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[QUOTE]Originally posted by AmHaYs87: [QB] 10-Q: PATRIOT SCIENTIFIC CORP Print E-mail Enable live quotes RSS Digg it Del.icio.us Last Update: 4:23 PM ET Apr 20, 2007 (EDGAR Online via COMTEX) -- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations THE FOLLOWING DISCUSSION INCLUDES FORWARD-LOOKING STATEMENTS WITH RESPECT TO OUR 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 UNDER THE SUB-HEADING, "RISK FACTORS" SEE ALSO OUR ANNUAL REPORT ON FORM 10-KSB FOR THE YEAR ENDED MAY 31, 2006. Overview During the fiscal years ended May 31, 2005 and May 31, 2006, the Company entered into agreements for the licensing of its technology with Advanced Micro Devices Inc. ("AMD") and Intel Corporation, among the largest of the microprocessor manufacturers. During the 2006 fiscal year, the Company entered into licensing agreements with Hewlett-Packard, Fujitsu and Casio through its joint venture entity, Phoenix Digital. Additional licensing agreements for the use of the Company's technology were signed through its joint venture entity during the nine months ended February 28, 2007. We believe that these agreements represent validation of the Company's position that its intellectual property was and is being infringed by major manufacturers of microprocessor technology. Also, we believe the agreements demonstrate the value of the Company's intellectual property in that they are "arms length" transactions with major electronics manufacturers. In June 2005, the Company entered into a series of agreements with Technology Properties Limited, Inc. ("TPL") and others to facilitate the pursuit of infringers of its intellectual property. The Company intends to continue its joint venture with TPL to pursue license agreements with infringers of its technology. Management believes that utilizing the option of working through TPL, as compared to creating and using a Company licensing team for those activities, avoids a competitive devaluation of the Company's principal assets and is a prudent way to achieve the desired results as the Company seeks to obtain fair value from users of its intellectual property. RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS On September 8, 2006, the Company determined that the manner in which it had accounted for the reset conversion feature and embedded put option of certain of its convertible debentures was not in accordance with Statement of Financial Accounting Standards ("SFAS") No. 133, Accounting For Derivative Instruments and Hedging Activities, as amended, and Emerging Issues Task Force ("EITF") Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock. The Company determined that the reset conversion feature was an embedded derivative instrument and that the conversion option was an embedded put option pursuant to SFAS No. 133. The accounting treatment of derivative financial instruments required that the Company record the derivatives and related warrants at their fair values as of the inception date of the convertible debenture agreements and at fair value as of each subsequent balance sheet date. In addition, under the provisions of EITF No. 00-19, as a result of entering into the convertible debenture agreements, the Company was required to classify all other non-employee warrants as derivative liabilities and record them at their fair values at each balance sheet date. Any change in fair value was required to be recorded as non-operating, non-cash income or expense at each balance sheet date. If the fair value of the derivatives was higher at the subsequent balance sheet date, the Company was required to record a non-operating, non-cash charge. If the fair value of the derivatives was lower at the subsequent balance sheet date, the Company was required to record non-operating, non-cash income. Accordingly, in connection with its restatement adjustments, the Company has appropriately reflected the non-operating, non-cash income or expense resulting from changes in fair value. The Company had previously not recorded the embedded derivative instruments as a liability and did not record the related changes in fair value. The Company did not have any derivative instruments at May 31, 2006 as all derivative instruments were settled prior to May 31, 2006. In addition, the Company determined the manner in which it accounted for its interest in Phoenix Digital was not in accordance with appropriate accounting literature. Beginning in June 2005, the Company accounted for its interest in Phoenix Digital as a variable interest entity, as defined in FASB Interpretation Based on the foregoing, the Company's Board of Directors determined that the Company was required to restate its financial results for the year ended May 31, 2005 and for the three month periods ended August 31, 2005, November 30, 2005 and February 28, 2006. See Note 2 to the accompanying condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for a summary of the effects of the restatement adjustments on the Company's condensed consolidated financial statements. The information provided in this Management's Discussion and Analysis of Financial Condition and Results of Operations reflects the effect of the restatement adjustments. Critical Accounting Policies and Estimates Our condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, which require us to make estimates and judgments that significantly affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Actual results could differ from those estimates, and such differences could affect the results of operations reported in future periods. We believe the following critical accounting policies affect our most significant estimates and judgments used in the preparation of our condensed consolidated financial statements. 1. Revenue Recognition Accounting for revenue recognition is complex and affected by interpretations of guidance provided by several sources, including the Financial Accounting Standards Board ("FASB") and the Securities and Exchange Commission ("SEC"). This guidance is subject to change. We follow the guidance established by the SEC in Staff Accounting Bulletin No. 104, as well as generally accepted criteria for revenue recognition, which require that, before revenue is recorded, there is persuasive evidence of an arrangement, the fee is fixed or determinable, collection is reasonably assured, and delivery to our customer has occurred. Applying these criteria to certain of our revenue arrangements requires us to carefully analyze the terms and conditions of our license agreements. Revenue from our technology license agreements is generally recognized at the time we enter into a contract and provide our customer with the licensed technology. We believe that this is the point at which we have performed all of our obligations under the agreement; however, this remains a highly interpretive area of accounting and future license agreements may result in a different method of revenue recognition. Fees for maintenance or support of our licenses are recorded on a straight-line basis over the underlying period of performance. 2. Assessment of Contingent Liabilities We are involved in various legal matters, disputes, and patent infringement claims which arise in the ordinary conduct of our business. We accrue for estimated losses at the time when we can make a reliable estimate of such loss and it is probable that it has been incurred. By their very nature, contingencies are difficult to estimate. We continually evaluate information related to all contingencies to determine that the basis on which we have recorded our estimated exposure is appropriate. 3. Stock Options and Warrants We account for equity issuances to non-employees in accordance with Statement of Financial Accounting Standards ("SFAS") No. 123, Accounting for Stock Based Compensation , and Emerging Issues Task Force ("EITF") Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods and Services . All transactions in which goods or services are the consideration received for the issuance of equity instruments are accounted for based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably measurable. The measurement date used to determine the fair value of the equity instrument issued is the earlier of the date on which the third-party performance is complete or the date on which it is probable that performance will occur. Prior to June 1, 2006, we accounted for stock-based compensation issued to employees using the intrinsic value method of accounting prescribed by Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees and related pronouncements. Under this method, compensation expense was recognized over the respective vesting period based on the excess, on the date of grant, of the fair value of our common stock over the grant price, net of forfeitures. Deferred stock-based compensation was amortized on a straight-line basis over the vesting period of each grant. On June 1, 2006, we adopted SFAS No. 123(R), Share-Based Payment, which requires the measurement and recognition of compensation expense for all share-based payment awards made to our employees and directors related to our stock option plans based on estimated fair values. We adopted SFAS No. 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of June 1, 2006, the first day of our fiscal year 2007. Our condensed consolidated financial statements as of and for the nine months ended February 28, 2007 reflect the impact of adopting SFAS No. 123(R). In accordance with the modified prospective transition method, our consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123(R). The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our consolidated statement of operations. As stock-based compensation expense recognized in the condensed consolidated statement of operations for the nine months ended February 28, 2007 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The estimated average forfeiture rate for the nine months ended February 28, 2007 of 5% was based on historical forfeiture experience and estimated future employee forfeitures. In our pro forma information required under SFAS No. 123 for the periods prior to fiscal 2007, we accounted for forfeitures as they occurred. Employee stock-based compensation expense recognized under SFAS No. 123(R) for the nine months ended February 28, 2007 was approximately $2,356,000, determined by the Black-Scholes valuation model. 4. Debt Discount We have issued warrants as part of our convertible debentures and other financings. We value the warrants using the Black-Scholes pricing model based on expected fair value at issuance and the estimated fair value is recorded as debt discount. The debt discount is amortized to non-cash interest over the life of the debenture assuming the debenture will be held to maturity, which is normally two years. If the debenture is converted to common stock previous to its maturity date, any debt discount not previously amortized is expensed to non-cash interest. As of May 31, 2006, the debt discount has been fully amortized as the debt instruments were settled prior to May 31, 2006. 5. Derivative Financial Instruments In connection with the issuance of certain convertible debentures, the terms of the debentures included a reset conversion feature which provided for a conversion of the debentures into shares of the Company's common stock at a rate which was determined to be variable. The conversion option was therefore deemed to be an embedded put option pursuant to SFAS No. 133, Accounting For Derivative Instruments and Hedging Activities , as amended, and EITF Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock . The Company determined that the reset conversion feature was an embedded derivative instrument and that the conversion option was an embedded put option pursuant to SFAS No. 133. The accounting treatment of derivative financial instruments required that the Company record the derivatives and related warrants at their fair values as of the inception date of the convertible debenture agreements and at fair value as of each subsequent balance sheet date. In addition, under the provisions of EITF No. 00-19, as a result of entering into the convertible debenture agreements, the Company was required to classify all other non-employee warrants as derivative liabilities and record them at their fair values at each balance sheet date. Any change in fair value was recorded as non-operating, non-cash income or expense at each balance sheet date. If the fair value of the derivatives was higher at the subsequent balance sheet date, the Company recorded a non-operating, non-cash charge. If the fair value of the derivatives was lower at the subsequent balance sheet date, the Company recorded non-operating, non-cash income. As of May 31, 2006, the Company does not have any outstanding derivative instruments as the related debt instruments were settled prior to May 31, 2006. 6. Patents and Trademarks Patents and trademarks are carried at cost less accumulated amortization and are amortized over their estimated useful lives of four years. The carrying value of patents and trademarks is periodically reviewed and impairments, if any, are recognized when the expected future benefit to be derived from an individual intangible asset is less than its carrying value. 7. Income Taxes The Company must assess the likelihood that it will be able to recover its deferred tax assets. If recovery is not likely, the Company must increase its provision for taxes by recording a valuation allowance against the deferred tax assets that the Company estimates will not ultimately be recoverable. The Company believes that a substantial majority of the deferred tax assets recorded on its balance sheet will ultimately be recovered. However, should there be a change in the Company's ability to recover the deferred tax assets, the tax provision would increase in the period in which the Company determined that the recovery was not probable. 8. Investment in Affiliated Companies The Company has a 50% interest in Phoenix Digital. This investment is accounted for using the equity method of accounting since the investment provides the Company the ability to exercise significant influence, but not control, over the investee. Significant influence is generally deemed to exist if the Company has an ownership interest in the voting stock of the investee of between 20% and 50%, although other factors, such as representation on the investee's Board of Directors, are considered in determining whether the equity method of accounting is appropriate. Under the equity method of accounting, the investment, originally recorded at cost, is adjusted to recognize the Company's share of net earnings or losses of the investee and is recognized in the condensed consolidated statement of operations in the caption "Equity in earnings of affiliated company". The Company owns 100% of the preferred stock of Scripps Secured Data, Inc. ("SSDI") This investment is accounted for at cost as the investment is in preferred shares which do not share in the earnings of SSDI and the Company does not have the ability to the ability to exercise significant influence over SSDI. The Company reviews its investments in affiliated companies to determine whether events or changes in circumstances indicate that its carrying amount may not be recoverable. The primary factors the Company considers in its determination are the financial condition, operating performance and near term prospects of the investee. If a decline in value is deemed to be other than temporary, the Company would recognize an impairment loss. Results of Operations Comparison of the Nine Months Ended February 28, 2007 and Nine Months Ended February 28, 2006. In June 2005, we entered into an agreement with Intel Corporation licensing our intellectual property for a one-time payment of $10,000,000. The license revenue was recognized in the quarter ended August 31, 2005. During the nine month period ended February 28, 2007 no such agreement was signed by the Company. In connection with entering into the agreement with Intel Corporation, we entered into an agreement with the co-owner of our patented technologies, through which we settled all legal disputes between us and agreed to jointly pursue others who have infringed upon our joint rights. Future licensing agreements for the use of the Company's technology are being made through a joint venture entity that is accounted for in accordance with the equity method of accounting for investments and, accordingly, the financial results of the joint venture are being recorded in the other income section of the Company's condensed consolidated statement of operations. Product sales amounting to approximately $297,000 and $67,000 were also recorded in the nine month periods ended February 28, 2006 and 2007, respectively, in connection with communications products that are no longer marketed by the Company. Inventory associated with the sales of these communications products is carried at zero value. Cost of sales of approximately $103,000 for the nine months ended February 28, 2006 consists of payments made to subcontractors for materials and labor in connection with the product sales. For the nine months ended February 28, 2007, no such costs were incurred on the product sales. Total revenues amounted to approximately $10,297,000 and $67,000 for the nine months ended February 28, 2006 and 2007, respectively. Research and development expenses decreased from approximately $226,000 for the nine months ended February 28, 2006 to zero for the nine months ended February 28, 2007. Presently, we do not expect to replace recently discontinued "in house" research and development operations. However, the Company may utilize consultants and other outsourced contractors for research and development activities in future periods. Selling, general and administrative expenses increased from approximately $2,517,000 for the nine months ended February 28, 2006 to approximately $5,915,000 for the nine months ended February 28, 2007. Legal and accounting related expenses increased by approximately $1,003,000 for the nine months ended February 28, 2007 compared with the nine months ended February 28, 2006 related to legal and accounting matters in connection with the restatement of the Company's financial statements for the fiscal years 2005, 2004, 2003 and 2002, as well as the quarterly reports for the periods ended August 31, 2005, November 30, 2005 and February 28, 2006 and the Company's required compliance with Sarbanes-Oxley procedures. Legal expenses related to a dispute with a former executive officer as well as other legal proceedings involving the interests of a co-inventor of a portion of the Company's technology and other legal matters contributed to the increase in legal expenses for the nine months ended February 28, 2007. Salary costs and related expenses included non-cash expenses associated with the fair value of options granted during the period in accordance with SFAS No. 123(R). On June 5, 2006, 1,500,000 options were granted to the chief executive officer of the Company resulting in non-cash compensation expense amounting to approximately $1,527,000. On October 23, 2006, 230,000 options were granted to employees resulting in non-cash compensation expense of approximately $184,000. On February 9, 2007, 1,070,000 options were granted to employees and directors resulting in non-cash compensation expense of approximately $584,000. Additional non-cash compensation for the nine months ended February 28, 2007 amounted to $61,000 for vesting of employee stock options in accordance with SFAS No 123(R). No such compensation expense was incurred for the nine months ended February 28, 2006. Public and investor relations expenses increased by approximately $197,000 for the nine months ended February 28, 2007 as compared with the nine months ended February 28, 2006 as a result of a change in the Company's public relations firm and one time contracts with investor relations consultants. Other salary expenses increased by approximately $167,000 for the nine months ended February 28, 2007 as compared with the nine months ended February 28, 2006 due to bonuses and 401(k) employer matching of which no such expense was incurred for the nine months ended February 28, 2006. Insurance expense increased by approximately $110,000 for the nine months ended February 28, 2007 as compared with the nine months ended February 28, 2006 primarily as a result of increased costs of directors and officers insurance coverage. Travel and related expenses increased approximately $19,000 for the nine months ended February 28, 2007 as compared with the nine months ended February 28, 2006 due to increased travel to attend various lawsuit mediations. Decreases in expenses were recorded for the nine months ended February 28, 2007 as compared with the nine months ended February 28, 2006 for rent, office supplies, patent enforcement expenses, website, marketing, utilities and for other expenses in the approximate amounts of $38,000, $12,000, $74,000, $22,000, $20,000, $8,000 and $280,000, respectively. Settlement and license expenses amounting to approximately $1,918,000 were recorded during the three months ended August 31, 2005 in connection with the agreements involving the formation of a joint venture and, separately, a license agreement with Intel Corporation. The expenses consisted of both cash and non-cash elements related to incremental, direct costs of completing the transactions. In connection with the transactions, it was necessary for the Company to obtain the consent of certain debenture and warrant holders. The necessary consents, together with certain warrants held by the debenture holders and the release of their security interests in our intellectual property, were obtained in exchange for cash, new warrants and repriced warrants. The expenses resulted primarily from cash payments to debt holders of approximately $1,300,000, to co-owners of various intellectual property assets of approximately $960,000 and to a committee of the Company's board of directors of approximately $170,000. Non-cash expenses totaled approximately $82,000 and resulted primarily from the incremental value of the effect of repricing various warrants and granting other warrants in excess of the expense previously recognized for warrants granted to these security holders. Offsetting the non-cash expenses were non-cash benefits to the Company from the reconveyance of warrants, amounting to approximately $622,000. During the nine months ended February 28, 2007, the Company recorded $6,604,000 of settlement and license expense relating to the mediation agreement with Fish (see Note 8 for more information). Other income and expenses for the Company for the nine months ended February 28, 2007 included equity in the earnings of Phoenix Digital. The investment is accounted for in accordance with the equity method of accounting for investments. The Company's investment in the joint venture for the nine months ended February 28, 2007 provided income after expenses in the amount of approximately $30,402,000 resulting from licensing agreements for our intellectual property with Sony, Nikon, Seiko Epson, Pentax, Olympus, Kenwood, Agilent, Lexmark, Schneider Electric, NEC Corporation and its selected subsidiaries and Funai Electric for one time payments. The Company's investment in the joint venture provided net income after expenses in the amount of approximately $28,608,000 for the nine months ended February 28, 2006. Total other income and expense for the nine months ended February 28, 2007 amounted to net other income of approximately $30,561,000 compared with total other income and expense for the nine months ended February 28, 2006 of net other income amounting to approximately $25,360,000. Changes in the fair value of warrant and derivative liabilities amounted to net other expense for the nine months ended February 28, 2006 of approximately $2,457,000 with no corresponding amount for the nine months ended February 28, 2007 as all convertible debt had been retired in prior fiscal periods. Non-cash adjustments to interest expense for the nine months ended February 28, 2006 amounted to expenses of approximately $413,000 resulting from amortization of debt discount and conversion of the remaining debentures. During the nine months ended February 28, 2006 the Company recorded a loss on debt extinguishment of $445,000 related to the 7,000,000 warrants issued to a debenture holder as consideration for entering into the reset agreements. Interest income and other income increased from approximately $172,000 for the nine months ended February 28, 2006 to approximately $499,000 for the nine months ended February 28, 2007 as interest bearing account balances increased from license revenues. During the nine months ended February 28, 2007 the Company recorded an impairment charge on the value of its note receivable from Holocom Networks, Inc. of approximately $340,000. (see Note 4 for more information). During the nine months ended February 28, 2007, the Company recorded a provision for income taxes of $4,382,911 related to federal and state taxes. Also, during the nine months ended February 28, 2006 and 2007, the Company utilized approximately $3,000,000 and $32,000,000, respectively, of its available federal net operating loss carry-forwards and approximately $3,000,000 and $16,700,000, respectively, of its available state net operating loss carry-forwards to offset its taxable income arising in the respective quarters. The Company recorded net income (as restated) for the nine months ended February 28, 2006 of $30,892,627 compared with net income of $13,725,834 for the nine months ended February 28, 2007. Comparison of the Three Months Ended February 28, 2007 and Three Months Ended February 28, 2006. In June 2005, we entered into an agreement with Intel Corporation licensing our intellectual property for a one-time payment of $10,000,000. During the three month periods ended February 28, 2007 and 2006, no such agreement was signed by the Company. In connection with entering into the agreement with Intel . . . Apr 20, 2007 [/QB][/QUOTE]
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