Note 9. Derivatives and Fair Value.

The Company has evaluated the application of GAAP with respect to certain detachable Warrants (See Note – 8 Financing Instruments, (b) Warrants, above) to purchase common stock and determined they are required to be accounted for as a derivative as of January 1, 2009 due to the down round protection feature on the exercise price. The Company records the fair value of derivatives on its balance sheet at fair value with changes in the value of derivatives reflected in the statements of operations as “(Gain) Loss on Derivative Liabilities.” The Company's derivative instruments are not designated as hedging instruments under GAAP and are disclosed on the balance sheet under “Derivative Liabilities”. At December 31, 2011 and 2010, the Company's derivative liabilities were categorized as Level 3 fair value assets, respectively.

Level 3 Valuation Techniques

Financial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable. Level 3 financial liabilities consist of the freestanding Warrants that contain down round provisions for which there is no current market for these securities such that the determination of fair value requires significant judgment or estimation. We have valued the freestanding Warrants using a lattice model, with the assistance of a valuation consultant, for which management understands the methodologies. This model incorporates transaction details such as the Company's stock price, contractual terms, maturity, risk free rates, as well as assumptions about future financings, volatility, and holder behavior as of January 1, and December 31, 2011 and 2010, respectively. For 2011, the primary assumptions include projected annual volatility of 120% and holder exercise targets at 150% of exercise price for the Warrants, decreasing as the Warrants approach maturity. The fair value of the derivatives as of December 31, 2011 was estimated to be $154,518. For 2010, the primary assumptions include projected annual volatility of 123% and holder exercise targets at 150% of exercise price for the Warrants, decreasing as the Warrants approach maturity. The fair value of the derivatives as of December 31, 2010 was estimated to be $292,240. The foregoing assumptions are reviewed quarterly and subject to change based primarily on management's assessment of the probability of the events described occurring. Accordingly, changes to these assessments could materially affect the valuation.

Financial Assets and Liabilities Measured at Fair Value on a Recurring Basis

Financial assets and liabilities measured at fair value on a recurring basis are disclosed below and on the balance sheet under derivative liabilities:

	Fair Value Measurement Using
	As of December 31, 2011						As of December 31, 2010
	Carrying Value		Level 3		Total		Carrying Value		Level 3		Total
Warrant Liabilities	$	154,518	$	154,518	$	154,518	$	292,240	$	292,240	$	292,240
Total Derivative Liabilities	$	154,518	$	154,518	$	154,518	$	292,240	$	292,240	$	292,240

The table below provides a summary of the changes in fair value, including net transfers in and/or out, of all financial assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3):

	Fair Value Measurements Using Level 3 Inputs
	2011						2010
	Derivative Liabilities			Totals			Derivative Liabilities			Totals
Beginning Balance on January 1,	$	292,240		$	292,240		$	571,864		$	571,864
Total Gains or Losses (realized/unrealized) included in Net Income (Loss)		(137,722	)		(137,722	)		(279,624	)		(279,624	)
Purchases, Issuances and Settlements		-			-			-			-
Transfers in and/or out of Level 3		-			-			-			-
Ending Balance on December 31,	$	154,518		$	154,518		$	292,240		$	292,240