamortized
   
Net at December 31,
   
Long-Term
       
       
2008
   
Discount
   
2008
   
Portion
       
Description and Rate
 
Maturity
 
$
   
$
   
$
   
$
 
Collateral
 
Conversion
18% Secured Promissory Note
 
Interest monthly, principal at June 23, 2009
    300,000       (2,868 )     297,132      
-
 
Security interest in substantially
all assets
 
Not applicable
                                           
12% Promissory
Note
 
Principal and interest due April 3, 2009
    40,000       (1,173 )     38,827      
-
 
None
 
Not applicable
                                           
7.5% Convertible
Term Note
 
Principal and interest in monthly installments $50,000 per month through maturity in November 2009
    528,208       (11,241 )     516,967      
-
 
None
 
At $.30 per share at holder option and callable for conversion at market of $0.40 per common share
          868,208       (15,282 )     852,926      
-
       
                                           

In April 2008 the Company issued 40,000 shares of common stock as payment of a $4,800 finance fee on the $40,000 12% promissory note.

On October 8, 2008 Eric M. Polis was appointed as a director of the Company. Mr. Polis is Secretary, Treasurer and a director of ASI Technology Corporation the holder of the 18% Secured Promissory Note. In June 2008 the Company made a $50,000 principal reduction and incurred a $4,000 finance fee upon a six month renewal and in December 2008 made a $100,000 principal reduction and incurred a $3,000 finance fee for a six-month renewal of the note. The $4,000 finance fee was paid by issuing 40,404 shares of common stock and the Company issued 28,517 shares in payment of the $3,000 fee in February 2009. Note financing fees paid to creditors are recorded as a debt discount and amortized over the term of each note using the interest method. Interest expense incurred during the nine months ended December 31, 2008 on this note was $30,750.

The Company has the option, subject to certain limitations, to elect to make installment payments on the 7.5% Convertible Term Note either in cash or in shares of common stock (“Monthly Installment Shares”). Monthly Installment Shares are valued at the arithmetic average of the closing prices for the last five trading days of the applicable month without discount. Payments must be paid in cash if the computed average price is less than $0.10 per share. During the nine months ended December 31, 2008 the Company made seven monthly installment payments aggregating $230,000 through the issuance of 1,941,884 shares of common stock and made two installment payments in cash of $60,000.

8. STOCKHOLDERS’ EQUITY
The following table summarizes stockholders’ equity transactions during the nine-month period ended December 31, 2008:

 
10

 


   
Preferred stock
   
Common stock
   
Additional paid-in
   
Accumulated
 
   
Shares
   
Amount
   
Shares
   
Amount
   
capital
   
deficit
 
Balance, March 31, 2008
    -       -       272,494,867       272,495       80,103,769       (82,081,588 )
Sale of Series AA preferred stock and warrants
                                               
  net of $134,773 recorded as warrant liability (1)
    75,000       615,227       -       -       -       -  
Record $134,773  beneficial conversion
                                               
  related to Series AA preferred stock (1)
    -       (134,773 )     -       -       134,773       -  
Reclassification of warrant liability to equity (2)
    -       -       -       -       132,315       -  
Value assigned to modification of Seriess AA
                                               
   warrants (2)
    -       -       -       -       177,125       -  
Dividends on Series AA preferred stock
    -       19,212       -       -       (19,212 )     -  
Accretion of discount on Series AA preferred
                                               
  stock (1)
    -       68,766       -       -       (68,766 )     -  
Shares issued for term debt payments
    -       -       1,941,884       1,942       228,058       -  
Shares issued for debt financing fees
    -       -       80,404       80       8,720       -  
Proceeds from sale of common stock at an average price of $0.101 per share
    -       -       5,545,549       5,546       574,454       -  
Stock-based compensation
    -       -       -       -       31,526       -  
Income for the period
    -       -       -       -       -       849,755  
Balance, December 31, 2008
    75,000       568,432       280,062,704       280,063       81,302,762       (81,231,833 )
 
 
(1)
The $134,773 allocated as the value of detachable warrants and the beneficial conversion feature of $134,773 are treated as a discount to the value of the Series AA Stock (see Note 9) and are being accreted  as a deemed dividend over the term of the preferred stock. Due to the accumulated deficit these charges are recorded  to paid-in capital.
 
(2)
See Note 9.

Fusion Capital Equity Purchase Agreement
On January 2, 2007, the Company entered into an agreement with Fusion Capital Fund II, LLC (“Fusion”) pursuant to which the Company had the right, subject to certain conditions and limitations, to sell to Fusion up to $8.0 million worth of common stock, at the Company’s election, over a period that ended February 4, 2009 at prices determined based upon the market price of the Company’s common stock at the time of each sale. During the nine months ended December 31, 2008, the Company sold 5,545,549 common shares to Fusion under the agreement for cash of $580,000.

Subsequent to December 31, 2008 the Company sold 800,000 common shares to Fusion under the agreement for cash of $80,000.

Options
The following table summarizes stock option activity for the period:

   
Shares
   
Weighted average exercise price
   
Weighted average life
   
Aggregate intrinsic value (2)
 
  
   
#
   
$
   
(years)
   
$
 
Outstanding March 31, 2008
    10,897,167       0.16              
Granted
    1,100,000       0.11              
Canceled/expired
    (2,584,167 )     0.16              
Exercised
    -       -    
 
   
 
 
Outstanding December 31, 2008 (1)
    9,413,000       0.15       1.8       30,000  
Exercisable at December 31, 2008
    7,655,332       0.15       1.6       30,000  
   
(1)
Options outstanding are exercisable at prices ranging from $0.09 to $0.44 and expire over the period from 2009 to 2013.
   
(2)
Aggregate intrinsic value is based on the closing price of our common stock on December 31, 2008 of $0.11 and excludes the impact of options that were not in-the-money.

 
11

 


Share warrants
The following table summarizes information on warrant activity during the nine months ended December 31, 2008:

         
Weighted average
 
   
Shares
   
exercise price
 
     
#
   
$
 
Outstanding March 31, 2008
    2,331,572       0.15  
Granted
    7,500,000       0.10  
Canceled/expired
    -       -  
Exercised
    -       -  
Outstanding December 31, 2008
    9,831,572       0.11  

The Company has outstanding share warrants as of December 31, 2008, as follows:

Description
 
Number of Common Shares
   
 
Exercise Price Per Share $
 
  Expiration Date
Warrants (1)
    2,331,572       0.15  
August 31, 2009
Warrants
    7,500,000       0.10  
June 30, 2011
 
(1)
exercise price subject to certain antidilution price protection.

9. PREFERRED STOCK
On December 30, 2002, the Company issued 205,000 shares of 12% Series D non-redeemable convertible preferred stock (the "Series D Stock") with a stated value of $10 per share. Dividends of 12% per annum were payable, with certain exceptions, either in cash or in shares of common stock at the Company's election. The remaining 91,000 shares of Series D Stock and accumulated dividends automatically converted to 18,200,000 shares of common stock at $0.08 per share on December 31, 2007. Dividends accrued during the nine months ended December 31, 2007 totaled $81,975 and increased the loss attributable to common stockholders.

On June 27, 2008 the Company issued 75,000 shares of 5% Series AA Convertible Preferred Stock (the “Series AA Stock”) with a stated value of $10 per share. Dividends of 5% per annum are payable in shares of common stock or at the Company’s election additional shares of Series AA Stock or under certain circumstances in cash. The Series AA Stock has voting rights of ten votes per share and a liquidation preference equal to $10.00 per share plus accrued and unpaid dividends. The stated value plus accrued dividends on Series AA Stock is convertible into common stock at $0.10 per common share with automatic conversion on June 30, 2010 subject to certain limitations. The Company may call the Series AA Stock for conversion if the common stock market price is at least $0.25 per share for ten consecutive trading days.

The Series AA Stock was issued for aggregate proceeds of $750,000 including $700,000 of cash and conversion of $50,000 of vendor debt. Purchasers were also issued warrants to purchase an aggregate of 7,500,000 shares of common stock exercisable at $0.10 per common share until June 30, 2011 (“Series AA Warrants”). One officer/director purchased for $100,000 cash 10,000 shares of Series AA Stock and was issued warrants to purchase 1,000,000 shares of common stock on the same terms as unaffiliated investors.

At the holder’s option the Series AA Stock and the Series AA Warrants were redeemable for cash at June 30, 2009 should sufficient shares of common stock not be authorized and reserved for conversion of all underlying shares by such date. This redemption right was terminated effective September 17, 2008 with the shareholders authorizing additional shares of common stock and the Board of Directors reserving sufficient shares for future conversions of the Series AA Stock and exercise of the Series AA Warrants.

The proceeds of $750,000 were allocated between the fair value of the Series AA Stock ($615,227) with the value of the Series AA Warrants ($134,773) treated as a discount to the Series AA Stock. The Company determined the fair value of the Series AA Warrants using the Black-Scholes option pricing model with the following assumptions: no dividend yield; weighted average risk free rate of 2.93%; volatility of 60.6% and a term of one year. Because  the redemption event was not certain to occur but was outside the Company’s control, the Company originally recorded the portion of the proceeds attributable to the stock as mezzanine equity pursuant to EITF Topic D-98, Classification and Measurement of Redeemable Securities after determining the guidance in FAS 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity did not apply. Upon termination of the redemption right on September 17, 2008 the value of the stock was reclassified as permanent equity.


 
12

 

Additionally, the Company evaluated whether the embedded conversion feature in the preferred stock required bifurcation and determined that the economic characteristics and risks of the embedded conversion feature in the stock were clearly and closely related to the stock and concluded that bifurcation was not required under SFAS 133. The Company calculated the intrinsic value of the beneficial conversion feature as $134,773 pursuant to the guidance in EITF 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments. The total discount to the Series AA Stock of $269,546, consisting of the value of the Series AA Warrants and the amount of the beneficial conversion feature, is being accreted  as a deemed dividend over the term of the Series AA Stock. A total of $68,766 of the discount was accreted  as a deemed dividend for the nine month period ended December 31, 2008 by a charge to paid-in capital. The stated 5% dividend also accrues to the carrying value of the Series AA Stock. The deemed and stated dividends are also used in determining the net income (loss) attributable to common stockholders for the respective periods.

The Company determined that the warrants met the definition of a derivative instrument at issuance as defined in SFAS 133, Accounting for Derivative Instruments and Hedging Activities, and was treated as a liability due to the lack of sufficient authorized shares of common stock. The Company recorded a liability of $134,773 for the value of the warrants. As a derivative liability this amount was evaluated for reclassification and if a derivative liability adjusted at each reporting period based on the current market price. Upon the authorization and reservation of shares of common stock for exercise of the warrants on September 17, 2008, the Company determined the warrants were no longer a derivative liability. The value at that date of $132,315 was reclassified to paid-in capital and a net non-cash gain of $2,458 was recorded in other income (expense).  The Company also determined that the termination of the warrant redemption rights was an effective modification of the warrant term and calculated the fair value of the warrants immediately prior to the modification compared to the value immediately after the modification and recorded the difference in warrant value of $177,125 as a financing expense in other expenses.

10. FAIR VALUE MEASUREMENTS
On April 1, 2008, the Company adopted SFAS No. 157 which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. In February 2008, the FASB deferred the effective date of SFAS 157 by one year for certain non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). The Company adopted the provisions of SFAS 157, except as it applies to those nonfinancial assets and nonfinancial liabilities for which the effective date has been delayed by one year.

SFAS No. 157 establishes a three-level valuation hierarchy of valuation techniques that is based on observable and unobservable inputs. Classification within the hierarchy is determined based on the lowest level of input that is significant to the fair value measurement. The first two inputs are considered observable and the last unobservable, that may be used to measure fair value and include the following:
Level 1 - Quoted prices in active markets for identical assets or liabilities.
Level 2 - Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

As of December 31, 2008, the Company held certain assets and liabilities that are required to be measured at fair value on a recurring basis, including its cash and cash equivalents. The fair value of these assets and liabilities was determined using the following inputs in accordance with SFAS 157 at December 31, 2008:

 
13

 


   
Fair Value Measurement as of December 31, 2008
 
   
Total
   
Level 1
   
Level 2
   
Level 3
 
Description
 
$
   
$
   
$
   
$
 
Cash and cash equivalents (1)
    742,740       742,740       -       -  
Warrant derivative liability (2)
    -       -       -       -  
                                 
 
 
(1)
Included in cash and cash equivalents on the accompanying consolidated balance sheet.
 
(2)
Represents Series AA Warrants issued in June 2008 and valued using the income approach using the Black-Scholes option pricing model (see Note 9). An initial liability of $134,773 was revalued to $132,315 at September 17, 2008 and reclassified as equity (see Note 9).

The following table reconciles the warrant derivative liability measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the nine months ended December 31, 2008:

   
Warrant
 
   
Derivative
 
   
Liability
 
   
$
 
Balance at April 1, 2008
    -  
Issuance of warrant derivative (1)
    134,773  
Adjustment to fair value included in net loss (2)
    (2,458 )
Reclassification to equity (2)
    (132,315 )
Balance at December 31, 2008
    -  
         
 
(1)
Represents Series AA Warrants issued in June 2008 (see Note 9).
 
(2)
The warrant derivative liability was revalued at the end of each reporting period until reclassification as equity and the resulting difference was included in the results of operations in “Other income and expense”.

11. SEGMENT INFORMATION
SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information,” (“SFAS No. 131”) provides annual and interim reporting standards for an enterprise’s business segments and related disclosures about its products, services, geographical areas and major customers. With the inception of patent license revenue in the current year, the Company determined that it has two operating segments: (1) products and services and (2) patent licensing. Products and services consist of sales of the Company’s electronic eVU mobile entertainment device and related content services and patent licensing consists of intellectual property revenues from the Flash-R patent portfolio.
 
Accounting policies for each of the operating segments are the same as on a consolidated basis however the Company has only recently commenced receiving patent license revenue. The Company recognizes revenue from patent license agreements when (i) the patent license agreement is executed, (ii) the amounts due are fixed, determinable, and billable, (iii) the customer has been provided rights to the licensed technology and (iv) collection of the resulting receivable, if any, is probable. At the time the Company enters into a contract and provides the customer with the licensed technology the Company has performed all of its obligations under contract, the rights to the Company’s technology have been transferred and no significant performance obligations remain. License revenue to date consists of one-time licenses requiring no future performance. The Company values nonexclusive cross licenses received only if directly used in operations. Patent license costs of revenues include contingency legal and other direct costs associated with patent licensing.
 
Our reportable segment information for the three and nine months ended December 31, 2008 is as follows:

 
14

 

 

   
For the three months ended
   
For the nine months ended
 
   
December 31,
   
December 31,
 
   
2008
   
2007
   
2008
   
2007
 
         
(as restated)
         
(as restated)
 
   
$
   
$
   
$
   
$
 
REVENUES:
                       
Products and services
    256,033       1,190,847       808,190       4,811,262  
Patent licensing
    3,650,000       -       5,250,000       -  
Total revenue
    3,906,033       1,190,847       6,058,190       4,811,262  
                                 
GROSS PROFIT:
                               
Products and services
    102,469       396,351       334,959       1,239,864  
Patent licensing
    2,184,081       -       3,222,755       -  
Total gross profit
    2,286,550       396,351       3,557,714       1,239,864  
                                 
RECONCILIATION:
                               
Total segment gross profit
    2,286,550       396,351       3,557,714       1,239,864  
Operating expenses
    (688,919 )     (727,597 )     (2,131,061 )     (2,166,936 )
Other income (expense)
    (49,836 )     (66,125 )     (312,898 )     (221,445 )
Income (loss) before provision for income taxes
    1,547,795       (397,371 )     1,113,755       (1,148,517 )
 
The Company does not have significant assets employed in the patent license segment and does not track capital expenditures or assets by reportable segment. Consequently it is not practical to show this information.
 
Revenue by geographic region is determined based on the location of the Company’s direct customers or distributors for product sales and services. Patent license revenue is considered United States revenue as payments are for licenses for United States operations irrespective of the location of the licensee’s home domicile.
   
For the three months ended
   
For the nine months ended
 
   
December 31,
   
December 31,
 
   
2008
   
2007
   
2008
   
2007
 
         
(as restated)
         
(as restated)
 
   
$
   
$
   
$
   
$
 
United States
    3,650,000       -       5,250,000       -  
International
    256,033       1,190,847       808,190       4,811,262  
Total revenue
    3,906,033       1,190,847       6,058,190       4,811,262  
                                 
Revenues from three customers comprised 33%, 27% and 26% of revenue for the nine months ended December 31, 2008. Sales to three customer comprised 37%, 26% and 20% of revenue for the nine months ended December 31, 2007. Accounts receivable from one customer comprised 95% of net accounts receivable at December 31, 2008 and three customers accounted for 61%, 14% and 12% of net accounts receivable at December 31, 2007.

12. COMMITMENTS AND CONTINGENCIES

Legal Matters

Business Litigation

In May 2006, the Company announced that a complaint had been filed against it and certain of its officers and employees by digEcor, Inc. in the Third Judicial District Court of Utah, County of Salt Lake. The complaint alleged breaches of contract, unjust enrichment, breaches of good faith and fair dealing, fraud, negligent misrepresentation, and interference with prospective economic relations. digEcor sought, among other things, an injunction to prevent our Company from selling or licensing certain digital rights management technology and "from engaging in any competition with digEcor until after 2009." digEcor also sought "actual damages" of $793,750 and "consequential damages...not less than an additional $1,000,000." This action was related to a purchase order the Company placed for this customer in the normal course of business on November 11, 2005 for 1,250 digEplayers with its contract manufacturer, Maycom Co., Ltd.. Maycom was paid in full for the order by both e.Digital and digEcor by March 2006, but Maycom failed to timely deliver the order. The Company recorded an impairment charge of $603,750 in March 2006 for deposits paid to Maycom due to the uncertainty of obtaining future delivery. In October 2006 the Company received delivery from Maycom of the delayed 1,250-unit digEplayer order and delivered the order to digEcor. The Company recognized $713,750 of revenue from this order and reversed an impairment charge of $603,750 in its third fiscal 2007 quarter.  The Company answered digEcor's complaint and is pursuing certain counterclaims.


 
15

 


In January 2007, the Court ruled on certain motions of the parties. In its ruling, the Court dismissed digEcor's unjust enrichment, fraud, negligent misrepresentation, tortious interference and punitive damage claims. The Court further acknowledged the delivery of the 1,250-unit order and a partial settlement between the parties reducing digEcor's claim for purchase-price or actual damages from $793,750 to $94,846 with such amount still being disputed by e.Digital. digEcor's contract and damages claims remain in dispute. digEcor has subsequently amended its Complaint to assert an alternative breach of contract claim, and claims for federal, state and common law unfair competition, and sought an injunction prohibiting us "from engaging in any competition with digEcor until after 2013."

In April 2007 the Company filed a second amended counterclaim in the United States District Court of Utah seeking a declaratory judgment confirming the status of prior agreements between the parties, alleging breach of the Company’s confidential information and trade secrets by digEcor, seeking an injunction against digEcor's manufacture and sale of a portable product based on the Company’s technology, alleging breach of duty to negotiate regarding revenue sharing dollars the Company believes it has the right to receive and tortious interference by digEcor in the Company’s contracts with third parties. The Company intends to vigorously prosecute these counterclaims.

In April 2007 digEcor filed a motion for summary judgment seeking enforcement of an alleged non-compete provision and an injunction prohibiting the Company from competing with digEcor. In October 2007 the Court denied, without prejudice, digEcor's motion for partial summary judgment and request for injunction. The foregoing and other findings of the Court may be subject to appeal by either party.

In September 2008 digEcor filed their third request for a partial summary judgment again seeking enforcement of the alleged non-compete provision.  digEcor also asked the Court to rule on issues surrounding the delayed 1250-unit order and e.Digital's alleged breach of  a 2002 contract between the parties.  

In September 2008 the Company filed a summary judgment motion seeking a ruling (i) that the alleged non-compete provision is unenforceable and /or superseded by the 2002 agreement between the parties, and (ii) that the Company has not breached any alleged non-compete provisions or the 2002 agreement.  The Company also asked the Court to dismiss digEcor's unfair competition claims and limit digEcor's damages claim.

The case has now completed the discovery phase. The Company has voluntarily dismissed some of its counterclaims, alleging misappropriation of its confidential information and trade secrets.  The Company believes that it has substantive and multiple defenses and intends to vigorously challenge the remaining matters and pursue all remaining counterclaims. However, there can be no assurance the Company will prevail in its counterclaims or in its defense of digEcor's remaining claims.

The Company is also unable to determine at this time the impact this complaint and matter may have on its financial position or results of operations. The Company has an accrual of $80,000 as an estimate of its obligation related to the remaining general damage claim and the Company intends to seek restitution from Maycom for any damages it may incur. Recovery from Maycom is not assured. Maycom is not involved in the design, tooling or production of the Company’s proprietary eVU mobile product. Moreover, the Company does not presently plan or expect to produce or sell digEplayer models to digEcor or other customers in the future.


 
16

 

Commitment Related to Intellectual Property Legal Services
On March 23, 2007 the Company entered into an agreement for legal services and a contingent fee arrangement with Duane Morris LLP. The agreement provides that Duane Morris is the Company’s legal counsel in connection with the assertion of the Company’s flash memory related patents against infringers (“Patent Enforcement Matters’).

Duane Morris has agreed to handle the Company’s Patent Enforcement Matters and certain related appeals on a contingent fee basis. Duane Morris also has agreed to advance certain costs and expenses including travel expenses, court costs and expert fees. The Company has agreed to pay Duane Morris a fee equal to 40% of any license or litigation recovery related to Patent Enforcement Matters, after recovery of expenses, and 50% of recovery if appeal is necessary.

In the event the Company is acquired or sold or elects to sell the covered patents or upon certain other corporate events or in the event the Company terminates the agreement for any reason, then Duane Morris shall be entitled to collect accrued costs and a fee equal to three times overall time and expenses accrued in connection with the agreement and a fee of 15% of a good faith estimate of the overall value of the covered patents. The Company has provided Duane Morris a lien and a security interest in the covered patents to secure its obligations under the agreement.
 
Contract Manufacturers and Suppliers
The Company depends on contract manufacturers and suppliers to (i) allocate sufficient capacity to its manufacturing needs, (ii) produce acceptable quality products at agreed pricing and (iii) deliver on a timely basis. If a manufacturer is unable to satisfy these requirements, the Company's business, financial condition and operating results may be materially and adversely affected. Any failure in performance by either of these manufacturers for any reason could have a material adverse affect on the Company's business. Production and pricing by such manufacturers is subject to the risk of price fluctuations and periodic shortages of components. The Company does not have supply agreements with component suppliers and, accordingly, it is dependent on the future ability of its manufacturers to purchase components. Failure or delay by suppliers in supplying necessary components could adversely affect the Company's ability to deliver products on a timely and competitive basis in the future.

At December 31, 2008 the Company had outstanding unfilled purchase orders and was committed to a contract manufacturers and component suppliers for approximately $127,000 of future deliveries. Purchase commitments for product and components are generally subject to modifications as to timing, quantities and scheduling and in certain instances may be cancelable without penalty.

Facility Lease
In March 2006 the Company entered into a sixty-two month lease, commencing June 1, 2006, for approximately 4,800 square feet with an aggregate payment of $5,805 per month excluding utilities and costs. The aggregate payments adjust annually with maximum aggregate payments totaling $6,535 in the fifty-first through the sixty-second month. Future lease commitments aggregated $197,652 at December 31, 2008.

Royalties
In connection with a prior note financing, the Company is obligated to pay a royalty of $20.00 for each entertainment device sold through December 31, 2008. During the nine months ended December 31, 2008 and 2007 the Company incurred royalties of $4,640 and $69,620, respectively.
 
Other Concentrations and Financial Instruments
The global economy, including the electronics industry, is experiencing a widespread decline in business activity, together with a reduction in general credit availability and instability in the commercial and investment banking systems, all of which are likely to have far-reaching effects on economic activity for an indeterminate period. The near- and long-term impact of these factors on the Company's operations cannot be predicted at this time but may be substantial.

From time-to-time, the Company carries cash and securities balances on deposit with financial institutions that are in excess of federally insured limits, and the risk of losses related to such concentrations may be increasing as a result of recent economic developments discussed in the foregoing paragraph. The extent of a future loss to be sustained as a result of uninsured deposits in the event of a future failure of a bank or other financial institution, if any, however, is not subject to estimation at this time.


 
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13. INCOME TAX
The Company adopted the provisions of FIN 48 on April 1, 2007 and commenced analyzing filing positions in the Jurisdictions where we are required to file income tax returns. As a result of the implementation of FIN 48, the Company recognized no adjustment for uncertain tax provisions and the total amount of unrecognized tax benefits as of April 1, 2007 was $-0-. The Tax Reform Act of 1986 (the Act) provides pursuant to Internal Revenue Code Sections 382 and 383 for a limitation of the annual use of NOL and research and development tax credit carryforwards (following certain ownership changes, as defined by the Act) that could significantly limit the Company's ability to utilize these carryforwards. The Company has experienced various ownership changes as a result of past financings and could experience future ownership changes. The Company's ability to utilize the aforementioned carryforwards may therefore be significantly limited. Additionally, because U.S. tax laws limit the time during which these carryforwards may be applied against future taxes, the Company may not be able to take full advantage of these reduced attributes for federal income tax purposes. The Company has not performed an analysis of its deferred tax assets for net operating losses or any possible research and development credits sufficient to meet the more likely than not threshold required by FIN 48. Accordingly, the deferred tax assets related to net operating losses and the offsetting valuation allowance were removed from deferred tax assets at April 1, 2007 until such an analysis is documented.

As discussed above, as of April 1, 2007, the Company removed its net operating losses from deferred tax assets and the offsetting valuation allowance until documented by a Section 382 analysis. During the quarter ended September 30, 2008 the Company provided a tax provision of $264,000 representing foreign taxes for which a credit (a deferred tax asset) may be allowable against future United States taxes subject to certain limitations. A full valuation allowance has been established to offset the remaining net deferred tax assets (after applying sufficient net operating losses to offset current income) and to the new foreign tax credit at December 31, 2008 as realization of these assets is uncertain. For the three and nine months ended December 31, 2008, the deferred tax expense of $755,000 and $543,000 respectively, was offset by a corresponding decrease of the deferred tax asset valuation allowance.  When, and if, the Company can sustain consistent profitability, and management determines that it is likely it will be able to utilize the net operating losses prior to their expiration and the amounts are adequately documented, then any additional valuation allowance can be reduced or eliminated.

 
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

THE FOLLOWING DISCUSSION INCLUDES FORWARD-LOOKING STATEMENTS WITH RESPECT TO THE COMPANY'S FUTURE FINANCIAL PERFORMANCE. ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE CURRENTLY ANTICIPATED AND FROM HISTORICAL RESULTS DEPENDING UPON A VARIETY OF FACTORS, INCLUDING THOSE DESCRIBED BELOW AND UNDER THE SUB-HEADING, "BUSINESS RISKS." SEE ALSO THE COMPANY'S ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED MARCH 31, 2008.

Cautionary Note on Forward Looking Statements

In addition to the other information in this report, the factors listed below should be considered in evaluating our business and prospects.  This prospectus contains a number of forward-looking statements that reflect our current views with respect to future events and financial performance.  These forward-looking statements are subject to certain risks and uncertainties, including those discussed below and elsewhere herein, that could cause actual results to differ materially from historical results or those anticipated.  In this report, the words “anticipates,” “believes,” “expects,” “intends,” “future” and similar expressions identify forward-looking statements.  Readers are cautioned to consider the specific factors described below and not to place undue reliance on the forward-looking statements contained herein, which speak only as of the date hereof.  We undertake no obligation to publicly revise these forward-looking statements, to reflect events or circumstances that may arise after the date hereof.

General
We are a holding company incorporated under the laws of Delaware  that operates through our wholly-owned California subsidiary of the same name. We have innovated a proprietary secure digital video/audio technology platform ("DVAP") and market our eVU™ mobile entertainment device for the travel and recreational industries. We also own and are licensing our Flash-R™ portfolio of patents related to the use of flash memory in portable devices. Our revenue is derived from the sale of DVAP products and accessories to customers, warranty and technical support services and content fees and related services. We also obtain patent license revenue from our Flash-R patent portfolio.

Our strategy is to market our eVU products and services to a growing base of U.S. and international companies in the airline, healthcare, and other travel and leisure industries. We employ both direct sales to customers and sales through value added resellers (VARs) that provide marketing, logistic and/or content services to customers.

We are commercializing our Flash-R patent portfolio through licensing and we are aggressively pursuing enforcement by litigating against those who may be infringing our patents. Our international legal firm Duane Morris LLP is handling our patent enforcement matters on a contingent fee basis. In September 2007 and March 2008 we filed our first tranche of patent infringement litigation against eight defendants. In September 2008 we recorded our first patent license revenue and recognized additional license revenue during the quarter ended December 31, 2008. While we expect additional patent licenses in future periods there can be no assurance of the timing or amounts of any related license revenue.

Our business is high risk in nature. There can be no assurance we can achieve sufficient eVU or patent license revenues to sustain profitability. We continue to be subject to the risks normally associated with any new business activity, including unforeseeable expenses, delays and complications. Accordingly, there is no guarantee that we can or will report operating profits in future periods.

Overall Performance and Trends
We have experienced significant operating losses and negative cash flow from operations in each of the last three years. Our recent profitability has resulted from one-time patent licensing revenues and there is no assurance of future licensing revenues from new licensees. Accordingly, we could incur losses in the future until product, service and/or licensing revenues are sufficient to sustain continued profitability. Our ability to continue as a going concern is in doubt and is dependent upon achieving a profitable level of operations and if necessary obtaining additional financing.




 
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For the nine months ended December 31, 2008:

 
·
We recognized net income before income taxes of $1,113,755 for the nine months ended December 31, 2008. This was before income tax expense of $264,000 for foreign taxes. The resulting net income of $849,755 was an improvement from the net loss of $1,148,517 for the first nine months of the prior year.  The improvement resulted primarily from new higher margin patent licensing revenue that offset a decline in eVU product and service revenues.

 
·
Our revenues were $6.1 million for the first nine months compared to $4.8 million for the prior year’s nine months. Revenues in the first nine months included $5.25 million of patent license revenue. Last year’s first nine months revenues included product sales to new European in flight entertainment (“IFE”) customers. Recent eVU sales activity has been slow due to airline industry economics and industry credit concerns resulting in airlines curtailing expansion and new projects. We are aggressively pursuing new business but our results will be dependent on the timing and quantity of additional patent licenses and eVU orders. We seek to expand and diversify our customer base both in the IFE space and other markets. The failure to obtain additional patent license revenues or eVU orders or delays of orders or production delays could have a material adverse impact on our operations.

 
·
Our gross profit for the first nine months was $3.6 million or 59% of revenues compared to $1.2 million or 26% of revenues for the prior year’s first nine months. Results benefited from higher patent licensing gross profit percentages as compared to product sales. Gross profit margins are highly dependent on revenue and product mix, prices charged, volume of orders and costs.

 
·
Operating expenses were $2.1 million for the first nine months of fiscal 2009 (year ending March 31, 2009) compared to $2.2 million for the first nine months of fiscal 2008.

We have recently reduced our monthly cash operating costs to an average of approximately $200,000 per month. However, we may increase expenditure levels in future periods to support and expand our revenue opportunities and continue advanced product and technology research and development. Accordingly, we may incur future losses until such time as we are able to realize recurring revenues and margins sufficient to cover our costs of operations.  We may also face unanticipated technical or manufacturing obstacles and face warranty and other risks in our business.

Critical Accounting Policies
We have identified a number of accounting policies as critical to our business operations and the understanding of our results of operations. These are described in our consolidated financial statements located in Item 1 of Part I, “Financial Statements,” and in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report of Form 10-K for the year ended March 31, 2008. The impact and any associated risks related to these policies on our business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations when such policies affect our reported and expected financial results.

The methods, estimates and judgments we use in applying our accounting policies, in conformity with generally accepted accounting principles in the United States, have a significant impact on the results we report in our financial statements. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. The estimates affect the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions.

The following critical accounting policies guided our judgment and estimates used in accounting for the new issuance of convertible preferred stock in June 2008, fair value measurements and new patent license revenues:

Accounting for Convertible Preferred Stock
The Company accounts for preferred stock subject to provisions for redemption that are outside of its control as mezzanine equity in accordance with FAS 150 "Accounting for Certain Financial Instruments with Characteristics of Both Debt and Equity," EITF Topic D-98 “Classification and Measurement of Redeemable Securities” and  SEC Accounting Series Release (ASR) No. 268 “Redeemable Preferred Stocks,” and is shown net of discounts for warrant values and beneficial conversion features. These securities are recorded at fair value at the date of issue and related discounts are accreted over the term of the securities. The securities are reclassified to permanent equity when the provisions for redemption are terminated.


 
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The Company accounts for redeemable convertible preferred stock and the related common stock warrants in accordance with the provisions of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock,” EITF Issue No. 98-5 “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” EITF Issue No. 00-27 “Application of Issue No. 98-5 to Certain Convertible Instruments” and other related accounting guidance.  Pursuant to this guidance, the Company has concluded that the conversion and redemption features of the redeemable convertible preferred stock are not embedded derivatives that need to be bifurcated from the host instrument and separately valued. In addition, the Company has accounted for its detachable common stock warrants as a derivative liability in accordance with the guidance of EITF 00-19 and reevaluates the status of such instruments at each reporting period.

Fair Value Measurements
The Company follows the provisions of SFAS No. 157, “Fair Value Measurements,” or SFAS 157, which defines fair value as the price that would be received to sell an asset or paid to transfer a liability (i.e., the exit price) in an orderly transaction between market participants at the measurement date. In measuring fair value, the Company considers the hierarchy for inputs provided in SFAS 157 to determine appropriate valuation approaches. Generally, valuations are based on quoted market prices for identical assets or liabilities which the Company has the ability to access, or for which significant inputs are observable either directly or indirectly. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires judgment. The Company’s assumptions are set to reflect those that market participants would use in pricing the asset or liability at the measurement date; however, different judgments could yield different results. The Company’s valuation pricing models consider time value, volatility factors, current market and contractual prices for the underlying financial instruments as well as other measurements. Changes in these factors can have a significant impact on carrying values and results of operations.

Patent License Revenue Recognition
The Company has only recently commenced receiving patent license revenue. The Company recognizes revenue from patent license agreements when (i) the patent license agreement is executed, (ii) the amounts due are fixed, determinable, and billable, (iii) the customer has been provided rights to the licensed technology and (iv) collection of the resulting receivable, if any, is probable. At the time the Company enters into a contract and provides the customer with the licensed technology the Company has performed all of its obligations under contract, the rights to the Company’s technology have been transferred and no significant performance obligations remain. License revenue to date consists of one-time licenses requiring no future performance. The Company values nonexclusive cross licenses received only if directly used in operations.

Patent license costs of revenues include contingency legal and other direct costs associated with patent licensing.

 
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Results of Operations

Three months ended December 31, 2008 compared to the three months ended December 31, 2007
                   
   
Three Months Ended December 31,
             
   
2008
         
2007
                   
         
% of
   
(as restated)
   
% of
   
Change
 
   
Dollars
   
Revenue
   
Dollars
   
Revenue
   
Dollars
   
%
 
Revenues:
                                   
Product revenues
    120,463       3.1 %     1,006,485       84.5 %     (886,022 )      
Service revenues
    135,570       3.5 %     184,362       15.5 %     (48,792 )      
Patent license
    3,650,000       93.4 %     -       0.0 %     3,650,000        
      3,906,033       100.0 %     1,190,847       100.0 %     2,715,186       228.0 %
Gross Profit:
                                               
Product gross profit
    24,129               257,956               (233,827 )        
Service gross profit
    78,340               138,395               (60,055 )