UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)
x		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2016
For the quarterly period ended September 30, 2016
o		TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934


For the transition period from:		to


Commission File No. 001-14949

Implant Sciences Corporation

Massachusetts		04-2837126
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

500 Research Drive, Unit 3, Wilmington, Massachusetts		01887
(Address of principal executive offices)		(Zip Code)

(978) 752-1700
(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

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 ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):


☐ Large Accelerated Filer	☐ Accelerated Filer
☐ Non-accelerated Filer	☒ Smaller reporting company

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

As of ~~May~~December 69, 2016, there were 79,~~025~~875,620 shares of the registrant’s Common Stock outstanding.

IMPLANT SCIENCES CORPORATION

TABLE OF CONTENTS

		Page
PART I	FINANCIAL INFORMATION
Item 1.	Condensed Consolidated Financial Statements
	Condensed Consolidated Balance Sheets as of March 31, 2016 (unaudited) and June 30, 2015 (audited)	3
	Condensed Consolidated Balance Sheets as of September 30, 2016 (unaudited) and June 30, 2016 (audited)	3
	Condensed Consolidated Statements of Operations and Comprehensive Loss for the three and nine months ended March 31, 2016 and 2015 (unaudited)	4
	Condensed Consolidated Statements of Operations and Comprehensive Loss for the three months ended September 30, 2016 and 2015 (unaudited)	4
	Condensed Consolidated Statements of Cash Flows for the nine months ended March 31, 2016 and 2015 (unaudited)	5
	Condensed Consolidated Statements of Cash Flows for the three months ended September 30, 2016 and 2015 (unaudited)	5
	Notes to Condensed Consolidated Financial Statements (unaudited)	6~~–29~~-35
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	3036-3944
Item 4.	Controls and Procedures	3944-4045
PART II	OTHER INFORMATION
Item 1.	Legal Proceedings	~~40-41~~45
Item 1A.	Risk Factors	4145-4247
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	4247
Item 6.	Exhibits	4348-49

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Implant Sciences Corporation
Condensed Consolidated Balance Sheets
(In thousands except share and per share amounts)
(In thousands, except share and per share amounts)
	March 31, 2016	June 30, 2015
	September 30, 2016 (Unaudited)	June 30, 2016 (Audited)
	(Unaudited)	(Audited)
ASSETS
Current assets:
Cash and cash equivalents	$ ~~280~~1,282	$ 1,~~985~~338
Restricted cash and investments	367	367
Accounts receivable-trade, net of allowances of $5 and $47, respectively	6,468	872
Accounts receivable-trade, net of allowances of $17 and $7, respectively	4,993	7,123
Inventories, net	56,~~981~~108	54,~~244~~681
Prepaid expenses and other current assets	~~1,609~~470	~~946~~464
Total current assets	1413,~~705~~220	913,~~414~~973
Property and equipment, net	~~840~~843	~~880~~874
Other non-current assets	98	98
Total assets	$ 1514,~~643~~161	$ 1014,~~392~~945
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities:
Senior secured promissory note – BAM	$ 20,000	$ 20,000
Senior secured convertible promissory note – Montsant Partners	5,284	35,~~184~~284
Senior secured promissory note – DMRJ	1,000	1,000
Second senior secured convertible promissory note – DMRJ	1811,970	1218,~~000~~970
Third senior secured convertible promissory note - DMRJ	17,523	1217,~~000~~523
Line of credit – DMRJ	17,662	16,662
Line of credit - DMRJ	17,662	17,662
Current maturities of obligations under capital lease	17	4518
Accrued expenses	13,179	17,080
Warrant derivative liability	12,664	-
Accounts payable	4,977	2,855
Accrued expenses	16,960	15,181
Deferred revenue	1,049	3,454
Accounts payable	6,378	4,655
Total current liabilities	99,661	88,280
Deferred revenue	859	406
Total current liabilities	110,317	100,699
Long-term liabilities:
Long-term obligations under capital lease, net of current maturities	1232	2035
Accrued expenses, net of current	-	48
Deferred revenue, net of current	615	479
Deferred revenue, net of current	539	221
Total long-term liabilities	647	514
Total long-term liabilities	551	289
Total liabilities	110,964	101,213
Total liabilities	100,212	88,569
Commitments and contingencies (Note 17)
Stockholders' deficit:
Common stock; $0.001 par value; 200,000,000 shares authorized; 79,036,165 and 79,025,620 shares issued and outstanding at March 31, 2016 and 75,113,665 and 75,103,120 shares issued and outstanding at June 30, 2015	79	75
Common stock; $0.001 par value; 250,000,000 and 200,000,000 shares authorized on September 30, 2016 and June 30, 2016, respectively; 79,886,165 and 79,875,620 shares issued and outstanding at September 30, 2016 and 79,396,165 and 79,385,620 shares issued and outstanding at June 30, 2016	80	79
Preferred stock; no stated value; 5,000,000 shares authorized
Series G Convertible Preferred Stock, no stated value; 650,000 shares authorized, no shares issued and outstanding	-	-
Series H Convertible Preferred Stock; no stated value; 22,500 shares authorized, no shares issued and outstanding	-	-
Series H Convertible Preferred Stock; no stated value; 22,500 shares authorized, 7,000 shares issued and outstanding at September 30, 2016 and no shares issued and outstanding at June 30, 2016	7,000	-
Series I Convertible Preferred Stock; no stated value; 21,000 shares authorized, no shares issued and outstanding	-	-
Series J Convertible Preferred Stock; no stated value; 6,500 shares authorized, no shares issued and outstanding	-	-
Additional paid-in capital	~~113~~123,~~883~~775	~~112~~114,~~613~~255
Accumulated deficit	(~~197~~227,~~749~~403)	(~~189~~200,~~429~~084)
Deferred compensation	(~~730~~204)	(~~1,366~~467)
Other comprehensive income	2122	322
Treasury stock, 10,545 common shares, at cost	(73)	(73)
Total stockholders’ deficit	(84,569)	(78,177)
Total stockholders' deficit	(96,803)	(86,268)
Total liabilities and stockholders’ deficit	$ 15,643	$ 10,392
Total liabilities and stockholders' deficit	$ 14,161	$ 14,945

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Implant Sciences Corporation
Condensed Consolidated Statements of Operations and Comprehensive Loss
Consolidated Statements of Operations and Comprehensive Loss
(In thousands except share and per share amounts)
(Unaudited)
	For the Three Months Ended September 30,
	For the Three Months Ended March 31,		For the Nine Months Ended March 31,
	2016	2015
	2016	2015	2016	2015
Revenues
Revenues
Product
Product
Government	$ 1,686	$ -
Government	$ 3,932	$ -	$ 7,194	$ -
Commercial	6,205	13,824
Commercial	6,816	3,237	27,539	7,155
	7,891	13,824
	10,748	3,237	34,733	7,155
Services
Services
Government	29	442
Government	40	-	465	-
Commercial	142	127
Commercial	135	68	410	160
	171	569
	175	68	875	160
Total revenues	8,062	14,393
Total revenues	10,923	3,305	35,608	7,315
Cost of revenues	5,590	8,136
Cost of revenues	7,691	2,129	22,266	5,157
Gross margin	2,472	6,257
Gross margin	3,232	1,176	13,342	2,158
Operating expenses:
Operating expenses:
Research and development	981	1,083
Research and development	1,040	1,347	3,024	3,919
Selling, general and administrative	3,765	3,538
Selling, general and administrative	3,811	3,318	11,067	9,188
Total operating expenses	4,746	4,621
Total operating expenses	4,851	4,665	14,091	13,107
Loss from operations	(2,274)	1,636
Loss from operations	(1,619)	(3,489)	(749)	(10,949)
Other income (expense), net:
Other income (expense), net:
Interest expense	(27,949)	(2,547)
Interest income	-	1	-	1
Change in fair value of embedded derivative	3,039	-
Interest expense	(2,477)	(2,243)	(7,571)	(6,402)
Total other expense, net	(24,910)	(2,547)
Total other expense, net	(2,477)	(2,242)	(7,571)	(6,401)
Net loss	(27,184)	(911)
Net loss	(4,096)	(5,731)	(8,320)	(17,350)
Preferred dividends	(135)	-
Other comprehensive loss net of tax:
Net loss applicable to common shareholders	(27,319)	(911)
Foreign currency translation adjustments	-	(1)	(19)	1
Other comprehensive income, net of tax:
Comprehensive loss	$ (4,096)	$ (5,732)	$ (8,339)	$ (17,349)
Foreign currency translation adjustments	-	(10)
Net loss per share, basic and diluted	$ (0.05)	$ (0.08)	$ (0.11)	$ (0.25)
Other comprehensive income	-	(10)
Weighted average shares used in computing net loss per common share, basic and diluted	78,878,953	72,677,287	77,871,509	69,454,343
Comprehensive loss	$ (27,319)	$ (921)
Net loss per share, basic and diluted	$ (0.34)	$ (0.01)
Net loss per share , applicable to common stockholders, basic and diluted	$ (0.34)	$ (0.01)
Weighted average shares used in computing net loss per common share, basic and diluted	79,658,953	76,206,953

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Implant Sciences Corporation
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited – In thousands)
(Unaudited)
	For the Three Months Ended September 30,
	For the Nine Months Ended March 31,
	2016	2015
Cash flows from operating activities:
Net loss	$ (827,~~320~~184)	$ (~~17,350~~911)
Adjustments to reconcile net loss to net cash flows used in operating activities:
Depreciation and amortization	~~153~~43	~~126~~54
Bad debt expense	~~(6)~~11	481
Stock-based compensation expense	~~982~~290	~~2,381~~342
Loss on disposal of equipment	3	-
Warrants issued to non-employees	15	24
Warrants issued to non-employees	58	265
Common stock issued to consultants	248	83
Common stock issued to consultants	579	68
Non-cash interest expense	15,703	-
Changes in assets and liabilities:
Senior secured convertible promissory note – beneficial conversion feature	9,217	-
Accounts receivable	(5,590)	(803)
Change in fair value of warrant derivative liability	(3,039)	-
Inventories	(737)	(468)
Change in assets and liabilities:
Prepaid expenses and other current assets	356	(298)
Accounts receivable	2,119	(1,799)
Accounts payable	2,122	(615)
Inventories	(1,427)	(2,126)
Accrued expenses	9,880	6,047
Prepaid expenses and other current assets	(6)	(388)
Deferred revenue	(2,087)	1,317
Accounts payable	1,723	1,630
Net cash used in operating activities	(2,607)	(9,282)
Accrued expenses	1,658	4,012
Deferred revenue	589	(2,190)
Net cash used in operating activities	(40)	(1,268)
Cash flows from investing activities:
Purchases of property and equipment	(~~117~~12)	(~~341~~63)
Net cash used in investing activities	(~~117~~12)	(~~341~~63)
Cash flows from financing activities:
Proceeds from common stock issued in connection with exercise of stock options and common stock purchase warrants	37-	~~262~~34
Principal repayments of long-term debt and capital lease obligations	(364)	(3410)
Net borrowings on line of credit	~~1,000~~-	~~10,917~~200
Net cash provided by financing activities	~~1,001~~(4)	~~11,145~~224
Effect of exchange rate changes on cash and cash equivalents	18-	110
Net change in cash and cash equivalents	(~~1,705~~56)	(1,~~523~~097)
Cash and cash equivalents at beginning of period	1,~~985~~338	~~391~~1,985
Cash and cash equivalents at end of period	$ ~~280~~1,282	$ ~~1,914~~888
Supplemental Disclosure of Cash Flow Information:
Interest paid	$ ~~813~~44	$ ~~2,380~~3
Non-cash Financing Activity:
Conversions of senior secured convertible promissory note interest to common shares	$ 245	$ 799
Conversions of senior secured convertible promissory note to Series H Convertible Preferred Stock	$ 7,000	$ -
Common stock issued to consultants	579	68
Senior secured convertible promissory note issued to DMRJ Group, LLC - beneficial conversion feature	$ 9,217	$ -
Accrued interest converted to debt	13,574	-
Warrant issued to DMRJ Group, LLC	$ 12,664	$ -
Prepaid interest added to debt	1,019	-
Conversions of senior secured convertible note interest to common shares	$ -	$ 45
Common stock issued to consultants	$ 248	$ 83

The accompanying notes are an integral part of these condensed consolidated financial statements.

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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Description of Business, Liquidity and Going Concern

Implant Sciences Corporation provides systems and sensors for the homeland security market and related industries. We have developed and acquired technologies using ion mobility spectrometry to develop a product line for use in trace explosives and narcotics detection. We currently market and sell our existing trace explosives and narcotics detector products while continuing to make significant investments in developing the next generation of these products.

~~Liquidity,~~Sale ~~Going~~of ~~Concern~~Explosives Detector Assets and ~~Management’s~~Bankruptcy ~~Plans~~Filing

On ~~December~~October 10, ~~2008~~2016, we and our subsidiaries entered into aan ~~note~~asset ~~and~~purchase ~~warrant~~agreement to sell the explosives trace detection assets to L-3 Communications Corporation for $117.5 million in cash, plus the assumption of specified liabilities, subject to adjustment. The asset purchase agreement ~~with~~constitutes ~~DMRJ~~a ~~Group~~“stalking ~~LLC~~horse ~~(“DMRJ~~bid”) ~~pursuant~~in toa ~~which~~sale weprocess ~~issued~~being conducted under Section 363 of the U.S. Bankruptcy Code. As the Stalking horse bidder, L-3 will be entitled to a ~~senior~~break-up ~~secured~~fee ~~convertible~~and ~~promissory~~expense ~~note~~reimbursement inif it does not prevail as the ~~principal~~successful ~~amount~~bidder ofat $5any subsequent Bankruptcy Court auction. L-3’s role as the stalking horse bidder upon Bankruptcy Court Appeal,~~600,000~~ and athe ~~warrant~~sale itself, are subject to ~~purchase~~approval 1by the Bankruptcy Court. In connection with the sale,~~000~~ on October 10,~~000~~ ~~shares~~2016, Implant Sciences Corporation and its subsidiaries IMX Acquisition Corp., C Acquisition Corp. and Accurel Systems International Corp. (together with the Company, the “Debtors”) filed voluntary relief petitions under Chapter 11 of ~~our~~the ~~common~~Bankruptcy ~~stock~~Code with the United States Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”). We ~~have~~will ~~entered~~continue ~~into~~to aoperate ~~series~~our businesses as debtors-in-possession under the jurisdiction of ~~amendments,~~the ~~waivers~~Bankruptcy Court and ~~modifications~~in accordance with ~~DMRJ~~the applicable provisions of the Bankruptcy Code. On the petition date, we filed several motions with the bankruptcy court, including a motion to have the Chapter 11 cases jointly administered.

On ~~May~~December 416, ~~2015~~2016, wethe ~~entered~~Bankruptcy ~~into~~Court issued an ~~assignment~~order ~~agreement~~authorizing ~~with~~the ~~DMRJ~~sale ~~and~~of ~~Montsant~~substantially ~~Partners,~~all ~~LLC~~of ~~(“Montsant”),~~our ~~wherein~~assets ~~DMRJ~~free ~~assigned~~and ~~its~~clear ~~rights~~of liens, ~~title~~claims, encumbrances and ~~interest~~other ininterests; authorized and approved our performance under the ~~senior~~asset ~~secured~~purchase ~~promissory~~agreement ~~note~~entered ~~dated~~into ~~December~~with ~~10,~~L-3; ~~2008~~approved the assumption and ~~appointed~~assignment ~~DMRJ~~of ascertain ~~its~~of ~~collateral~~our ~~agent~~contracts ~~under~~and unexpired leases. In conjunction with this order, on December 16, 2016, we amended the ~~promissory~~asset ~~note~~purchase agreement. ~~DMRJ~~with ~~and~~L-3 ~~Montsant~~whereby ~~are~~both ~~funds~~parties ~~managed~~agreed bythat ~~Platinum~~the ~~Partners~~closing ~~Value~~date ~~Arbitrage~~will ~~Fund~~be LPJanuary 5, 2017.

OnIn ~~April~~connection 6,with ~~2016~~the Chapter 11 filings, we ~~amended~~filed ~~our~~a ~~credit~~motion ~~agreements~~seeking ~~with~~the ~~DMRJ~~approval ~~and~~of ~~Montsant,~~the ~~effective~~bankruptcy ascourt for a superpriority senior secured loan of ~~March~~$5.7 31million (the “DIP Loan”) between the Company and DIP SPV I, ~~2016~~L.P., as the debtor-in-possession lender ( the “DIP Lender”) pursuant to ~~which,~~a ~~amongst~~senior ~~other~~secured ~~matters,~~superpriority wedebtor-in-possession ~~extended~~loan and security agreement entered into by the ~~maturity~~Debtors ~~date~~and ofthe ~~our~~DIP ~~indebtedness~~Lender toon ~~June~~October 3010, 2016. The DIP loan would bear interest at 12% and ~~December~~included ~~30,~~a ~~2016~~one-time closing fee of $199,500 ~~respectively.~~on ~~Please~~the ~~refer~~closing date of the DIP Loan and an exit fee equal to ~~Note~~$427,500, 13less ~~for~~any interest, other that default interest (which is at a ~~complete~~rate ~~discussion~~of 24%), paid to the DIP Lender as of the ~~amended~~termination ~~terms~~date of the ~~credit~~DIP ~~agreements~~Loan. The DIP Loan is payable in full upon the consummation of the sale under the asset purchase agreement with L-3 Communications Corporation or a sale to any other winning bidder in the Bankruptcy Court auction. On October 13, 2016, we borrowed $1,500,000 under the DIP Loan.

OnThe ~~March~~use ~~19,~~of ~~2014,~~proceeds wefrom ~~entered~~the ~~into~~DIP aLoan ~~note~~would ~~purchase~~be ~~agreement~~limited ~~with~~to aworking ~~group~~capital ~~of institutional investors~~ and ~~BAM~~other ~~Administrative~~general ~~Services~~corporate ~~LLC~~purposes ~~(“BAM”),~~consistent anwith ~~administrative~~the ~~agent~~budget ~~for~~that the ~~investors,~~Company ~~pursuant~~presented to ~~which we issued senior secured promissory notes in~~ the ~~aggregate~~DIP ~~principal amount of $20~~Lender,~~000,000.~~ ~~The~~including ~~notes~~payment ~~bear~~of ~~interest~~costs atand ~~16%~~expenses ~~per~~related ~~annum. We~~to ~~used all of~~ the ~~proceeds~~administration ~~from the sale~~ of the ~~notes~~bankruptcy toproceedings ~~repay (i) $17,624,000 of principal of our outstanding indebtedness to DMRJ under revolving promissory note (ii) $1,809,000 of interest outstanding under that facility~~ and ~~(iii)~~payment ~~$567,000~~ of ~~interest~~other ~~outstanding~~expenses ~~under~~as ~~our~~approved ~~senior~~by ~~secured~~the ~~convertible~~bankruptcy ~~promissory note (see Note 13)~~court. Unless Onotherwise ~~April 6~~extended, ~~2016,~~the weDIP ~~amended~~Loan ~~our~~would ~~credit~~mature ~~agreements~~six ~~with~~months ~~BAM,~~from ~~effective as of March 31, 2016, pursuant to which, amongst other matters, we extended~~ the ~~maturity~~anniversary date of ~~all~~the ~~of our indebtedness from March 31~~agreement, ~~2016~~subject to ~~June~~certain ~~29,~~provisions ~~2016.~~that ~~Please~~may ~~refer~~lead to ~~Note~~an 13earlier ~~for a complete discussion of the amended terms of this note agreement~~termination.

On ~~December~~November 117, ~~2015~~2016, we ~~entered~~terminated ~~into~~the anSenior ~~Accounts~~Secured, ~~Receivable~~Super-Priority ~~Purchase~~Debtor-in-Possession ~~Agreement~~Loan ~~(the~~and ~~“Purchase~~Security Agreement”), ~~with~~dated ~~Republic~~as ~~Capital~~of ~~Access,~~October ~~LLC (“RCA”)~~10, ~~pursuant~~2016 ~~to which we may sell eligible accounts receivable relating to U.S. government prime contracts or subcontracts~~ (as ~~defined~~amended inon ~~the~~November ~~Purchase~~3, ~~Agreement~~2016, the “~~Eligible~~Original ~~Receivables~~DIP Agreement”), towith ~~RCA. On~~the ~~April~~original 11lender, ~~2016,~~DIP weSPV ~~amended~~I, ~~the~~L.P. ~~Purchase Agreement~~ (the “~~Amended~~Original ~~Purchase~~DIP ~~Agreement~~Lender”). In Asconnection ~~amended~~with such termination, the ~~total~~Company ~~amount~~paid of$1,610,769 ~~Eligible~~to ~~Receivables~~the ~~that~~Original weDIP ~~may~~Lender ~~sell~~and toits ~~RCA~~advisors ~~is subject~~ to asatisfy ~~maximum~~outstanding ~~limit~~obligations ofunder ~~$3,500,000~~the ofOriginal ~~outstanding~~DIP ~~receivables~~Agreement, atincluding ~~any~~$74,354 ~~given~~for ~~time. The~~expense ~~Amended~~reimbursement ~~Purchase~~for ~~Agreement~~the ~~terminates~~Original onDIP ~~November~~Lender’s ~~30, 2016~~advisors.

~~Despite~~On ~~our~~November ~~current~~7, ~~sales~~2016 (the “Effective Date”), ~~expense~~we ~~and~~entered ~~cash~~into ~~flow~~a ~~projections~~replacement ~~and~~Senior $1Secured,~~582,000~~ Super-Priority Debtor-in-Possession ~~cash~~Loan ~~available~~and ~~from~~Security ~~our~~Agreement ~~line~~(the of“New ~~credit~~DIP Agreement”) with ~~DMRJ,~~Tannor atPartners ~~May~~Credit 6Fund, ~~2016~~LP, tothe ~~fund~~New ~~our~~DIP ~~operations~~Lender, ~~and~~which ~~continue~~DIP Agreement was approved by the ~~development,~~Bankruptcy ~~commercialization~~Court ~~and~~on ~~marketing~~an interim basis pursuant to an order dated as of ~~our~~the ~~products~~Effective ~~will~~Date ~~require~~for ~~that~~the weinitial ~~extend~~loan ~~our~~amount ~~note~~of ~~agreements~~$5,700,000. Under ~~with~~the ~~DMRJ~~New DIP Agreement, ~~BAM~~subject ~~and~~to ~~Monstant.~~the ~~There~~terms ~~can~~and beconditions nothereof, ~~assurance~~the ~~that~~New ~~DMRJ~~DIP ~~will~~Lender ~~continue~~agreed to ~~make~~lend ~~advances~~up ~~under~~to ~~our~~a ~~revolving~~total ~~line~~ of ~~credit~~$8.0 ~~Our~~million ~~failure~~ to ~~achieve~~the ~~our~~Borrowers, ~~projections~~with ~~and/or~~the ~~obtain~~initial ~~sufficient~~installment ~~additional~~of ~~capital~~$5,700,000 onpayable ~~acceptable~~upon ~~terms~~the ~~would~~Bankruptcy ~~have~~Court aentering ~~material~~the ~~adverse~~interim ~~effect~~order onfor ~~our~~the ~~liquidity~~New ~~and~~DIP ~~operations~~Agreement and ~~could~~the ~~require~~remaining us$2,300,000 topayable ~~file~~upon ~~for~~the ~~protection~~Bankruptcy ~~under~~Court ~~bankruptcy laws.~~

Our common stock was delisted by the NYSE Amex LLC in June 2009 as a result of our failure to comply with certain continued listing requirements. Our common stock has been quoted on the OTC Bulletin Board since May 2009 and is also quoted on the OTC Markets Group’s OTCQB tier under the symbol “IMSC”. We believe that trading ‘over the counter’ has limited our stock’s liquidity and has impaired our ability to raise capital.

- 6 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

~~develop~~entering ~~and~~the ~~market~~final ~~commercially~~order ~~usable products and obtain regulatory approval~~ for ~~our products under development; and (d) our ability to obtain substantial additional financing necessary to adequately fund~~ the ~~development,~~New ~~commercialization~~DIP ~~and marketing of our products~~Agreement. ~~For~~On ~~the~~November ~~nine months ended March 31~~8, 2016, we ~~reported~~borrowed a$5,700,000 ~~net~~under ~~loss~~the ofNew ~~approximately~~DIP ~~$8,320,000~~Agreement and ~~used~~borrowed ~~approximately~~an additional $2,~~607~~300,000 inon ~~cash~~November ~~for~~30, ~~operations~~2016. As of ~~March~~December 319, 2016, ~~the~~our ~~Company~~obligations ~~had~~under anthe ~~accumulated~~New ~~deficit~~DIP ofAgreement ~~approximately~~for ~~$197,749,000~~principal and afor ~~working~~accrued ~~capital~~interest ~~deficit~~were ~~of approximately~~ $848,~~956~~000,000~~. Management~~ ~~continually~~and ~~evaluates~~$25,600, ~~operating~~respectively. ~~expenses~~The ~~and~~New ~~cash~~DIP ~~flow~~Agreement ~~from~~is ~~operations. Failure~~substantially ofidentical to the ~~Company~~Original toDIP ~~achieve~~Agreement, ~~its~~except ~~projections~~for ~~will~~the ~~require~~amounts ~~that~~of wethe ~~seek~~closing ~~additional~~fee ~~financing~~and orthe ~~discontinue~~exit ~~operations~~fee.

AsThe loans under the New DIP Agreement will accrue interest of ~~March~~12% ~~31,~~per ~~2016~~annum, ~~our~~and ~~principal~~shall ~~obligations~~be subject to ~~DMRJ~~a ~~under~~default ~~each~~interest rate of 12% above the ~~three~~applicable ~~promissory~~non-default ~~notes~~rate ~~and~~(i.e., aan ~~revolving~~aggregate ~~line~~of 24% per annum) at any time when there is an event of ~~credit~~default ~~approximated~~under ~~$18,970,000,~~the ~~$17~~New DIP Agreement. We have agreed in the New DIP Agreement to pay fees to the New DIP Lender in an aggregate amount of 5.75% of the maximum loan amount,~~523,000,~~ regardless of how long the New DIP Loan was outstanding consisting of a closing fee of $135,000~~,000~~ at the time the initial loan is made and an exit fee upon the termination of the New DIP Agreement of $17425,~~662,~~000, ~~respectively.~~minus ~~Further~~any interest, asother ofthan ~~March~~default 31interest, ~~2016,~~paid ~~our~~to ~~obligation~~the toNew ~~DMRJ~~DIP ~~for~~Lender. We ~~accrued~~are ~~interest~~also ~~under~~required ~~these~~to ~~instruments~~reimburse ~~approximated~~the ~~$4,603,000~~New ~~and~~DIP isLender ~~included~~for inits ~~accrued~~fees and expenses in connection with the ~~condensed~~New ~~consolidated~~DIP ~~financial~~Agreement ~~statements~~and the loans thereunder. Interest on the loans and the expense reimbursement are payable monthly in arrears.

AsThe ofloans ~~May~~under 6,the ~~2016,~~New ~~our~~DIP ~~principal~~Agreement ~~obligations~~have tosuper-priority ~~DMRJ~~security ~~under~~status ~~each~~and are ahead of ~~the~~our ~~three~~other ~~promissory~~secured ~~notes~~obligations ~~and~~owed ato ~~revolving~~the ~~line~~investors ofunder ~~credit~~the ~~approximated~~Note ~~$18~~Purchase Agreement,~~970~~ dated March 19,~~000~~ 2014, ~~$17~~as amended,~~523~~ between the us,~~000~~ the investors named therein and BAM Administrative Services LLC, $1as administrative agent for the investors thereunder,~~000,000~~ and ~~$17~~holders of the notes under each of the Credit Agreements,~~662~~ dated as of September 4,~~000~~ 2009, ~~respectively.~~as ~~Further~~amended, with DMRJ Group LLC and the Note and Warrant Purchase Agreement dated as of ~~May~~December 610, ~~2016~~2008, ~~our~~as ~~obligation~~amended, towith DMRJ ~~for~~Group ~~accrued~~LLC, ~~interest~~and ~~under~~Montsant ~~these~~Partners ~~instruments~~LLC, ~~approximated~~as ~~$4,883,000.~~partial assignee thereof.

AsThe loans under the New DIP Agreement and all other obligations are due and payable (i) upon the occurrence of ~~March~~an ~~31,~~event ~~2016~~of default that is not cured within the applicable cure periods and ~~May~~for 6,which ~~2016,~~the ~~our~~New ~~principal~~DIP Lender has given notice to accelerate our obligations under the New DIP Agreement, (ii) the entry of an order converting the Chapter 11 Case to ~~Montsant~~a case under chapter 7 of the Bankruptcy Code, (iii) the entry of an order in the Chapter 11 Case appointing a ~~promissory~~chapter ~~note~~11 ~~approximated~~trustee $5or examiner,~~284~~ (iv) if the interim order for the New DIP Agreement is modified at the final hearing for the New DIP Agreement in a manner unacceptable to the New DIP Lender,~~000.~~ ~~Further~~(v) the effective date of a chapter 11 plan in the Chapter 11 Case, as(vi) the approval by the Bankruptcy Court of ~~March~~an 31alternative financing transaction transferring the collateral other than the sale of the our assets to L-3 Communications Corporation (“Buyer”) under the asset purchase agreement, ~~2016~~dated ~~and~~as ~~May~~of 6October 10, 2016 (as amended, ~~our~~the ~~obligation~~“Purchase Agreement”), by and among the Company and L-3 Communications Corporation or to ~~Montsant~~another ~~for~~winning ~~accrued~~bidder ~~interest~~in ~~under~~the ~~this~~Bankruptcy ~~instrument~~auction ~~was~~process $0(the “Sale”), (vii) the date of the closing of the Sale and (viii) the first business day after the 6 month anniversary of the New DIP Agreement. The loans can be prepaid at any time and mandatory prepayments are required upon the disposition of assets outside of the ordinary course, the receipt of extraordinary receipts or the incurrence of any additional indebtedness.

OnWe ~~September~~believe ~~24,~~that ~~2015~~the proceeds from the sale of our explosives detection assets to L-3 and the assumption by L-3 of certain liabilities will be sufficient to pay the New DIP Loan, ~~Montsant~~related ~~converted~~expenses and $~~245~~425,000 ofexit ~~the~~fee; ~~accrued~~all ~~interest~~secured ~~owed~~and byunsecured uscreditor claims; financial advisor and legal expenses associated with the sale; payment due under aour ~~promissory~~Change ~~note~~of ~~into~~Control 3Plan; and,~~062,500~~ ~~shares~~legal fees and other expenses associated with the bankruptcy filing. The Board of Directors is exploring opportunities to provide optionality to our ~~common~~shareholders ~~stock,~~following atthe anticipated successful completion of the ETD asset sale to L-3. We believe the economics of the sale will ensure that creditors and shareholders will receive economic benefit. We intend to provide alternatives as part of the plan to emerge from voluntary Chapter 11 bankruptcy that would recognize the value of a publicly listed shell. These alternatives may include the merger of an ~~adjusted~~operating ~~conversion~~entity ~~price~~into the shell or a liquidation of $0the company, which determination is subject to approval by our shareholders.08. ~~per~~A ~~share~~plan of reorganization must be filed with the court on February 7, 2017.

~~As of March 31~~Liquidity, ~~2016,~~Going ~~our~~Concern principal obligations under the senior secured promissory notes for which BAM is the agent were $20,000,000. Further, as of March 31, 2016, our obligation under such notes for accrued interest amounted to approximately $1,600,000 and isManagement’s ~~included in accrued expenses in the condensed consolidated financial statements.~~ Plans

AsOn ofDecember ~~May 6~~10, ~~2016~~2008, ~~our~~we ~~principal~~entered ~~obligations~~into ~~under~~a ~~the~~note ~~senior~~and ~~secured~~warrant ~~promissory~~purchase ~~notes~~agreement ~~for~~with DMRJ Group LLC (“DMRJ”) pursuant to which ~~BAM~~we isissued a senior secured convertible promissory note in the ~~agent~~principal ~~were~~amount of $205,600,000 and a warrant to purchase 1,000,000 shares of our common stock. We ~~Further,~~have asentered into a series of ~~May~~amendments, 6waivers and modifications with DMRJ. On July 20, 2016, we amended our ~~obligation~~credit ~~under~~agreements ~~such~~with ~~notes~~DMRJ ~~for~~pursuant ~~accrued~~to ~~interest~~which, ~~amounted~~amongst other matters, we extended the maturity date of all of our indebtedness to ~~approximately~~DMRJ $1to October 31,~~920,000~~ 2016.

~~These~~On ~~conditions~~May ~~raise~~4, ~~substantial~~2015, ~~doubt~~we asentered tointo ~~our~~an ~~ability~~assignment toagreement ~~continue as a going concern. Our ability to comply~~ with ~~our~~DMRJ ~~debt covenants in the future depends on our ability to generate sufficient sales~~ and toMontsant ~~control expenses~~Partners, ~~and~~LLC will require that we seek additional capital through private financing sources. There can be no assurances that we will achieve our forecasted financial results or that we will be able to raise additional capital to operate our business. Any such failure would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely. Further(“Montsant”), ~~upon~~wherein ~~the~~DMRJ ~~occurrence~~assigned ofits ~~an event of default under certain provisions of our credit agreements~~rights, wetitle ~~could~~and ~~be required to pay default rate~~ interest ~~equal~~in to the ~~interest~~senior ~~rate~~secured ~~per~~promissory ~~annum under each term~~ note ~~increased~~dated byDecember ~~an additional fourteen percent (14%) per annum (pro-rated for partial years)~~10, ~~not~~2008 toand ~~exceed~~appointed ~~the~~DMRJ ~~maximum~~as ~~legal~~its ~~rate~~collateral ~~per~~agent ~~annum~~under on the ~~outstanding~~promissory ~~principal~~note ~~balance outstanding as permitted by applicable New York law~~agreement. ~~The~~On ~~failure~~July to20, refinance or otherwise negotiate further extensions of our obligations to our secured lenders would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.

Based on current sales, operating expense and cash flow projections, and the cash available from our line of credit, management believes there are plans in place to sustain operations, provided that our credit facilities are extended. These plans depend on a substantial increase in sales of our handheld trace explosives detector product and our desktop explosives and narcotics trade detector product and on the extension of the maturity date of our credit facilities with DMRJ, BAM and Montsant. However, there can be no assurances that sales will materialize as forecasted, and/or that management will be successful in refinancing or extending our obligations to our secured lenders, which mature on various dates between June 29, 2016 and December 30, 2016. To further sustain us, improve our cash position, and enable us to grow while reducing debt, management plans to continue to seek additional capital through private financing sources. However, there can be no assurance that management will be successful in executing these plans. Management will continue to closely monitor and attempt to control our costs and actively seek needed capital through sales of our products, equity infusions, government grants and awards,

- 7 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

~~strategic~~2016, ~~alliances~~we amended our credit agreement with Montsant, ~~and~~extending ~~through~~the maturity date of our ~~lending~~indebtedness ~~institutions~~to October 31, 2016.

WeDMRJ ~~have suffered recurring losses from operations. Our consolidated financial statements have been presented on the basis that it is a going concern, which contemplates the realization of assets~~ and ~~the~~Montsant ~~satisfaction~~are offunds ~~liabilities~~managed inby ~~the~~Platinum ~~normal~~Partners ~~course~~Value ofArbitrage ~~business.~~Fund LP.

On March 19, 2014, we entered into a note purchase agreement with a group of institutional investors and BAM Administrative Services LLC (“BAM”), an administrative agent for the investors, pursuant to which we issued senior secured promissory notes in the aggregate principal amount of $20,000,000. We used all of the proceeds from the sale of the notes to repay (i) $17,624,000 of our outstanding indebtedness to DMRJ under revolving promissory note (ii) $1,809,000 of interest outstanding under that facility and (iii) $567,000 of interest outstanding under our senior secured convertible promissory note (see Note 12 to the condensed consolidated financial statements). We have entered into several amendments, waivers and modifications with BAM. The notes bear interest at 16% per annum.

The maturity of our indebtedness to BAM was automatically extended to October 30, 2016 as a result of the extension of the maturity date of our indebtedness to DMRJ and Montsant.

The payment of our indebtedness to DMRJ, Montsant and BAM are stayed pending the conclusion of the bankruptcy proceedings.

The New DIP loans and all other obligations are due and payable (i) upon the occurrence of an event of default that is not cured within the applicable cure periods and for which the New DIP Lender has given notice to accelerate our obligations under the New DIP Agreement, (ii) the entry of an order converting the Chapter 11 Case to a case under Chapter 7 of the Bankruptcy Code, (iii) the entry of an order in the Chapter 11 Case appointing a chapter 11 trustee or examiner, (iv) if the interim order for the New DIP Agreement is modified at the final hearing for the New DIP Agreement in a manner unacceptable to the New DIP Lender, (v) the effective date of a chapter 11 plan in the Chapter 11 Case, (vi) the approval by the Bankruptcy Court of an alternative financing transaction transferring the collateral other than the sale of our assets to L-3 Communications Corporation (“Buyer”) under the asset purchase agreement, dated as of October 10, 2016.

Despite our projected sales, expense and cash flow projections to fund our operations and continue the development, commercialization and marketing of our products will require that we maintain our credit facilities with Tannor Partners Credit Fund, LP, DMRJ, BAM and Montsant. There can be no assurance that we will achieve the covenant test under our New DIP Loan, which would be deemed an event of default. Upon the occurrence of an event of default that is not cured within the applicable cure periods and for which the New DIP Lender can give notice to accelerate our obligations under the New DIP Agreement or that DMRJ is willing or is able to continue to make advances under our revolving line of credit. Our failure to achieve our projections and/or obtain sufficient additional capital on acceptable terms would have a material adverse effect on our liquidity and operations and could require us to convert our voluntary filing under bankruptcy laws from Chapter 11 to Chapter 7. Furthermore, we are incurring and will incur increased legal and financial adviser cost associated with the activities of the Official Committee of Equity Holders appointed by the U.S. Trustee and increased legal and administrative cost associated with the bankruptcy proceedings following the anticipated successful completion of the ETD asset sale to L-3. These conditions raise substantial doubt as to our ability to continue as a going concern.

Our common stock was delisted by the NYSE Amex LLC in June 2009 as result of our failure to comply with certain continued listing requirements. Our common stock has been quoted on the OTC Bulletin Board since May 2009 and is also quoted on the OTC Markets Group’s OTCQB tier under the symbol “IMSC”. We believe that trading ‘over the counter’ has limited our stock’s liquidity and has impaired our ability to raise capital.

In addition, while we strive to bring new products to market, we are subject to a number of risks similar to the risks faced by other technology-based companies, including risks related to: (a) our dependence on key individuals and collaborative research partners; (b) competition from substitute products and larger companies; (c) our ability to develop and market commercially usable products and obtain regulatory approval for our products under development; and (d) our ability to obtain substantial additional financing necessary to adequately fund the development, commercialization and marketing of our products. For the three months ended September 30, 2016, we reported a net loss of $27,184,000 and used $40,000 in cash from operations.

As of September 30, 2016, the Company had an accumulated deficit of approximately $227,403,000 and a working capital deficit of $97,097,000. Management continually evaluates its operating expenses and its cash flow from operations.

As of September 30, 2016, our obligations to DMRJ under each of the three promissory notes and a revolving

- 8 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

line of credit approximated $11,970,000, $17,523,000, $1,000,000 and $17,662,000, respectively. Further, as of September 30, 2016, our obligation to DMRJ for accrued interest under these instruments approximated $7,282,000 and is included in current liabilities in the condensed consolidated financial statements.

As of September 30, 2016, our obligations to Montsant under a promissory note approximated $5,284,000. Further, as of September 30, 2016, our obligation to Montsant for accrued interest under this instrument approximated was $203,000.

As of September 30, 2016, our obligations under the senior secured promissory notes for which BAM is the agent were $20,000,000. Further, as of September 30, 2016, our obligation under such notes for accrued interest amounted to approximately $3,200,000 and is included in current liabilities in the condensed consolidated financial statements.

As of December 9, 2016, our obligations to DMRJ under each of the three promissory notes and a revolving line of credit approximated $11,970,000, $17,523,000, $1,000,000 and $17,662,000, respectively. Further, as of December 9, 2016, our obligation to DMRJ for accrued interest under these instruments approximated $8,687,000. Please refer to Note 14 to the condensed consolidated financial statements for a discussion of the August 2016 conversions of principal indebtedness by DMRJ.

As of December 9, 2016, our obligations to Montsant under a promissory note approximated $5,284,000. Further, as of December 9, 2016, our obligation to Montsant for accrued interest under this instrument approximated $328,000.

As of December 9, 2016, our obligations under the senior secured promissory notes for which BAM is the agent were $20,000,000. Further, as of December 9, 2016, our obligation under such notes for accrued interest amounted to approximately $3,802,000.

On December 11, 2015, we entered into an Accounts Receivable Purchase Agreement (the “Purchase Agreement”) with Republic Capital Access, LLC (“RCA”), pursuant to which we may sell eligible accounts receivables relating to U.S. government prime contracts or subcontracts (as defined in the Purchase Agreement, “Eligible Receivables”) to RCA. The total amount of Eligible Receivables that we may sell to RCA is subject to a maximum limit of $2,000,000 of outstanding receivables at any given time. On April 11, 2016, we amended the Purchase Agreement (the “Amended Purchase Agreement”). As amended, the total amount of Eligible Receivables that we may sell to RCA is subject to a maximum limit of $3,500,000 of outstanding receivables at any given time.

Pursuant to the terms of the Purchase Agreement, we will receive from RCA, within two business days of the submission of the applicable invoice, an initial payment equal to 90% of the face value of an Eligible Receivable purchased by RCA. Following payment of such Eligible Receivable to RCA by the relevant customer, RCA shall pay the Company the residual 10% of such receivable, less transaction fees payable to RCA by the Company pursuant to the Purchase Agreement.

We have paid, or will pay, as applicable, the following fees, as applicable, to RCA pursuant to the Purchase Agreement: (i) an initial enrollment fee equal to $5,000.00; (ii) a discount factor equal to 0.35%, for U.S. government contracts (or 0.53% for U.S. government subcontracts), of the amounts of purchased receivables; (iii) a program access fee equal to 0.017% of the daily ending account balance for each day that receivables are outstanding; (iv) a commitment fee equal to 1% of Maximum Amount minus the amount of purchased receivables; and (v) expenses relating to the negotiation of the Purchase Agreement, which amount is not expected to exceed $1,000. As of September 30, 2016, RCA has purchased $16,913,000 of our receivables pursuant to the Purchase Agreement.

The Purchase Agreement terminated on October 10, 2016, as a consequence of our filing of voluntary relief petitions under Chapter 11 of the Bankruptcy Code with the United States Bankruptcy Court. As of that date, we are no longer able to sell eligible accounts receivable to RCA and we have collected all amounts owed under the Purchase Agreement from RCA.

These conditions raise substantial doubt as to our ability to continue as a going concern.

Our ability to comply with our debt covenants in the depends on our ability to to control expenses and may require that we seek additional capital through private financing sources. The payment of our secured obligations with DMRJ and Montsant will be stayed until such time that the Official Committee of Equity Holders has concluded their activities to assert certain estate claims and causes of action and challenge the validity, enforceability, and perfection of certain prepetition secured claims, which challenge period was extended by the bankruptcy court up to and including January 23, 2017. Interest on our debt obligations with DMRJ and Montsant

- 9 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

will continue to accrue until such time that the obligations are paid by us. There can be no assurances that we will achieve our forecasted financial results or that we will be able to raise additional capital to operate our business. Any such failure would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely. Further, upon the occurrence of an event of default under certain provisions of our credit agreements with DMRJ, Montsant and BAM, we could be required to pay default rate interest equal to the lesser of 2.5% per month and the maximum applicable legal rate per annum on the outstanding principal balance. The occurrence of an event of default under certain provisions of our New DIP Loan would require us to pay default interest equal to 24% per annum on the outstanding principal loan balance. The failure to cure an event of default or negotiate further extensions of our obligations to our secured lenders would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely and/or file for protection under Chapter 7 of the U.S. bankruptcy laws.

Based on projected cash flows, and the cash available from under the New DIP Loan, management believes there are plans in place to sustain operations during the bankruptcy process, provided that our credit facilities are maintained. These plans depend on a substantial increase in sales of our handheld trace explosives detector product and our desktop explosives and narcotics trade detector product and the prudent management of our resources. However, there can be no assurances that sales will materialize as forecasted, and/or that management will be successful in refinancing or extending our obligations to our secured lenders, which matured between October 30, 2016 and October 31, 2016. To further sustain us, improve our cash position, and enable us to grow while reducing debt, management plans to continue to seek additional capital through private financing sources. However, there can be no assurance that management will be successful in executing these plans or that we would receive permission from the New DIP Lender, BAM, DMRJ, Montsant or the bankruptcy court to obtain additional capital. Management will continue to closely monitor and attempt to control our costs and actively seek needed capital through sales of our products, government grants and awards and through our lending institutions.

On August 24, 2016, a Cayman Islands court appointed an insolvency specialist, RHSW Caribbean, to liquidate the assets of Platinum Partners Value Arbitrage Fund LP (“Platinum”). On October 18, 2016, RHSW Caribbean filed a Chapter 15 bankruptcy petition with the United States Bankruptcy Court for the District of Southern New York, which seeks to protect Platinum's U.S. assets from its creditors while an insolvency proceeding is underway in the Cayman Islands. Our ability to obtain additional funds under our credit agreements with DMRJ is unlikely given the pending liquidation of the funds and the Chapter 15 bankruptcy petition.

However, there can be no assurances that sales will materialize as forecasted, and/or that management will be successful in refinancing or extending our obligations to our secured lenders, which matured between October 30, 2016 and October 31, 2016.

The payment of our indebtedness to DMRJ and Montsant are stayed pending the conclusion of the bankruptcy proceedings.

We have suffered recurring losses from operations. Our condensed consolidated financial statements have been presented on the basis that it is a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.

There can be no assurances that our forecasted results will be achieved or that we will be able to raise additional capital necessary to operate our business. These conditions raise substantial doubt about our ability to continue as a going concern. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue as a going concern.

~~Security~~We ~~product~~have ~~sales~~a ~~tend~~history toof ~~have~~being aactive ~~long~~in ~~sales~~submitting ~~cycle,~~proposals ~~and~~for ~~are~~government ~~often~~sponsored ~~subject~~grants toand ~~export~~contracts ~~controls. In~~and ansuccessful ~~effort~~in tobeing ~~identify~~awarded ~~new~~grants ~~opportunities~~ and ~~stimulate~~contracts ~~sales~~from government agencies. However, we ~~hired~~have ~~additional~~recorded ~~sales~~no ~~personnel~~revenues ~~during~~from ~~fiscal~~government ~~2013~~contracts, ~~that~~due ~~have~~to ~~specific~~the ~~industry~~expiration ~~experience~~of several contracts and ~~have~~our ~~retained~~inability to secure new ~~distributors~~contracts. Management ~~However,~~will ~~there~~continue ~~can~~to bepursue nothese ~~assurance~~grants ~~that~~and ~~these~~contracts to support our research and development efforts ~~will~~primarily ~~increase~~in ~~revenue~~the areas of trace explosives detection.

WeOn ~~have~~October a16, ~~history~~2014, ofthe ~~being~~U.S. ~~active~~Department inof ~~submitting~~Homeland ~~proposals~~Security ~~for~~(“DHS”) ~~government~~selected ~~sponsored~~our ~~grants~~proposal ~~and~~to ~~contracts~~develop ~~and~~next ~~successful~~generation inexplosives ~~being~~trace ~~awarded~~detection ~~grants~~screening ~~and~~systems ~~contracts~~for ~~from~~funding. ~~government~~We ~~agencies.~~entered ~~However,~~into wea ~~have~~cost-plus ~~recorded~~fixed-fee nocontract ~~revenues~~with ~~from~~the ~~government~~DHS ~~grants~~on orAugust ~~contracts~~24, ~~due~~2016. toThe ~~the~~contract ~~expiration~~consists of ~~several~~a ~~contracts~~definitive task and ~~our~~an ~~inability~~optional totask, ~~secure~~each ~~new~~valued ~~contracts~~at approximately $1. ~~Management~~1 ~~will~~million. ~~continue~~The tototal ~~pursue~~performance ~~these~~period ~~grants~~will ~~and~~be ~~contracts~~twenty-four tomonths, ~~support~~provided ~~our~~the ~~research~~optional ~~and~~task ~~development~~is ~~efforts~~exercised. ~~primarily~~The project commenced in the ~~areas~~first quarter of ~~trace~~fiscal ~~explosives detection~~2017.

On- ~~October~~10 16, 2014, the U.S. Department of Homeland Security (“DHS”) selected our proposal to develop next generation explosives trace detection screening systems for funding under a statement of work. The project, pending successful negotiations, is potentially worth up to approximately $2 million. Subject to successful conclusion of negotiations with the DHS, we expect the project to commence in the fourth of quarter of fiscal 2016.-

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

We are currently expending significant resources to develop the next generation of our current products and to develop new products. We will require additional funding in order to continue the advancement of the commercial development and manufacturing of the explosives detection system. We will attempt to obtain such financing by: (i) government grants, (ii) private financing, or (iii) strategic partnerships. However, there can be no assurance that we will be successful in our attempts to raise such additional financing.

We will require substantial funds for further research and development, regulatory approvals, and the marketing of our explosives detection products. Our ~~working~~ capital requirements depend on numerous factors, including but not limited to the progress of our research and development programs; the cost of filing, prosecuting, defending and enforcing any intellectual property rights; competing technological and market developments; changes in our development of commercialization activities and arrangements; and the hiring of additional personnel, and acquiring capital equipment. Our failure to achieve our projections and/or obtain sufficient additional capital on acceptable terms would have a material adverse effect on our liquidity and operations and could require us to file for protection under bankruptcy laws.

Security product sales tend to have a long sales cycle, and are often subject to export controls. In an effort to identify new opportunities and stimulate sales, we have hired additional sales personnel during fiscal 2013 that have specific industry experience and have retained new distributors. However, there can be no assurance that these efforts will increase revenues.

Interim Financial Statements and Basis of Presentation

Principles of Consolidation

The accompanying condensed consolidated financial statements include our operations in Massachusetts, ~~our former facilities in~~ California and Shanghai, China, and those of our wholly-owned subsidiaries. On March 25, 2015, our Board of Directors approved restructuring actions to better align costs with current and future geographic revenue sources and to improve efficiencies. Our San Diego, CA advanced technology office was relocated to our Wilmington, MA facility and our Shanghai office was closed. All intercompany transactions and accounts have been eliminated in consolidation.

Accounting Principles

The accompanying condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”). In the opinion of management, the accompanying condensed consolidated financial statements include all adjustments (consisting only of normal recurring adjustments), which we consider necessary for a fair presentation of the financial position at such date and of the operating results and cash flows for the periods presented. The results of operations and cash flows for the three months ended may not necessarily be indicative of results that may be expected for any succeeding quarter or for the entire fiscal year. The balance sheet at June 30, 2016 has been derived from our audited consolidated financial statements at that date, but does not include all of the information and notes required by U.S. GAAP for complete financial statements.

The information contained in this Form 10-Q 8should be read in conjunction with our audited financial statements, included in our Form 10-K, as of and for the year ended June 30, 2016.

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

operating results and cash flows for the periods presented. The results of operations and cash flows for the nine months ended March 31, 2016 may not necessarily be indicative of results that may be expected for any succeeding quarter or for the entire fiscal year. The balance sheet at June 30, 2015 has been derived from our audited consolidated financial statements at that date, but does not include all of the information and notes required by U.S. GAAP for complete financial statements.

The information contained in this Form 10-Q should be read in conjunction with our audited financial statements, included in our Form 10-K, as of and for the year ended June 30, 2015.

Use of Accounting Estimates

The preparation of these financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Some of the more significant estimates include allowance for doubtful accounts, allowance for sales returns, inventory valuation, warranty reserves, ~~stock-based compensation~~ and long-lived assets. Management's estimates are based on the facts and circumstances available at the time estimates are made, past historical experience, risk of loss, general economic conditions and trends and management's assessments of the probable future outcome of these matters. Consequently, actual results could differ from such estimates.

Significant accounting policies are described in Note 2 to the condensed consolidated financial statements included in Item 7 of our Form 10-K for the fiscal year ended June 30, ~~2015~~2016.

Foreign Currency Translation

The assets and liabilities of our Shanghai representative office were translated into U.S. dollars at current exchange rates as of the balance sheet date;, expenses were translated at average monthly exchange rates. Net unrealized translation gains or losses associated with the Shanghai office were recorded directly to other comprehensive income. Realized gains and losses from foreign currency transactions were not material for any of the periods presented. We had short-term inter-company receivables from our Shanghai office which were adjusted each period for changes in foreign currency exchange rates with a corresponding entry recorded as a component of the condensed consolidated statement of operations and comprehensive loss.

- 11 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

unrealized translation gains or losses associated with the Shanghai office were recorded directly to other comprehensive income. Realized gains and losses from foreign currency transactions were not material for any of the periods presented. We had short-term inter-company receivables from our Shanghai office which were adjusted each period for changes in foreign currency exchange rates with a corresponding entry recorded as a component of the consolidated statement of operations and comprehensive loss.

Reclassification

Certain prior year amounts have been reclassified for consistency with the current period presentation. On October 10, 2016, we and our subsidiaries entered into an asset purchase agreement to sell the explosives trace detection assets to L-3 Communications Corporation for $117.5 million in cash, plus the assumption of specified liabilities, subject to adjustment. We concluded that it was appropriate to classify the assets used in our explosives detection business as held for sale. as all of the criteria established under ASC 205 were met. Corresponding reclassifications have also been made to the balance sheet at June 30, 2016. These changes in classification had no effect on the previously reported condensed consolidated statement of operations for any period and did not materially affect previously reported cash flows in the condensed consolidated statement of cash flows.

Discontinued Operations and Assets Classified as Held for Sale

Accounting Standards Codification (Topic 205) Presentation of Financial Statements – Reporting Discontinued Operations (“ASC 205”), establishes the criteria for a component of an entity classification as held for sale and reporting an entities financial statements as a discontinued operation. Under ASC 205, a component or group of components, or a business should be classified as held for sale in period in which all of the criteria are met.

Management, having the authority to approve the action, commits to a plan to sell the entity to be sold.

The entity to be sold is available for immediate sale in its present condition subject only to terms that are usual and customary for sales of such entities to be sold.

An active program to locate a buyer or buyers and other actions required to complete the plan to sell the entity to be sold have been initiated.

The sale of the entity to be sold is probable (the future event or events are likely to occur), and transfer of the entity to be sold is expected to qualify for recognition as a completed sale, within one year, unless events or circumstances beyond an entity’s control extend the period required to complete the sale as discussed below.

The entity to be sold is being actively marketed for sale at a price that is reasonable in relation to its current fair value.

Actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.

The Financial Accounting Standards Board issued Accounting Standards Update No. 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity (“ASU 2014-08”). Under ASU 2014-08, a disposal of a component of an entity, a component or group of components shall be reported in discontinued operation if the if the disposal represents a strategic shift that has or will have a major effect on an entity’s operations and financial results, as determined when the component or group of components; meets the criteria to be classified as held for sale; is disposed of by sale; or, is disposed of other than by sale.

The sale of our explosive detection assets does not represent a strategic shift in our operations but will have a significant effect on our operations and financial results, given that we are disposing of essentially all of the assets used in our sole business or product line.

- 12 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The following balance sheet provides the major classes of our explosives detection business’ held for sale assets and liabilities and is reconciled to our condensed consolidated balance sheet as of September 30, 2016 and June 30, 2016.


Implant Sciences Corporation
Condensed Consolidated Balance Sheet
As of September 30, 2016
(in thousands)

	Held for Sale	Continuing	Total
ASSETS
Current assets:
Cash and cash equivalents	$ 1,282	$ -	$ 1,282
Restricted cash and investments	367	-	367
Accounts receivable-trade, net	4,993	-	4,993
Inventories, net	6,108	-	6,108
Prepaid expenses and other current assets	237	233	470
Total current assets	12,987	233	13,220
Property and equipment, net	843	-	843
Other non-current assets	98	-	98
Total assets	$ 13,928	$ 233	$ 14,161
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities:
Senior secured promissory note – BAM	$ -	$ 20,000	$ 20,000
Senior secured convertible promissory note – Montsant Partners	-	5,284	5,284
Senior secured promissory note – DMRJ	-	1,000	1,000
Second senior secured convertible promissory note – DMRJ	-	11,970	11,970
Third senior secured convertible promissory note - DMRJ	-	17,523	17,523
Line of credit - DMRJ	-	17,662	17,662
Current maturities of obligations under capital lease	17	-	17
Warrant derivative liability	-	12,664	12,664
Accrued expenses	4,974	11,986	16,960
Accounts payable	4,705	1,673	6,378
Deferred revenue	859	-	859
Total current liabilities	10,555	99,762	110,317
Long-term liabilities:
Long-term obligations under capital lease, net of current maturities	32	-	32
Deferred revenue, net of current	615	-	615
Total long-term liabilities	647	-	647
Total liabilities	11,202	99,762	110,964
Commitments and contingencies
Stockholders' deficit:
Common stock;	-	80	80
Preferred stock; no stated value; 5,000,000 shares authorized
Series G Convertible Preferred Stock	-	-	-
Series H Convertible Preferred Stock	-	7,000	7,000
Series I Convertible Preferred Stock	-	-	-
Series J Convertible Preferred Stock	-	-	-
Additional paid-in capital	-	123,775	123,775
Accumulated deficit	-	(227,403)	(227,403)
Deferred compensation	-	(204)	(204)
Other comprehensive income	-	22	22
Treasury stock, at cost	-	(73)	(73)
Total stockholders' deficit	-	(96,803)	(96,803)
Total liabilities and stockholders' deficit	$ 11,202	$ 2,959	$ 14,161

- 13 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


Implant Sciences Corporation
Condensed Consolidated Balance Sheet
As of June 30, 2016
(in thousands)

	Held for Sale	Continuing	Total
ASSETS
Current assets:
Cash and cash equivalents	$ 1,338	$ -	$ 1,338
Restricted cash and investments	367	-	367
Accounts receivable-trade, net	7,123	-	7,123
Inventories, net	4,681	-	4,681
Prepaid expenses and other current assets	229	235	464
Total current assets	13,738	235	13,973
Property and equipment, net	874	-	874
Other non-current assets	98	-	98
Total assets	$ 14,710	$ 235	$ 14,945
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities:
Senior secured promissory note – BAM	$ -	$ 20,000	$ 20,000
Senior secured convertible promissory note – Montsant Partners	-	5,284	5,284
Senior secured promissory note – DMRJ	-	1,000	1,000
Second senior secured convertible promissory note – DMRJ	-	18,970	18,970
Third senior secured convertible promissory note - DMRJ	-	17,523	17,523
Line of credit - DMRJ	-	17,662	17,662
Current maturities of obligations under capital lease	18	-	18
Warrant derivative liability	-	-	-
Accrued expenses	5,729	9,452	15,181
Accounts payable	3,143	1,512	4,655
Deferred revenue	406	-	406
Total current liabilities	9,296	91,403	100,699
Long-term liabilities:
Long-term obligations under capital lease, net of current maturities	35	-	35
Deferred revenue, net of current	479	-	479
Total long-term liabilities	514	-	514
Total liabilities	9,810	91,403	101,213
Commitments and contingencies
Stockholders' deficit:
Common stock;	-	79	79
Preferred stock; no stated value; 5,000,000 shares authorized
Series G Convertible Preferred Stock	-	-	-
Series H Convertible Preferred Stock	-	-	-
Series I Convertible Preferred Stock	-	-	-
Series J Convertible Preferred Stock	-	-	-
Additional paid-in capital	-	114,255	114,255
Accumulated deficit	-	(200,084)	(200,084)
Deferred compensation	-	(467)	(467)
Other comprehensive income	-	22	22
Treasury stock, at cost	-	(73)	(73)
Total stockholders' deficit	-	(86,268)	(86,268)
Total liabilities and stockholders' deficit	$ 9,810	$ 5,135	$ 14,945

Warrant Derivative Liability

Accounting Standards Codification (“ASC”) 815-40-15 “Derivatives and Hedging”, requires freestanding contracts that are settled in common stock, including common stock warrants to be designated as an equity instrument, asset or liability. On July 20, 2016, we issued a warrant to purchase 50,657,894 shares of our common stock to DMRJ LLC. Under the provisions of ASC 815-40-15, a contract designated as an asset or a liability must be

- 14 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

carried at fair value until exercised or expired, with any changes in fair value recorded in the results of operations. The warrant derivative liability should initially and subsequently be measured at fair value with changes in fair value recorded in earnings in each reporting period.

The fair value is estimated using a binomial option pricing model, which includes variables such as the expected volatility of our share price, interest rates, and dividend yields. These variables are projected based on our historical data, experience, and other factors. Changes in any of these variables could result in material adjustments to the expense / income recognized for changes in the valuation of the warrant liability.

Beneficial Note Conversion Feature - DMRJ

Accounting Standards Codification (“ASC”) 470-20 “Debt,” addresses the accounting for financial instruments which have a beneficial conversion feature. In accordance with ASC 470-20, a conversion feature is beneficial, or “in the money,” when the conversion rate of the convertible security is below the market price of the underlying common stock. A beneficial conversion feature, calculated as of the commitment date, is the difference between the convertible instruments conversion price and the fair value of the company’s common stock on that date multiplied by the number of common shares the debt converts into.

Recent Accounting Pronouncements

In May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which supersedes the revenue recognition requirements in ASC 605, “Revenue Recognition”. The FASB issued ASU 2014-09 to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and International Financial Reporting Standards. The core principle of this updated guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The new rule also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. This guidance is effective for annual reporting periods beginning after December 15, 2017, including interim reporting periods therein, which is effective for our fiscal year beginning July 1, 2018, the first day of our 2019 fiscal year. We are currently evaluating the impact of this accounting guidance and do not expect any significant impact on our consolidated financial statements.

In June 2014, the FASB issued Accounting Standards Update 2014-12, Compensation-Stock Compensation (“ASU 2014-12”). The FASB issued ASU 2014-12 to provide specific guidance on share-based payment awards that provide for achievement of a specific performance target that could be achieved after the requisite service period. ASU 2014-12 requires that a performance target that affects vesting and that could be achieved after the requisite service period should be treated as a performance condition. As such, the performance target should not be reflected in estimating the grant-date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. This guidance is effective for annual periods and interim periods within those annual periods beginning after December 15, 2015, which is effective for our fiscal year beginning July 1, 2016, the first day of our 2017 fiscal year. Earlier adoption is permitted. ASU 2014-12 may be applied prospectively to all awards granted or modified after the effective date or retrospectively to all awards with performance targets that are outstanding as of the beginning of the earliest annual period presented in the financial statements and to all new or modified awards thereafter. If retrospective transition is adopted, the cumulative effect of applying this guidance should be recognized in the financial statements as an adjustment to the opening retained earnings balance at that date. The adoption of ASU 2014-12 did not have a material impact on our consolidated financial statements.

In August 2014, the FASB issued Accounting Standards Update 2014-15, 9Presentation of Financial Statements-Going Concern (Subtopic 205-40) (“ASU 2014-15”). ASU 2014-15 provides guidance to U.S. GAAP about management’s responsibility to evaluate whether there is a substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. This new rule requires management to assess an entity’s ability to continue as a going concern by incorporating and expanding upon certain principles currently in U.S. auditing standards. Specifically, ASU 2014-15 (1) defines the term substantial doubt, (2) requires an evaluation of every reporting period including interim periods, (3) provides principles for considering the mitigating effect of management’s plan, (4) requires certain disclosures when substantial doubt is alleviated as a result of consideration of management’s plans, (5) requires an express statement and other disclosures when substantial doubt is not alleviated, and (6) requires an assessment for a period of one year after the date that the financial statements are

- 15 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

issued. This guidance is effective for ~~our~~annual ~~fiscal~~periods ~~year~~ending ~~beginning~~after ~~July~~December 115, 2016, ~~the~~which ~~first~~is ~~day~~effective offor our ~~2017~~ fiscal year. Earlier adoption is permitted. ASU 2014-12 may be applied prospectively to all awards granted or modified after the effective date or retrospectively to all awards with performance targets that are outstanding as of the beginning ofJuly ~~the~~1, ~~earliest annual period presented in the financial statements and to all new or modified awards thereafter. If retrospective transition is adopted~~2016, the ~~cumulative~~first ~~effect~~day of ~~applying~~our ~~this~~2017 ~~guidance~~fiscal ~~should be recognized in the financial statements as an adjustment to the opening retained earnings balance at that date~~year. WeThe ~~are~~adoption ~~currently evaluating the impact~~ of ~~this~~ASU ~~accounting~~2014-15 ~~guidance~~did ~~and do~~ not ~~expect~~have ~~any~~a ~~significant~~material impact on our consolidated financial statements.

In August 2014, the FASB issued Accounting Standards Update 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40) (“ASU 2014-15”). ASU 2014-15 provides guidance to U.S. GAAP about management’s responsibility to evaluate whether there is a substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. This new rule requires management to assess an entity’s ability to continue as a going concern by incorporating and expanding upon certain principles currently in U.S. auditing standards. Specifically, ASU 2014-15 (1) defines the term substantial doubt, (2) requires an evaluation of every reporting period including interim periods, (3) provides principles for considering the mitigating effect of management’s plan, (4) requires certain disclosures when substantial doubt is alleviated as a result of consideration of management’s plans, (5) requires an express statement and other disclosures when substantial doubt is not alleviated, and (6) requires an assessment for a period of one year after the date that the financial statements are issued. This guidance is effective for annual periods ending after December 15, 2016, which is effective for our fiscal year beginning July 1, 2016, the first day of our 2017 fiscal year. We are currently evaluating the impact of this accounting guidance and do not expect any significant impact on our consolidated financial statements.

In July 2015, the FASB issued Accounting Standards Update 2015-11, Inventory (Topic 330) (“ASU 2015-11”). ASU 2015-11 was issued to more closely align the measurement of inventory in U.S. GAAP with the measurement of inventory in International Financial Reporting Standards. The core principle of this updated guidance is that an entity should measure inventory at the lower of cost or net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. The amendments in ASU 2015-11 apply to inventory that is measured using the first-in, first-out or average cost methods. ASU 2015-11 amends some of the guidance in Topic 330 to more clearly articulate the requirements for the measurement and disclosure of inventory, but the clarifications are not intended to result in any changes in practice other than the change in the subsequent measurement guidance from the lower of cost or market to the lower of cost or net realizable value for inventory. There are no other substantive changes to the guidance on the measurement of inventory. This guidance is effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years, which is effective for our fiscal year beginning July 1, 2017, the first day of our 2018 fiscal year. We are currently evaluating the impact of this accounting guidance and do not expect any significant impact on our consolidated financial statements.

In August 2015, the FASB issued Accounting Standards Update 2015-15, Interest – Imputation of Interest (Subtopic 835-30) Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements (“ASU 2015-15”). ASU 2015-15 states that Staff at the Securities and Exchange Commission would not object to an entity deferring or presenting debt issuance costs as an asset and subsequently amortizing deferred debt issuance cost ratably over the term of the line-of-credit arrangement, regardless of whether there were outstanding borrowings under the arrangement. ~~We are currently evaluating the impact of this accounting guidance and do not expect any significant impact on our consolidated financial statements.~~

In April 2015, the FASB issued Accounting Standards Update 2015-03, Interest – Imputation of Interest (Subtopic 835-30) Simplifying the Presentation of Debt Issuance Costs (“ASU 2015-03”). ASU 2015-03 was issued to simplify the presentation of debt issuance costs. The amendment requires that debt issuance costs be presented in the balance sheet as a direct deduction from the debt liability, consistent with the presentation of a debt discount under Concepts Statement 6. Debt issuance costs are similar to a debt discount and in effect reduce the proceeds of borrowing, thereby increasing the effective interest rate and improves consistency with IFRS. This guidance is effective for fiscal years beginning after December 15, 2015 and interim periods within those fiscal years, which is effective for our fiscal year beginning July 1, 2016, the first day of our 2017 fiscal year. We are currently evaluating the impact of this accounting guidance and do not expect any significant impact on our consolidated financial statements.

- 10 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Concentration of Credit Risk and Major Customers

Financial instruments that potentially subject us to concentration of credit risk consist of trade receivables.

We grant credit to our customers, primarily large corporations, foreign governments and the U.S. government. We perform periodic evaluations of customer’s payment history and generally do not require collateral. Receivables are generally due within thirty days. Credit losses have historically been minimal, which is consistent with our expectations. Allowances are provided for estimated amounts of accounts receivable which may not be collected.

As of March 31, 2016, we had one irrevocable standby letter of credit outstanding in the approximate amount of $297,000. The letter of credit provides warranty performance security equal to 5% of the contract amount with the India Ministry of Defence. We have amended the letter of credit, extending the expiration date to April 15, 2017.

We have no other significant off-balance sheet risk such as foreign-exchange contracts, option contracts or other foreign hedging arrangements.

We place our cash with financial institutions which we believe are of high credit quality.

Our revenues are derived from both domestic and international sales. During the nine months ended March 31, 2016, a customer from France and an agency of the U.S. government represented approximately 28% and 22% of our revenue, respectively. During the nine months ended March 31, 2015, a customer from Norway and a customer from Spain represented 12% and 11%, respectively, of our revenue.

At March 31, 2016, two customers accounted for approximately $4,735,000 of accounts receivable, or 73% of accounts receivable outstanding as of that date. At March 31, 2015, four customers accounted for approximately $1,042,000 of accounts receivable, or 80% of accounts receivable outstanding as of that date.

For the nine months ended March 31, 2016 and 2015, we had one supplier who provides component parts used in the manufacture of our QS-B220 from whom our aggregate purchases represented approximately 20% and 11%, respectively, of our component inventory purchases for these periods. The refusal or inability of this manufacture to provide these component parts for a substantial period, or the loss of this manufacturer altogether, could significantly disrupt production as well as increase the cost of production, thereby increasing the prices of our products. These changes could have a material adverse effect on our business and results of operations.

Fair Value Measurement

Accounting Standards Codification (“ASC”) 820, “Fair Value Measurements and Disclosures,” establishes a three-level fair value hierarchy to classify the inputs used in measuring fair value, which are as follows:

Level 1 inputs to the valuation methodology are based on quoted prices (unadjusted) in active markets for identical assets or liabilities;

Level 2 inputs to the valuation methodology are based on inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly; and

Level 3 inputs to the valuation methodology are based on unobservable inputs that reflect the company’s own assumptions about the assumptions market participants would use in pricing the asset or liability.

Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. Our financial instruments at March 31, 2016 and June 30, 2015 include cash equivalents, restricted cash, accounts receivable, accounts payable and borrowings under our senior secured convertible promissory note, senior secured promissory note and a revolving line of credit. The carrying amounts of cash and cash equivalents, restricted cash, receivables, and accounts payable are representative of their respective fair values because of the short-term maturities or expected settlement dates of these instruments. The fair value of debt, included in Note 13, is based on the fair value of similar instruments. These instruments are short-term in nature and there is no known trading market for our debt.

Our financial instruments at September 30, 2016 and June 30, 2016 include cash equivalents, restricted cash, accounts receivable accounts payable, derivative instruments, borrowings under our senior secured convertible promissory note, senior secured promissory note and a revolving line of credit. The carrying amounts of cash and cash equivalents, restricted cash, receivable and accounts payable are representative of their respective fair values because of the short-term 11maturities or expected settlement dates of these instruments. The fair value of debt, included in Note 12 to the condensed consolidated financial statements, is based on the fair value of similar instruments. These instruments are short-term in nature and there is no known trading market for our debt.

- 16 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The following table provides the non-recurring fair value measurements of assets and liabilities as of ~~March~~September 3130, 2016:

		Fair Value Measurements as of March 31, 2016
		Fair Value Measurements as of September 30, 2016
Description (In thousands)	Carrying Value at March 31, 2016	Quoted Prices in Active Markets for Identical Asset Level 1	Significant Other Observable Inputs Level 2	Significant Unobservable Inputs Level 3
(In thousands)	Carrying Value at September 30, 2016	Quoted Prices in Active Markets for Identical Asset Level 1	Significant Other Observable Inputs Level 2	Significant Unobservable Inputs Level 3
Certificates of deposit	$ 312	$ 312	$ -	$ -
Certificate of deposit	$ 312	$ 312	$ -	$ -
Senior secured promissory note – BAM	20,000	-	-	20,000
Senior secured convertible promissory note – Montsant	5,284	-	-	5,284
Second senior secured convertible promissory note – DMRJ	18,970	-	-	18,970
Senior secured promissory note – DMRJ	1,000	-	-	1,000
Second senior secured convertible promissory note – DMRJ	11,970	-	-	11,970
Third senior secured convertible promissory note – DMRJ	17,523	-	-	17,523
Senior secured promissory note - DMRJ	1,000	-	-	1,000
Line of credit - DMRJ	17,662	-	-	17,662
Line of credit – DMRJ	17,662	-	-	17,662

The following table provides the non-recurring fair value measurements of assets and liabilities as of June 30, ~~2015~~2016:

		Fair Value Measurements as of June 30, 2015
		Fair Value Measurements as of June 30, 2016
Description (In thousands)	Carrying Value at June 30, 2015	Quoted Prices in Active Markets for Identical Asset Level 1	Significant Other Observable Inputs Level 2	Significant Unobservable Inputs Level 3
(In thousands)	Carrying Value at June 30, 2016	Quoted Prices in Active Markets for Identical Asset Level 1	Significant Other Observable Inputs Level 2	Significant Unobservable Inputs Level 3
Certificates of deposit	$ 312	$ 312	$ -	$ -
Certificate of deposit	$ 312	$ 312	$ -	$ -
Senior secured promissory note – BAM	20,000	-	-	20,000
Senior secured convertible promissory note – Montsant	35,~~184~~284	-	-	35,~~184~~284
Senior secured promissory note - DMRJ	1,000	-	-	1,000
Senior secured promissory note – DMRJ	1,000	-	-	1,000
Second senior secured convertible promissory note – DMRJ	1218,~~000~~970	-	-	1218,~~000~~970
Third senior secured convertible promissory note – DMRJ	1217,~~000~~523	-	-	1217,~~000~~523
Line of credit - DMRJ	1617,662	-	-	1617,662

-The 12following -table summarizes the changes in the fair value of our Level 3 financial liabilities that are measured at fair value for each reporting period:


	Warrant Derivative Liability
(In thousands)	For the Three Months Ended September 30,
	2016	2015
Balance at beginning of period	$ -	$ -
Fair value on date of issuance	15,703	-
Net change in fair value of financial instrument	(3,039)	-
Balance at end of period	$ 12,664	$ -

- 17 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Restricted Cash and Investments

As of ~~March~~September 3130, 2016 and June 30, ~~2015~~2016, we had restricted cash and investments, with maturities of less than one year, of $367,000 and $367,000, respectively. Restricted cash and investments consisted of the following:

(In thousands)	~~March~~September 3130, 2016	June 30, ~~2015~~2016
Current assets
Certificates of deposit	$ 312	$ 312
Cash maintained to secure corporate credit card	55	55
Total	$ 367	$ 367

The restricted investments of $312,000 held in certificates of deposit collateralize our performance under an irrevocable letter of credit issued in April 2010, aggregating to $297,000, in connection with our contract with the India Ministry of Defence, plus the bank required collateralization deposit of $15,000. The letter of credit provides warranty performance security equal to 5% of the contract amount under the terms of the contract with the India Ministry of Defence. We have amended the letter of credit, extending the expiration date to April 15, 2017.

In May 2015, we entered into a corporate credit card agreement with our primary bank, pursuant to which the bank reserves $55,000 of ~~the~~our available cash held in our operating account maintained with the bank to collateralize 105% of the credit limit that is available under the credit card agreement.

Stock Based Compensation

For the three months ended ~~March~~September 3130, 2016 and 2015, our consolidated statements of operations and comprehensive loss include $~~314~~290,000 and $1342,~~154,~~000, respectively, of compensation costs and no income tax benefit related to our stock-based compensation arrangements for employee and non-employee director awards~~. For the nine months ended March 31~~, 2016 and 2015, our condensed consolidated statements of operations and comprehensive loss include $982,000 and $2,381,000, respectively, of compensation costs and no income tax benefit related to our stock-based compensation arrangements for employee and non-employee director awards, as follows:

	For the Three Months Ended March 31,		For the Nine Months Ended March 31,
	For the Three Months Ended September 30,
(In thousands)	2016	2015	~~2016~~	~~2015~~
Cost of revenues	$ 1425	$ 7130	~~$ 75~~	~~$ 172~~
Research and development	3322	~~137~~84	~~163~~	~~379~~
Selling, general and administrative	~~267~~243	~~946~~228	~~744~~	~~1,830~~
Total	$ ~~314~~290	$ ~~1,154~~342	~~$ 982~~	~~$ 2,381~~

As of ~~March~~September 3130, 2016, the total amount of unrecognized stock-based compensation expense was approximately $1795,~~394,~~000, which will be recognized over a weighted average period of 1.6 years.

As of ~~March~~September 3130, 2016, there were options outstanding to purchase 20,~~651~~488,~~483~~984 shares of our common stock at exercise prices ranging from $0.08 to $2.30~~, with a weighted-average exercise price of $1~~.~~15.~~

- 13 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Related Party Transactions

In April 2011, we entered into an advisory and consulting agreement with Robert Liscouski, our President and a member of our Board of Directors, to assist our U.S. government sales and marketing team with our efforts to advance our interests with the U.S. government. During the three and nine months ended March 31, 2015, we paid Mr. Liscouski $0 and $105,000, respectively for services performed under this agreement which terminated effective on February 1, 2015, when Mr. Liscouski joined the Company. As of March 31, 2016, we had no obligation to Mr. Liscouski under this agreement.

On August 15, 2014, August 29, 2014, September 18, 2014 and October 2, 2014, Roger Deschenes, our Chief Financial Officer, advanced $100,000, $125,000, $125,000 and $100,000, respectively, for general working capital purposes, of which $450,000 of principal and $12,000 of interest was repaid to Mr. Deschenes during the fiscal year ended June 30, 2015. The advances were payable on demand and bore interest at 15%. As of March 31, 2016 our obligation to Mr. Deschenes was $0.

Prepaid Expenses and Other Current Assets

Prepaid expenses and other current assets consist of the following:

(In thousands)	~~March~~September 3130, 2016	June 30, ~~2015~~2016
Interest	$ 1,019	$ -
Inventory deposit	$ 110	$ 109
Inventory deposits	237	677
Insurance	224	128
Insurance	165	87
Bank fees	8	12
Bank fees	2	14
Other prepaid expenses	128	215
Other prepaid expenses	186	168
Total	$ 470	$ 464
Total	$ 1,609	$ 946

On- ~~March~~18 31, 2016, we further amended each of our credit instruments with DMRJ and Montsant, which were entered into on April 6, 2016 and effective March 31, 2016, pursuant to which we agreed to prepay the interest due on each of the March 2009 Note, the September 2012 Note and the February 2013 Notes from the date of the amendment through June 30, 2016 by increasing the outstanding aggregate principal amount under each such Note. The prepayment of all interest to be accrued from the March 31, 2016 through June 30, 2016, on each of the March 2009 Note, the September 2012 Note and the February 2013 Note amounted to $119,400 on account of the March 2009 Note, $450,000 on account of the September 2012 Note and $450,000 on account of the February 2013 Note, by increasing the outstanding aggregate principal amount under each of the March 2009 Note, the September 2012 Note and the February 2013 Note, respectively.-

Inventories, net

We value our inventories at lower of cost or market. Cost is determined by the first-in, first-out (FIFO) method, including material, labor and factory overhead. The components of inventories, net of reserves, consist of the following:

(In thousands)	March 31, 2016	June 30, 2015
Raw materials	$ 4,040	$ 3,283
Work in progress	1,013	1,455
Finished goods	928	506
Total	$ 5,981	$ 5,244

As of March 31, 2016 and June 30, 2015, our reserves for excess and slow-moving inventories were $211,000 and $218,000, respectively.

- 14 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

97.

Inventories, net


(In thousands)	September 30, 2016	June 30, 2016
Raw materials	$ 3,640	$ 3,067
Work in progress	1,234	976
Finished goods	1,234	638
Total	$ 6,108	$ 4,681

As of September 30, 2016 and June 30, 2016, our reserves for excess and slow-moving inventories were $175,000 and $171,000, respectively.

Property and Equipment, net

Property and equipment consist of the following:

(In thousands)	~~March~~September 3130, 2016	June 30, ~~2015~~2016
Machinery and equipment	$ ~~524~~529	$ ~~533~~529
Computers and software	~~457~~510	~~415~~507
Furniture and fixtures	9697	8396
Leasehold improvements	178	~~159~~178
Equipment under capital lease	~~159~~94	~~157~~94
Construction in progress	342	342
Sub-total	1,756	1,689
	1,750	1,746
Less: accumulated depreciation and amortization	~~916~~907	~~809~~872
Total	$ ~~840~~843	$ ~~880~~874

For the three months ended ~~March~~September 3130, 2016 and 2015, depreciation expense was approximately $4943,000 and $4554,000, respectively.

~~For the nine months ended March 31, 2016 and 2015, depreciation expense was approximately $153,000 and $126,000, respectively~~9.

~~10.~~Accrued Expenses

Accrued Expenses – Current and Long-Term

Accrued expenses consist of the following:

(In thousands)	~~March~~September 3130, 2016	June 30, ~~2015~~2016
Current liabilities
Accrued interest	$ 610,~~203~~685	$ 137,~~264~~703
Accrued compensation and benefits	2,~~961~~231	13,~~774~~347
Accrued warranty costs	12,~~808~~473	~~556~~2,282
Accrued legal and accounting	~~434~~268	~~257~~533
Accrued taxes	~~249~~218	74106
Other accrued liabilities	1,524	1,155
Accrued dividends	135	-
Total	$ 13,179	$ 17,080
Other accrued liabilities	950	1,210
Long-term liabilities
Total	$ 16,960	$ 15,181
Accrued compensation and benefits	$ -	$ 48
	$ -	$ 48

On ~~March~~January 3116, ~~2016~~2015, weGlenn ~~further~~D. ~~amended~~Bolduc, ~~each~~resigned ofhis ~~our~~positions ~~credit~~as ~~instruments~~Chief ~~with~~Executive ~~DMRJ~~Officer and ~~Montsant~~President of the Company), ~~which~~as ~~were~~well ~~entered~~as ~~into~~his seat on ~~April~~the 6,Company’s ~~2016~~Board of Directors and ~~effective~~his ~~March~~position ~~31,~~as ~~2016,~~Chairman ~~pursuant~~of the Board. In connection with and prior to ~~which~~Mr. ~~the~~Bolduc’s ~~accrued~~resignations, ~~interest~~Mr. ~~amount~~Bolduc ~~due~~entered ~~under~~into ~~each~~a ofSeparation Agreement and Release (the ~~March~~“Separation ~~2009~~Agreement”) ~~Note,~~with the ~~September~~Company. The ~~2012~~Separation ~~Note~~Agreement provides that Mr. Bolduc’s resignation will be deemed an involuntary termination without cause pursuant to his Amended and ~~the~~Restated ~~February~~Employment ~~2013~~Agreement ~~Note,~~dated as of ~~March~~June 3125, ~~2016,~~2013. In ofthis $1regard,~~980,000,~~ ~~$6,520,000~~ and ~~$5,073,000,~~subject ~~respectively~~to the terms contained in the Employment Agreement, ~~were~~Mr. ~~added~~Bolduc is entitled to ~~the~~receive: ~~outstanding~~(i) ~~principal~~annual ~~amount~~base ~~under~~salary ~~each~~for 18 months on a regular payroll basis; (ii) a pro rata portion of ~~the~~any ~~notes,~~bonus asearned in 2015; (iii) continuation of ~~March~~coverage ~~31,~~under ~~2016.~~ and contributions to

On- ~~January~~19 16, 2015, Glenn D. Bolduc, resigned his positions as Chief Executive Officer and President of the Company, as well as his seat on the Company’s Board of Directors and his position as Chairman of the Board. In connection with and prior to Mr. Bolduc’s resignations, Mr. Bolduc entered into a Separation Agreement and Release (the “Separation Agreement”) with the Company. The Separation Agreement provides that Mr. Bolduc’s resignation will be deemed an involuntary termination without cause pursuant to his Amended and Restated Employment Agreement dated as of June 25, 2013. In this regard, and subject to the terms contained in the Employment Agreement, Mr. Bolduc is entitled to receive: (i) annual base salary for 18 months on a regular payroll basis; (ii) a pro rata portion of any bonus earned in 2015; (iii) continuation of coverage under and contributions to health care, dental and life insurance benefits for a 12 month period; and (iv) transfer of any key man life insurance. -

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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

health care, dental and life insurance benefits for a 12 month period; and (iv) transfer of any key man life insurance. In connection with Mr. Bolduc’s resignation, we recorded a non-recurring charge of $725,000 in our consolidated statements of operations and comprehensive loss for the year ended June 30, 2015. As of ~~March~~September 3130, 2016 and June 30, ~~2015~~2016, $~~177,000~~0 and $~~480~~55,000, respectively, of separation benefits are included in accrued expenses in our condensed consolidated financial statements.

1110.

Deferred Revenues – Current and Long-Term

Deferred revenues are recorded when we receive payments for product or services for which we have not yet completed our obligation to deliver product or have not completed services required by the contractual agreements.

As of ~~March~~September 3130, 2016 and June 30, ~~2015~~2016, we had customer advance ~~payments~~payment and extended warranty service agreements with maturities of less than one year, of $1859,~~049,~~000 and $3406,~~454,~~000, respectively, and extended warranty service agreements, with maturities of more than one year, of $~~539~~615,000 and $~~221~~479,000, respectively. Deferred revenues consisted of the following:

(In thousands)	~~March~~September 3130, 2016	June 30, ~~2015~~2016
Current liabilities
Customer advance payments	$ ~~690~~264	$ ~~3,121~~42
Extended warranty service agreements	~~359~~595	~~333~~364
Total	$ ~~1,049~~859	$ ~~3,454~~406
Long-term liabilities
Extended warranty service agreements	$ ~~539~~615	$ ~~221~~479
Total	$ ~~539~~615	$ ~~221~~479

1211.

Earnings Per Share

Basic earnings per share is computed by dividing net loss by the weighted average number of common shares outstanding during the period. Diluted earnings per share are based upon the weighted average number of common shares outstanding during the period plus additional weighted average common equivalent shares outstanding during the period. Common equivalent shares result from the assumed exercise of outstanding stock options and warrants, the proceeds of which are then assumed to have been used to repurchase outstanding common stock using the treasury stock method and assumed conversion of certain convertible promissory notes and convertible preferred stock. In addition, the numerator is adjusted for any changes in income or loss that would result from the assumed conversion of potential shares. As of ~~March~~September 3130, 2016 and 2015, potentially dilutive shares are excluded from the earnings per share calculation, because their effect would be antidilutive. Shares deemed to be antidilutive include stock options, warrants, convertible debt and convertible preferred stock.

	For the Three Months Ended March 31,		For the Nine Months Ended March 31,
	For the Three Months Ended September 30,
(In thousands, except share and per share amounts)	2016	2015	~~2016~~	~~2015~~
Basic and diluted loss per share:
Basic and diluted loss per share
Numerator:
Numerator
Net loss	$ (427,~~096~~184)	$ (~~5,731~~911)	~~$ (8,320)~~	~~$ (17,350)~~
Denominator:
Denominator
Weighted average shares	7879,~~878~~658,953	7276,~~677~~206,~~287~~953	~~77,871,509~~	~~69,454,343~~
Basic and diluted loss per share	$ (0.0534)	$ (0.0801)	~~$ (0.11)~~	~~$ (0.25)~~

- 1620 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Common stock equivalents excluded from the diluted earnings per share calculation for the three ~~and nine~~ months ended ~~March~~September 3130, 2016 and 2015, were as follows:

	For the Three Months Ended March 31,		For the Nine Months Ended March 31,
	For the Three Months Ended September 30,
	2016	2015	2016	2015
(In thousands, except share and per share amounts)	2016	2015
Common stock equivalents excluded
Common stock equivalents excluded:
Stock options	~~425~~442,~~097~~686	1789,~~333,193~~993	~~575,792~~	~~1,900,692~~
Warrants	-15,577,160	~~230~~56,~~624~~538	~~6,191~~	~~485,997~~
Convertible debt	4078,~~342~~088,~~568~~367	39,800,000	~~39,983,458~~	~~50,809,174~~
	40,767,665	41,363,817	40,565,441	53,195,863
Convertible preferred stock	18,071,174	-
	112,179,387	40,646,531

1312.

Long-Term Debt and Credit Arrangements

Term Debt and Revolving Credit Facility with DMRJ Group, LLC and Term Debt with Montsant Partners, LLC

We are a party to several loan and credit agreements with DMRJ Group LLC (“DMRJ”), an accredited institutional investor. In December 2008, we entered into a note and warrant purchase agreement with DMRJ pursuant to which we issued a senior secured convertible promissory note in the principal amount of $5,600,000 and a warrant to purchase 1,000,000 shares of our common stock. Thereafter, we entered into a series of amendments, waivers and modifications of this facility. The note, which is collateralized by all of our assets, originally bore interest at 11.0% per annum.

The note contains restrictions and financial covenants including: (i) restrictions against declaring or paying dividends or making any distributions; against creating, assuming or incurring any liens ~~or indebtedness~~; against creating, assuming or incurring any indebtedness; against merging or consolidating with any other company, provided, however, that a merger or consolidation is permitted if we are the surviving entity; against the sale, assignment, transfer or lease of our assets, other than in the ordinary course of business and excluding inventory and certain asset sales expressly permitted by the note purchase agreement; against making investments in any company, extending credit or loans, or purchasing stock or other ownership interest of any company; and (ii) covenants that we have authorized or reserved for the purpose of issuance, 150% of the aggregate number of shares of our common stock issuable upon exercise of the warrant; that we maintain a minimum cash balance of at least $500,000; that the aggregate dollar amount of all accounts payable be no more than 100 days past due; and that we maintain a current ratio, defined as current assets divided by current liabilities, of no less than 0.60 to 1.00.

InOn ~~September~~March ~~2011~~19 2015, we amended each of our credit instruments with DMRJ., ~~Pursuant~~pursuant to ~~those~~which ~~amendments: (i)~~ the maturity of all of our indebtedness to DMRJ was extended from ~~September~~March 3031, ~~2011~~2015 to March 31, ~~2013;~~2016 ~~(ii)~~and DMRJ waived our compliance with certain financial covenants contained in ~~the~~each ~~notes and all related credit agreements through maturity; (iii) our line~~ of ~~credit under the September 2009 credit agreement was increased from $15,000,000 to $23,000,000; and (iv) we were required to repay sufficient amounts of~~ our ~~outstanding~~promissory ~~indebtedness under the~~ notes and all related credit agreements ~~and~~through ~~other amounts owing to DMR such that as of December 31, 2011,~~ the ~~outstanding~~new ~~obligations~~maturity ~~to DMRJ shall not exceed $15,000,000~~date.

InOn ~~October~~May ~~2011~~4, 2015, we ~~further~~entered ~~amended~~into ~~each~~an ofassignment ~~our~~agreement ~~credit~~with ~~instruments~~DMRJ ~~with~~and Montsant Partners LLC ( “Montsant”), wherein DMRJ assigned its rights, totitle ~~eliminate~~and interest in the ~~obligation~~senior tosecured ~~repay~~promissory ~~any~~note ~~portion~~dated ofDecember ~~our~~10, ~~outstanding~~2008 ~~indebtedness~~and toappointed DMRJ byas ~~December~~its ~~31,~~collateral ~~2011~~agent under the promissory note agreement.

InDMRJ ~~February~~and ~~2012,~~Montsant ~~we amended each of our credit instruments with DMRJ~~Partners, toLLC ~~extend~~are ~~the~~funds ~~maturity~~managed ofby ~~all~~Platinum ofPartners ~~our~~Value ~~indebtedness~~Arbitrage toFund ~~DMRJ to September 30, 2012~~LP.

InThe ~~September~~note ~~2012~~purchase agreement with Montsant contains restrictions and financial covenants including: (i) restrictions against declaring or paying dividends or making any distributions; against creating, weassuming ~~further~~or ~~amended~~incurring any ~~each~~liens; ofagainst ~~our~~creating, ~~credit~~assuming ~~instruments~~or ~~with~~incurring ~~DMRJ.~~any ~~Pursuant~~indebtedness; toagainst ~~those~~merging ~~amendments:~~or ~~(i)~~consolidating wewith ~~extended~~any other company, against the ~~maturity~~sale, ~~date~~assignment, oftransfer ~~all~~or lease of our ~~indebtedness~~assets, ~~from~~other ~~September~~than 30in the ordinary course of business; against making investments in any company, ~~2012~~extending tocredit ~~March~~or 31loans, ~~2013~~or purchasing stock or other ownership interest of any company; and (ii) ~~issued~~covenants tothat we ~~DMRJ~~maintain a ~~second~~minimum ~~senior~~cash ~~secured~~balance ~~convertible~~of ~~promissory~~at ~~note~~least in$500,000; that the ~~principal~~weighted ~~amount~~average age of ~~$12~~all accounts payable be no more than 100 days past due; and that we maintain a current ratio,~~000~~ defined as current assets divided by current liabilities,~~000~~ ~~(the~~of ~~“September~~no ~~2012~~less ~~Note”)~~than 0.60 to 1.00. Montsant waived our compliance with certain financial covenants in our promissory notes through the maturity date, consistent with the financial covenants which have been waived in each of our promissory notes and all related credit agreements with DMRJ.

~~The~~- ~~second~~21 senior secured convertible promissory note originally gave DMRJ the option to require us to repurchase any or all of the shares of Series H Preferred Stock owned by DMRJ, at the Series H Original Issue Price per share, if we did not (i) by March 31, 2013, have at least one of our products receive qualified or approved status -

- 17 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

on the “Transportation Security Administration Air Cargo Screening Technology List (ACSTL) – For Passenger Aircraft” or placed on the Transportation Security Administration’s “Explosive Trace Detector Qualified Product List (QPL)”; or (ii) achieve revenues of at least $7,500,000 per fiscal quarter, commencing with fiscal quarter ending June 30, 2013. As described below, the note was subsequently amended to eliminate this option.

On February 28, 2013, we further amended each of our credit instruments with DMRJ. Pursuant to those amendments:

the maturity of all of our indebtedness to DMRJ was extended from March 31, 2013 to March 31, 2014;

DMRJ waived our compliance with certain financial covenants in each of our promissory notes and all related credit agreements through the new maturity date;

DMRJ’s option to require us to repurchase any or all of the shares of Series H Convertible Preferred Stock ) which may be issued upon conversion of the September 2012 Note was eliminated;

we issued to DMRJ a third senior secured convertible promissory note dated February 28, 2013, in the aggregate principal amount of $12,000,000. Payment for the February 2013 Note was made by the cancellation of $12,000,000 of principal of the outstanding indebtedness under our credit agreement;

DMRJ acquired the option to convert the amended and restated senior secured convertible promissory note dated March 12, 2009 (the “March 2009 Note”) into shares of Series J Convertible Preferred Stock in lieu of shares of Common Stock; and

the March 2009 Note and the September 2012 Note were amended to permit us to prepay any or all of our indebtedness thereunder on 30 days prior notice.

The third senior secured convertible promissory note bears interest at the rate of 15% per annum. The principal balance of this note, together with all outstanding interest and all other amounts owed thereunder, were due and payable on March 31, 2015. The third senior secured convertible promissory note is convertible in whole or in part, at DMRJ’s option, into shares of Series I Convertible Preferred Stock at an initial conversion rate of $1,000 per share (as adjusted in the event of any stock dividend, stock split, combination or other similar recapitalization with respect to the Series I Preferred Stock, the “Series I Original Issue Price”). We may prepay this note on 30 days prior notice.

On November 14, 2013, we amended each of our credit agreements with DMRJ to extend the maturity date of all of our indebtedness to DMRJ from March 31, 2014 to September 30, 2014.

On March 19, 2014, we further amended each of our credit instruments with DMRJ. Pursuant to those amendments:

the maturity of all of our indebtedness to DMRJ was extended from September 30, 2014 to March 31, 2015;

DMRJ waived our compliance with certain financial covenants in each of our promissory notes and all related credit agreements through the new maturity date;

DMRJ consented to the execution and delivery of the note purchase agreement with BAM and agreed to waive all prepayment limitations and prepayment notice requirements set forth in any of the credit documents to which DMRJ and the company are parties with respect to the repayments and prepayments financed by the sale of the notes; and

DMRJ agreed to subordinate its first position security interest in all of our assets to BAM.

On March 19 2015, we further amended each of our credit instruments with DMRJ, pursuant to which the maturity of all of our indebtedness to DMRJ was extended from March 31, 2015 to March 31, 2016 and DMRJ waived our compliance with certain financial covenants contained in each of our promissory notes and all related credit agreements through the new maturity date.

On May 4, 2015, we entered into an assignment agreement with DMRJ and Montsant Partners LLC ( “Montsant”), wherein DMRJ assigned its rights, title and interest in the senior secured promissory note dated December 10, 2008 and appointed DMRJ as its collateral agent under the promissory note agreement. DMRJ and Montsant Partners, LLC are funds managed by Platinum Partners Value Arbitrage Fund LP.

The note purchase agreement with Montsant contains restrictions and financial covenants including: (i)

- 18 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

restrictions against declaring or paying dividends or making any distributions; against creating, assuming or incurring any liens; against creating, assuming or incurring any indebtedness; against merging or consolidating with any other company, against the sale, assignment, transfer or lease of our assets, other than in the inventory ordinary course of business; against making investments in any company, extending credit or loans, or purchasing stock or other ownership interest of any company; and (ii) covenants that we maintain a minimum cash balance of at least $500,000; that the weighted average age of all accounts payable be no more than 100 days past due; and that we maintain a current ratio, defined as current assets divided by current liabilities, of no less than 0.60 to 1.00. Montsant waived our compliance with certain financial covenants in our promissory notes through the maturity date, consistent with the financial covenants which have been waived in each of our promissory notes and all related credit agreements with DMRJ.

On March 31, 2016, we further amended each of our credit instruments with DMRJ and Montsant, which were entered into on April 6, 2016 and effective March 31, 2016, pursuant to which:

the maturity of all of our indebtedness to DMRJ under (i) a senior secured promissory note dated July 1, 2009 and (ii) a credit agreement dated September 4, 2009, was extended from March 31, 2016 to June 30, 2016;

the maturity of all of our indebtedness to (i) Montsant under an amended and restated senior secured convertible promissory note dated March 12, 2009 (the “March 2009 Note”), (ii) DMRJ under a senior secured convertible promissory note dated September 5, 2012 (the “September 2012 Note”) and (iii) to DMRJ under a senior secured convertible promissory note dated February 28, 2013 (the “February 2013 Note” and together with the March 2009 Note, the July 2009 Note, the September 2012 Note, the “Notes”), was extended from March 31, 2016 to December 30, 2016;

the provisions regarding the prepayment of the March 2009 Note were deleted;

the “blocker” provisions of the March 2009 Note limiting the number of shares of our common stock, par value $0.001 per share (“Common Stock”) to be issued upon the conversion of the March 2009 Note, when aggregated with the all other shares of Common Stock beneficially owned by the holder of the March 2009 Note at that time, to 4.99% of the then issued and outstanding shares of the Common Stock outstanding at such time were deleted;

the conversion provisions of the March 2009 Note were fixed to remove the limitations on the conversion to only upon prepayment of the note or during the 30-day period ending March 31, 2014;

we agreed to make the amendments to our Series H Convertible Preferred Stock (the “Series H Preferred Stock”), Series I Convertible Preferred Stock (the “Series I Preferred Stock”) and Series J Convertible Preferred Stock (the “Series J Preferred Stock” and together with the Series H Preferred Stock and the Series I Preferred Stock, the “Amended Preferred Stock Series”;

we agreed to prepay the interest due on each of the March 2009 Note, the September 2012 Note and the February 2013 Notes from the date of the amendment through June 30, 2016 by increasing the outstanding aggregate principal amount under each such Note;

all outstanding amounts due to DMRJ and Montsant shall be immediately due and payable if (a) we receive an offer from another person or entity with respect to a Major Transaction, (b) DMRJ notifies us that such offer is satisfactory to DMRJ (in its sole discretion), and (c) either (i) our Board of Directors does not approve such transaction within ten (10) days of our receipt of such notice from DMRJ, (ii) if such transaction is subject to stockholder approval, we do not file a preliminary proxy statement with the SEC within fifteen (15) days of the receipt of such notice from DMRJ or (iii) if such transaction is subject to stockholder approval, our stockholders do not approve such transaction within ninety (90) days of the receipt of such notice from DMRJ, that we shall be obligated to immediately forward to DMRJ any offer that we receive with respect to any Major Transaction;

- 19 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

we shall provide not less than thirty (30) business days’ written notice to DMRJ and Montsant, as applicable, of the our intent to repay all or any portion of the principal, interest and other amounts outstanding under our indebtedness and following receipt of any such notice, DMRJ and Montsant shall have the option to convert all or any portion of their Notes in accordance with the applicable conversion terms of the applicable Note;

each Note, plus all accrued and unpaid interest thereon at the time of any conversion, may be converted at the option of DMRJ or Montsant, as applicable, at any time and from time to time into such number of shares of the applicable preferred stock of the Company, upon one (1) business days’ notice to us, and upon Montsant’s conversion of the March 2009 Note, the shares of preferred stock shall be issued to Montsant or any designee(s) of Montsant;

we agreed that if there is any breach of the Comfort Letter , the interest rate under each term note and advances under the Credit Agreement will be increased by an additional fourteen percent (14%) per annum (pro-rated for partial years), not to exceed the maximum amount of such interest permitted by applicable New York law;

agreed that we will not, and will not permit any Subsidiary to, enter into, create, incur, assume, suffer, become or be liable for in any manner, or permit to exist, any indebtedness, or guarantee, assume, endorse or otherwise become responsible for (directly or indirectly), any indebtedness, performance or obligations of any other person, and failure by us to comply with this clause shall be an immediate event of default;

- 22 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

endorse or otherwise become responsible for (directly or indirectly), any indebtedness, performance or obligations of any other person, and failure by us to comply with this clause shall be an immediate event of default;

we shall be obligated to provide DMRJ and Montsant with written notice of the anticipated record date with respect to any Major Transaction at least five (5) business days prior to such record date, and failure by us to comply with this clause shall be an immediate event of default;

we agreed not to amend the terms of any Amended Preferred Stock Series without the prior written consent of the DMRJ and Montsant, and any breach is an immediate event of default; and

we agreed not to issue any shares of any Amended Preferred Stock Series other than upon the conversion of the March 2009 Note, the September 2012 Note and the February 2013 Note or with the prior written consent of the Investor, and any breach of this provision is an immediate event of default.

The prepayment by us of all interest to be accrued from the March 31, 2016 through June 30, 2016, amounted to $119,400 on account of the March 2009 Note, $450,000 on account of the September 2012 Note and $450,000 on account of the February 2013 Note. Such prepayments were effected by increasing the outstanding aggregate principal amount under each of the March 2009 Note, the September 2012 Note and the February 2013 Note, respectively. Further, the accrued interest amount due under each of the March 2009 Note, the September 2012 Note and the February 2013 Note, as of March 31, 2016, of $1,980,000, $6,520,000 and $5,073,000, respectively, were added to the outstanding principal amount under each of the notes, as of March 31, 2016. Consequently, the new outstanding principal balance under (i) the March 2009 Note was $5,284,000, (ii) the September 2012 Note was $18,970,000 and (iii) the February 2013 Note was $17,523,000, as of March 31, 2016.

AsHowever, despite the best efforts of ~~March~~the 31Company, ~~2016~~DMRJ and the Assignee, ~~our~~certain ~~principal~~post-closing ~~obligations~~effectiveness conditions to ~~DMRJ~~the ~~under~~April ~~each~~6, of2016 amendment with respect to the ~~three~~delivery ~~promissory~~of ~~notes~~an ~~and~~opinion aof ~~revolving~~counsel ~~line~~and payment of ~~credit~~the ~~approximated~~fees ~~$18,970,000,~~and ~~$17,523,000,~~expenses ~~$1,000,000~~of DMRJ and ~~$17,662,000,~~the ~~respectively.~~Assignee ~~Further~~were not satisfied, asand ofthe ~~March~~April 316, 2016, ~~our~~amendment ~~obligation~~was, totherefore, ~~DMRJ~~never ~~for~~deemed ~~accrued~~effective, ~~interest~~resulting ~~under~~in ~~these~~our ~~instruments~~being ~~approximated~~in ~~$4,603,000~~default ~~and~~of isour ~~included~~obligations into ~~accrued~~DMRJ ~~expenses~~and in the ~~condensed~~Montsant ~~consolidated~~since ~~financial~~March ~~statements.~~31, 2016.

AsOn ofJuly ~~May 6~~20, 2016, ~~our~~we ~~principal~~further ~~obligations~~amended ~~to DMRJ under~~ each of ~~the~~our ~~three promissory notes and a revolving line of~~ credit ~~approximated~~instruments ~~$18,970,000,~~with ~~$17,523,000,~~DMRJ ~~$1,000,000~~ and ~~$17~~Montsant,~~662,000,~~ ~~respectively.~~effective ~~Further,~~ as of ~~May~~June 630, 2016, ~~our~~pursuant ~~obligation~~ to ~~DMRJ for accrued interest under these instruments approximated $4,883,000.~~ which:

As of March 31, 2016 and May 6, 2016, our principal obligations to Montsant under a promissory note approximated $5,284,000. Further, as of March 31, 2016 and May 6, 2016, our obligation to Montsant for accrued ·

-the 20maturity -of all of our indebtedness to DMRJ under (i) the amended and restated senior secured convertible promissory note, dated March 12, 2009 (as amended, the “March 2009 Note”), (ii) the senior secured promissory note dated July 1, 2009 (as amended, the “July 2009 Note”), (iii) the credit agreement dated September 4, 2009 (as amended, the “September 2009 Credit Agreement”), (iv) the senior secured convertible promissory note, dated September 5, 2012 (as amended, the “September 2012 Note”), and (v) the senior secured convertible promissory note, dated February 28, 2013 (as amended, the “February 2013 Note”) were each extended to October 31, 2016;

the “blocker” provisions of the March 2009 Note held by the Assignee, limiting the number of shares of Common Stock, to be issued upon the conversion of such notes, when aggregated with the all other shares of Common Stock beneficially owned by the holders of such notes at that time, to 4.99% of the then issued and outstanding shares of the Common Stock outstanding at such time, were confirmed as never having been deleted by the April 6, 2016 Amendment and an identical “blocker” provision was added to the September 2012 Note held by DMRJ;

the conversion and anti-dilution provisions of the February 2013 Note held by DMRJ were deleted in their entirety, and the conversion provisions of the September 2012 Note were limited to an aggregate total of $7,000,000 in obligations thereunder;

the conversion price for the September 2012 Note was reduced from $1.09 to $0.19 per share for up to $7,000,000 of the obligations thereunder, DMRJ agreed to convert $7,000,000 of the principal under the September 2012 Note prior to the consummation of the Zapata Acquisition, and the remaining conversion rights under the September 2012 Note and the February 2013 Note were waived;

we agreed to amend our Series H Convertible Preferred Stock (the “Series H Preferred Stock”), Series I Convertible Preferred Stock (the “Series I Preferred Stock”) and Series J Convertible Preferred Stock (the “Series J Preferred Stock” and together with the Series H Preferred Stock and the Series I Preferred Stock, the “Amended Preferred Stock Series”) to correct and amend and reinsert the 4.99%

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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

~~interest~~“blocker” ~~under~~provisions ~~this~~in ~~instrument~~lieu and in replacement of the similar provision that was ~~$0.~~added in the Articles of Amendment to the Restated Articles of Organization that was filed on July 18, 2016;

On September 24, 2015, Montsant converted $245,000 of the accrued interest owed by us under a promissory note into 3,062,500 shares of our common stock, at an adjusted conversion price of $0.08 per share.·

in connection with the Zapata Acquisition, we agreed, subject to the approval of our stockholders, to (i) re-domesticate from Massachusetts to Delaware and (ii) amend our Articles of Organization to increase its authorized share capital to 650,000,000 shares of Common Stock;

we agreed to issue to DMRJ a warrant to purchase 50,657,894 shares of our common stock (see Note 16 to the condensed consolidated financial statements); and

DMRJ and Montsant waived any defaults from the failure of the effectiveness of the March 31, 2016 amendment.

As of September 30, 2016, our obligations to DMRJ under each of the three promissory notes and a revolving line of credit approximated $11,970,000, $17,523,000, $1,000,000 and $17,662,000, respectively. Further, as of September 30, 2016, our obligation to DMRJ for accrued interest under these instruments approximated $7,282,000 and is included in current liabilities in the condensed consolidated financial statements.

The payment of our indebtedness to DMRJ and Montsant are stayed pending the conclusion of the bankruptcy proceedings.

Term Debt with BAM

On March 19, 2014, we entered into a note purchase agreement with a group of institutional investors and BAM Administrative Services LLC (“BAM”), an administrative agent for the investors, pursuant to which we issued senior secured promissory notes in the aggregate principal amount of $20,000,000. The notes ~~originally~~bear ~~bore~~ interest at 15% per annum and ~~matured~~mature on March 31, 2015. The proceeds from the sale of the notes were used to repay (i) $17,624,000 of our outstanding indebtedness to DMRJ under the amended and restated revolving promissory note dated September 29, 2011 (ii) $1,809,000 of interest outstanding under the amended and restated promissory note and (iii) $567,000 of interest outstanding under our senior secured convertible promissory note dated September 5, 2012.

On March 19, 2015, we extended our credit agreement with BAM pursuant to which, amongst other matters, the interest rate increased to 16% per annum, commencing on April 1, 2015 and we extended the maturity date of our indebtedness from March 31, 2015 to March 31, 2016. The maturity of our indebtedness to BAM was automatically extended to October 30, 2016 as a result of the extension of the maturity date of our indebtedness to DMRJ and Montsant.

The notes purchase agreement contains restrictions and financial covenants including: (i) restrictions against declaring or paying dividends or making any distributions; against creating, assuming or incurring any liens; against creating, assuming or incurring any indebtedness; against merging or consolidating with any other company, against the sale, assignment, transfer or lease of our assets, other than in the inventory ordinary course of business ; against making investments in any company, extending credit or loans, or purchasing stock or other ownership interest of any company; and (ii) covenants that we maintain a minimum cash balance of at least $500,000; that the weighted average age of all accounts payable be no more than 100 days past due; and that we maintain a current ratio, defined as current assets divided by current liabilities, of no less than 0.60 to 1.00. BAM waived our compliance with certain financial covenants in our promissory notes through the maturity date, consistent with the financial covenants which have been waived in each of our promissory notes and all related credit agreements with DMRJ.

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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Further, upon the occurrence of an event of default under certain provisions of our agreements with BAM, we could be required to pay default rate interest equal to the lesser of 2.5% per month and the maximum applicable legal rate per annum on the outstanding principal balance outstanding.

On April 6, 2016, we extended our credit agreement with BAM, effective March 31, 2016 pursuant to which;

the maturity of our indebtedness to the investors extended from March 30, 2016 to June 29, 2016; provided that in the event we extend the maturity date on all obligations owed to DMRJ, to a date past June 30, 2016, the maturity date of the Secured Term Notes shall automatically extend to such business day as is immediately prior to such extended maturity date of the DMRJ obligations;

all outstanding amounts due to the under the notes shall be immediately due and payable if (a) we receive an offer from another person or entity with respect to a Major Transaction (as defined below under the heading “Amendments to Preferred Stock”), (b) BAM, on behalf of the investors, notifies us that such offer is satisfactory to the investors (in their sole discretion), and (c) either (i) our Board of Directors does not approve such transaction within ten (10) days of receipt of such notice from BAM, (ii) if such transaction is subject to stockholder approval, we do not file a preliminary proxy statement with the SEC within fifteen (15) days of receipt of such notice from BAM or (iii) if such transaction is subject to stockholder approval, our stockholders do not approve such transaction within ninety (90) days of receipt of such notice from BAM; provided, that we shall be obligated to immediately forward to BAM, on behalf of the investors, any offer that we receive with respect to any Major Transaction;

we shall provide not less than thirty (30) business days’ written notice to BAM, of our intent to repay all or any portion of the principal, interest and other amounts outstanding under our obligations to the investors;

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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

agreed that we will not, and will not permit any subsidiary to, enter into, create, incur, assume, suffer, become or be liable for in any manner, or permit to exist, any indebtedness, or guarantee, assume, endorse or otherwise become responsible for (directly or indirectly), any indebtedness, performance or obligations of any other person, and failure by us to comply with this clause shall be an immediate event of default;

As of ~~March~~September 3130, 2016, our ~~principal~~ obligations under the senior secured promissory notes for which BAM is the agent were $20,000,000. Further, as of ~~March~~September 3130, 2016, our obligation under such notes for accrued interest amounted to approximately $13,~~600~~200,000 and is included in ~~accrued~~current ~~expenses~~liabilities in the ~~condensed~~ consolidated financial statements.

As of ~~May~~December 69, 2016, our ~~principal~~ obligations under the senior secured promissory notes for which BAM is the agent were $20,000,000. Further, as of ~~May~~December 69, 2016, our obligation under such notes for accrued interest amounted to approximately $13,~~920~~802,000.

14The payment of our indebtedness to BAM is stayed pending the conclusion of the bankruptcy proceedings.

13.

Convertible Preferred Stock

Series H Convertible Preferred Stock

In connection with the September 7, 2012 amendment to our credit instruments with DMRJ we issued to DMRJ a second senior secured convertible promissory note in the principal amount of $12,000,000 (the “September 2012 Note”). The September 2012 convertible promissory note is convertible in whole or in part, at DMRJ’s option, into shares of Series H Convertible Preferred Stock at an initial conversion rate of $1,000 per share (as adjusted in the event of any stock dividend, stock split, combination or other similar recapitalization with respect to the Series H Preferred Stock, the “Series H Original Issue Price”). The number of shares of our Preferred Stock, par value $0.10 per share (the “Preferred Stock”), designated as Series H Preferred Stock was 15,000.

The holders of the Series H Preferred Stock will be entitled to receive, prior to the payment of any dividends with respect to our Common Stock and/or Series G Convertible Preferred Stock, cumulative dividends on each share of Series H Preferred Stock at a rate equal to 15% of the Series H Original Issue Price per annum, (i) when, as and if declared by our Board of Directors, (ii) upon a liquidation, dissolution or winding up of the Company (a “Liquidation Event”), or (iii) upon the repurchase or conversion of the Series H Preferred Stock All dividends accruing on the Series H Preferred Stock are payable by the issuance of additional shares of Series H Preferred Stock.

~~Each~~- ~~share~~25 of Series H Preferred Stock will be convertible, at the option of the holder, into that number of shares of Common Stock as is determined by (i) dividing the Series H Original Issue Price by the Series H Conversion Price (as defined below) in effect at the time of conversion and (ii) multiply the result by 1,000. The “Series H Conversion Price” will initially be equal to $1,090, and is subject to adjustment in the event that (a) we issue additional shares of Common Stock as a dividend or other distribution on outstanding shares of Common Stock, (b) there is a split or subdivision of outstanding shares of Common Stock, or (c) there is a combination or reverse stock split of outstanding shares of Common Stock into a smaller number of shares of Common Stock. Assuming no adjustments to the Series H Original Issue Price or the Series H Conversion Price, the New Note will be convertible indirectly, at DMRJ’s option, into shares of Common Stock at an effective conversion price of $1.09 per share, which represents a discount of approximately 20% from the daily volume weighted average price of the Common Stock over the 20 trading days preceding the date of the amendment.-

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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

to“Liquidation ~~such consolidation~~Event”), ~~merger~~ or ~~reorganization~~(iii) doupon ~~not~~the ~~hold~~repurchase ator ~~least~~conversion ~~a majority~~ of the ~~resulting~~Series orH ~~surviving~~Preferred ~~entities’~~Stock. ~~voting~~All ~~power~~dividends ~~immediately~~accruing ~~following~~on ~~such~~the ~~consolidation,~~Series ~~merger~~H orPreferred ~~reorganization,~~Stock orare ~~(ii)~~payable aby ~~sale~~the orissuance ~~transfer~~ of ~~all~~additional orshares ~~substantially all~~ of ~~our~~Series ~~assets~~H ~~for~~Preferred ~~cash, securities or other property, will be deemed to be a Liquidation Event~~Stock.

Each share of Series H Preferred Stock will be convertible, at the option of the holder, into that number of shares of Common Stock as is determined by (i) dividing the Series H Original Issue Price by the Series H Conversion Price (as defined below) in effect at the time of conversion and (ii) multiply the result by 1,000. The “Series H Conversion Price” will initially be equal to $1,090, and is subject to adjustment in the event that (a) we issue additional shares of Common Stock as a dividend or other distribution on outstanding shares of Common Stock, (b) there is a split or subdivision of outstanding shares of Common Stock, or (c) there is a combination or reverse stock split of outstanding shares of Common Stock into a smaller number of shares of Common Stock. Assuming no adjustments to the Series H Original Issue Price or the Series H Conversion Price, the New Note will be convertible indirectly, at DMRJ’s option, into shares of Common Stock at an effective conversion price of $1.09 per share, which represents a discount of approximately 20% from the daily volume weighted average price of the Common Stock over the 20 trading days preceding the date of the amendment.

Upon a Liquidation Event, the holders of shares of Series H Preferred Stock then outstanding will be entitled to be paid out of the assets of the company available for distribution to its stockholders, before any payment is made to the holders of Common Stock and/or Series G Preferred Stock in respect of such stock, an amount per share equal to the Series H Original Issue Price, plus any accrued but unpaid dividends thereon, whether or not declared. At the option of holders of a majority of the outstanding Series H Preferred Stock, (i) a consolidation or merger of us with or into another entity or person, or any other corporate reorganization, in which our stockholders immediately prior to such consolidation, merger or reorganization do not hold at least a majority of the resulting or surviving entities’ voting power immediately following such consolidation, merger or reorganization, or (ii) a sale or transfer of all or substantially all of our assets for cash, securities or other property, will be deemed to be a Liquidation Event.

The holders of the Series H Preferred Stock will have no voting rights except as required by applicable law. However, without the consent of the holders of a majority of the outstanding Series H Preferred Stock, we may not (i) amend, alter or repeal any provision of its Articles of Organization or By-laws in a manner that adversely affects the powers, preferences or rights of the Series H Preferred Stock; (ii) authorize or issue any equity securities (or any equity or debt securities convertible into equity securities) ranking prior and superior to the Series H Preferred Stock with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up; or (iii) consummate any capital reorganization or reclassification of any of its equity securities (or debt securities convertible into equity securities) into equity securities ranking prior and superior to the Series H Preferred Stock with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up.

On July 18, 2016, in anticipation of the Purchase Agreement Amendment, the Company adopted and filed Articles of Amendment to the Restated Articles of Organization of the Company (the “July 18 Preferred Stock Articles of Amendment”), pursuant to which the initial conversion price of the Series H Preferred Stock was reduced from $1,090 per share to $190 per share; and the “blocker” provisions of the Amended Series H Preferred Stock Series limiting the number of shares of the Common Stock to be issued upon the conversion of the applicable Amended Preferred Stock Series, when aggregated with the all other shares of Common Stock beneficially owned by the holder of such Amended Preferred Stock Series at that time, to 4.99% of the then issued and outstanding shares of the Common Stock outstanding at such time, which the Company purported to delete in the Articles of Amendment filed in connection with the Fourteenth Amendment, were reinserted.

Between August 11, 2016 and August 23, 2016, DMRJ converted $7,000,000 of principal into 7,000 Series H Convertible Preferred Stock shares, of which DMRJ assigned 4,401.54 shares of Series H Convertible Preferred Stock to Platinum Partners Value Arbitrage Fund LP and distributed 1,467.18 shares to ED&F Man Capital Markets Limited and 1,131.28 shares to Prime Capital (Bermuda) Limited.

As of September 30, 2016, 7,000 shares of Series H Convertible Preferred Stock were issued and outstanding.

Series I Convertible Preferred Stock and Series J Convertible Preferred Stock

In connection with the February 28, 2013 amendment to our credit instruments with DMRJ we issued to DMRJ a third senior secured convertible promissory note in the principal amount of $12,000,000 (the “February 2013 Note”). The February 2013 Note is convertible in whole or in part, at DMRJ’s option, into shares of Series I Convertible Preferred Stock at an initial conversion rate of $1,000 per share (as adjusted in the event of any stock dividend, stock split, combination or other similar recapitalization with respect to the Series I Preferred Stock, the ~~“Series I Original Issue Price”). The number of shares of our Preferred Stock, par value $0.10 per share (the “Preferred Stock”), designated as Series I Preferred Stock was 15,000.~~

As- ~~amended,~~26 the March 2009 Note is convertible in whole or in part, at DMRJ’s option, into shares of Series J Convertible Preferred Stock at an initial conversion rate of $1,000 per share (as adjusted in the event of any stock dividend, stock split, combination or other similar recapitalization with respect to the Series J Preferred Stock, the “Series J Original Issue Price”). The number of shares of our Preferred Stock, par value $0.10 per share (the “Preferred Stock”), designated as Series J Preferred Stock was 6,000.-

Each share of Series I Preferred Stock will be convertible, at the option of the holder, into that number of shares of Common Stock as is determined by (i) dividing the Series I Original Issue Price by the Series I Conversion Price (as defined below) in effect at the time of conversion and (ii) multiplying the result by 1,000. The “Series I Conversion Price” will initially be equal to $1,180.00, and is subject to adjustment in the event that (a) we issue additional shares of Common Stock as a dividend or other distribution on outstanding shares of Common Stock, (b) there is a split or subdivision of outstanding shares of Common Stock, or (c) there is a combination or reverse stock split of outstanding shares of Common Stock into a smaller number of shares of Common Stock. Assuming no adjustments to the Series I Original Issue Price or the Series I Conversion Price, the February 2013 Note will be convertible indirectly, at DMRJ’s option, into shares of Common Stock at an effective conversion price of $1.18 per share, which represents premium of approximately 3% over the closing price of the Common Stock on the trading day preceding the date of the February 28, 2013 amendments.

Each share of Series J Preferred Stock will be convertible, at the option of the holder, into that number of shares of Common Stock as is determined by dividing the Series J Original Issue Price by the Series J Conversion Price (as defined below) in effect at the time of conversion. The “Series J Conversion Price” will initially be equal to $.08, and is subject to adjustment in the event that (a) the Company issues additional shares of Common Stock as a dividend or other distribution on outstanding shares of Common Stock, (b) there is a split or subdivision of outstanding shares of Common Stock, or (c) there is a combination or reverse stock split of outstanding shares of Common Stock into a smaller number of shares of Common Stock. Assuming no adjustments to the Series J Original Issue Price or the Series J Conversion Price, the March 2009 Note will be convertible indirectly, at DMRJ’s option, into shares of Common Stock at an effective conversion price of $.08 per share. Prior to the execution of the amendment, the March 2009 Note was convertible directly into shares of Common Stock at a conversion price of $.08 per share. Accordingly, we do not believe this change to be material.

The holders of the Series I Preferred Stock will be entitled to receive, prior to the payment of any dividends with respect to our Common Stock and/or Series G Preferred Stock, cumulative dividends on each share of Series I Preferred Stock at a rate equal to 15% of the Series I Original Issue Price per annum, (i) when, as and if declared by our Board of Directors, (ii) upon a “Liquidation Event”, or (iii) upon the conversion of the Series I Preferred Stock

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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

~~All~~“Series ~~dividends~~I ~~accruing~~Original onIssue ~~the~~Price”). ~~Series~~The Inumber of shares of our Preferred Stock, ~~are~~par ~~payable~~value by$0.10 ~~the~~per ~~issuance~~share of(the ~~additional~~“Preferred ~~shares~~Stock”), ofdesignated as Series I Preferred Stock was 15,000.

As amended, the March 2009 Note is convertible in whole or in part, at DMRJ’s option, into shares of Series J Convertible Preferred Stock at an initial conversion rate of $1,000 per share (as adjusted in the event of any stock dividend, stock split, combination or other similar recapitalization with respect to the Series J Preferred Stock, the “Series J Original Issue Price”). The number of shares of our Preferred Stock, par value $0.10 per share (the “Preferred Stock”), designated as Series J Preferred Stock was 6,000.

The holders of Series J Preferred Stock will be entitled to participate on an “as converted” basis in all dividends or distributions declared or paid on our Common Stock.

Upon a Liquidation Event, the holders of shares of Series I Preferred Stock and Series J Preferred Stock then outstanding will be entitled to be paid out of the assets of the company available for distribution to its stockholders, pari passu with distributions made with respect to the Series H Preferred Stock but before any payment is made to the holders of Common Stock and /or Series G Preferred Stock in respect of such stock, (i) an amount per share of Series I Preferred Stock equal to the Series I Original Issue Price, plus any accrued but unpaid dividends thereon, whether or not declared, and (ii) an amount per share of Series J Preferred Stock equal to the Series J Original Issue Price, plus any dividends declared but unpaid thereon. At the option of holders of a majority of the outstanding Series I Preferred Stock, (i) a consolidation or merger of the company with or into another entity or person, or any other corporate reorganization, in which the stockholders of the company immediately prior to such consolidation, merger or reorganization do not hold at least a majority of the resulting or surviving entities’ voting power immediately following such consolidation, merger or reorganization, or (ii) a sale or transfer of all or substantially all of our assets for cash, securities or other property, will be deemed to be a Liquidation Event.

Upon any such Liquidation Event, and after all payments described in the preceding paragraph are made in full in respect of the Series H Preferred Stock, the Series I Preferred Stock and the Series J Preferred Stock, the holders of the Series G Preferred Stock will be entitled to be paid out of the assets of the company available for distribution to its stockholders an amount equal to $8.00 per share of Series G Preferred Stock, plus any declared but unpaid dividends, prior to the payment of any amounts to the holders of our Common Stock by reason of their ownership of such stock.

Each share of Series J Preferred Stock will be convertible, at the option of the holder, into that number of shares of Common Stock as is determined by dividing the Series J Original Issue Price by the Series J Conversion Price (as defined below) in effect at the time of conversion. The “Series J Conversion Price” will initially be equal to $0.08, and is subject to adjustment in the event that (a) the Company issues additional shares of Common Stock as a dividend or other distribution on outstanding shares of Common Stock, (b) there is a split or subdivision of outstanding shares of Common Stock, or (c) there is a combination or reverse stock split of outstanding shares of Common Stock into a smaller number of shares of Common Stock. Assuming no adjustments to the Series J Original Issue Price or the Series J Conversion Price, the March 2009 Note will be convertible indirectly, at DMRJ’s option, into shares of Common Stock at an effective conversion price of $.08 per share. Prior to the execution of the

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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

amendment, the March 2009 Note was convertible directly into shares of Common Stock at a conversion price of $0.08 per share. Accordingly, we do not believe this change to be material.

The holders of the Series I Preferred Stock and the Series J Preferred Stock will have no voting rights except as required by applicable law. However, without the consent of the holders of a majority of the outstanding Series I Preferred Stock or Series J Preferred Stock, as the case may be, with each such series voting as a separate class, we may not (i) amend, alter or repeal any provision of our Articles of Organization or By-laws in a manner that adversely affects the powers, preferences or rights of the Series I Preferred Stock or Series J Preferred Stock, as the case may be; (ii) authorize or issue any equity securities (or any equity or debt securities convertible into equity securities) ranking prior and superior to the Series I Preferred Stock or Series J Preferred Stock, as the case may be, with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up; or (iii) consummate any capital reorganization or reclassification of any of its equity securities (or debt securities convertible into equity securities) into equity securities ranking prior and superior to the Series I Preferred Stock or Series J Preferred Stock, as the case may be, with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up.

In connection with the March 31, 2016 amendment to our credit agreements with DMRJ and Montsant, we agreed to amend certain terms of each of the Amended Preferred Stock Series as follows, which amendments were set forth in Articles of Amendment adopted on April 6, 2016:

the number of shares of our Preferred Stock, par value $0.10 per share (the “Preferred Stock”), designated as Series H Preferred Stock was increased from 15,000 shares to 22,500 shares, Series I Preferred Stock was increased from 15,000 shares to 21,000 shares and Series J Preferred Stock was increased from 6,000 shares to 6,500 shares;

the Series J Preferred Stock was amended so that its holders are entitled to receive preferred dividends equal to fifteen percent (15%) of the original issue price (subject to certain adjustments) of such shares of Preferred Stock, which is paid by the issuance of additional shares of Series J Preferred Stock;

the Series J Preferred Stock was amended so that it has the same dividend rights as the Series H Preferred Stock and the Series I Preferred Stock wherein we cannot declare, pay or set aside any dividends on any shares of Common Stock unless the holders of the Series J Preferred Stock then outstanding shall simultaneously receive a dividend on each outstanding share of Series J Preferred Stock in an amount at least equal to that dividend per share of Series J Preferred Stock as would equal the product of (i) the dividend payable on each share of Common Stock and (ii) the number of shares of Common Stock issuable upon conversion of a share of Series J Preferred Stock, in each case calculated on the record date for determination of holders entitled to receive such dividend;

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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

the product of (i) the dividend payable on each share of Common Stock and (ii) the number of shares of Common Stock issuable upon conversion of a share of Series J Preferred Stock, in each case calculated on the record date for determination of holders entitled to receive such dividend;

we agreed that if there is any breach of the Comfort Letter, the preferred dividend rate under each Amended Preferred Stock Series will be increased by an additional fourteen percent (14%) per annum (pro-rated for partial years), not to exceed the maximum amount (if any) permitted by law;

each Amended Preferred Stock Series was amended so that in the event of any voluntary or involuntary liquidation, dissolution or winding up of the Company (a “Liquidation Event”), instead of receiving just the original issue price (subject to certain adjustments) of such shares of Preferred Stock, the holders of such Preferred Stock receive the greater of the original issue price (subject to certain adjustments) of such shares of Preferred Stock and the amount that they would have received if all such shares of such Amended Preferred Stock Series were converted into Common Stock in accordance with the terms of such Amended Preferred Stock Series immediately prior to such Liquidation Event;

the Series J Preferred Stock was amended so that its holders have the same rights as the holders of Series H Preferred Stock and Series I Preferred Stock to, at the option of the holders of a majority of the outstanding applicable Amended Preferred Stock Series, have a Liquidation Event also include (i) a consolidation or merger of the Company with or into another entity or person, or any other corporate reorganization, in which the stockholders of the Company immediately prior to such consolidation, merger or reorganization do not hold at least a majority of the resulting or surviving entities voting power immediately following such consolidation, merger or reorganization (solely in respect of their equity interests), or (ii) a sale or transfer of all or substantially all of the Company’s assets for cash, securities or other property;

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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

each Amended Preferred Stock Series was amended to give their respective holders voting rights on any Major Transaction that is approved by our board of directors and presented to the our stockholders for their action or consideration at any meeting of our stockholders (or, if applicable, by written consent of stockholders in lieu of meeting) (a “Major Transaction Stockholder Vote”), entitling them to cast the number of votes equal to the number of whole shares of Common Stock into which the shares of the applicable Amended Preferred Stock Series held by such holder are convertible as of the record date for determining stockholders entitled to vote on such matter (irrespective of whether any such conversion would result in economic gain or loss to the holder) and shall be entitled to notice of any such meeting of stockholders in accordance with our by-laws, which holders of the applicable ~~Amended Preferred Stock Series, except as provided by law or as otherwise provided therein, vote on any Major Transaction Stockholder Vote together with the holders of Common Stock as a single class;~~

Amended Preferred Stock Series, except as provided by law or as otherwise provided therein, vote on any Major Transaction Stockholder Vote together with the holders of Common Stock as a single class;

the “blocker” provisions of each Amended Preferred Stock Series limiting the number of shares of the Common Stock to be issued upon the conversion of the applicable Amended Preferred Stock Series, when aggregated with the all other shares of Common Stock beneficially owned by the holder of such Amended Preferred Stock Series at that time, to 4.99% of the then issued and outstanding shares of the Common Stock outstanding at such time were deleted; and,

we shall be obligated to provide each holder of an Amended Preferred Stock Series with written notice of the anticipated record date with respect to any Major Transaction at least five (5) business days prior to such record date, where “Major Transaction” means (i) the consolidation, merger or other business combination by us with or into another entity or person (other than (x) pursuant to a migratory merger effected solely for the purpose of changing the our jurisdiction of incorporation or (y) a consolidation, merger or other business combination in which holders of the Company’s voting power immediately prior to the transaction continue after the transaction to hold, directly or indirectly, the voting power of the surviving entity or entities necessary to elect a majority of the members of the board of directors (or their equivalent if other than a corporation) of such entity or entities); (ii) the sale or transfer of more than fifty percent (50%) of our assets (based on the fair market value as determined in good faith by the Board of Directors) other than inventory in the ordinary course of business in one or a related series of transactions; or (iii) the closing of a purchase, tender or exchange offer made to the holders of more than fifty percent (50%) of the outstanding shares of Common Stock in which more than fifty percent (50%) of the outstanding shares of Common Stock were tendered and accepted.

-Further, 25we -adopted on July 20, 2016, and filed on July 21, 2016, Articles of Amendment to the Restated Articles of Organization of the Company (the “July 21 Preferred Stock Articles of Amendment”), pursuant to which each of the Amended Preferred Stock Series was corrected and amended to reinsert the “blocker” provisions of each Amended Preferred Stock Series limiting the number of shares of the Common Stock to be issued upon the conversion of the applicable Amended Preferred Stock Series, when aggregated with the all other shares of Common Stock beneficially owned by the holder of such Amended Preferred Stock Series at that time, to 4.99% of the then issued and outstanding shares of the Common Stock outstanding at such time, in lieu and in replacement of the similar provisions in the July 18 Preferred Stock Articles of Amendment.

As of September 30, 2016, there were no shares of Series I Preferred Stock or Series J Preferred Stock outstanding.

14.

Derivative Liabilities

Beneficial Note Conversion Feature - DMRJ

Accounting Standards Codification (“ASC”) 470-20 “Debt,” addresses the accounting for financial instruments which have a beneficial conversion feature. On July 20, 2016, we extended the maturity date of our obligations with DMRJ LLC. As amended, the conversion and anti-dilution provisions of the February 2013 Note held by DMRJ were deleted in their entirety, and the conversion provisions of the September 2012 Note were limited to an aggregate total of $7,000,000 in obligations thereunder. The conversion price for the September 2012 Note was reduced from $1.09 to $0.19 per share for up to $7,000,000 of the obligations thereunder. The market price of our common stock on the date of the note extension was $0.44 per share; therefore a beneficial conversion feature existed.

In accordance with ASC 470-20, a conversion feature is beneficial, or “in the money,” when the conversion rate of the convertible security is below the market price of the underlying common stock. A beneficial conversion feature, calculated as of the commitment date, is the difference between the convertible instruments conversion price

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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

~~more~~and ~~than~~the ~~fifty~~fair ~~percent~~value ~~(50%)~~ of ~~our assets (based on~~ the ~~fair~~company’s ~~market~~common ~~value~~stock ason ~~determined~~that indate ~~good~~multiplied ~~faith~~ by the ~~Board~~number of ~~Directors)~~common ~~other~~shares ~~than inventory in~~ the ~~ordinary~~debt ~~course~~converts ofinto. ~~business~~For inthe ~~one~~three ormonths aended ~~related~~September ~~series~~30, of2016 ~~transactions;~~we orrecorded ~~(iii) the closing of~~ a ~~purchase,~~non-cash ~~tender~~interest orcharge ~~exchange offer made to the holders~~ of ~~more~~$9,217,000 ~~than fifty percent (50%) of the outstanding shares of Common Stock~~ in ~~which~~our ~~more~~condensed ~~than~~consolidated ~~fifty~~statements ~~percent (50%)~~ of ~~the outstanding shares of Common Stock were tendered and accepted~~operations.

AsBetween ofAugust ~~March~~11, 312016 and August 23, 2016, ~~there~~DMRJ ~~were~~converted no$7,000,000 ~~shares~~ of principal into 7,000 Series H Convertible Preferred Stock shares, ~~Series~~of Iwhich ~~Preferred~~DMRJ ~~Stock~~assigned or4,401.54 shares of Series JH Convertible Preferred Stock ~~outstanding~~to Platinum Partners Value Arbitrage Fund LP and assigned 1,467.18 shares to ED&F Man Capital Markets Limited and 1,131.28 shares to Prime Capital (Bermuda) Limited.

Warrant Derivative Liability

Accounting Standards Codification (“ASC”) 815-40-15 “Derivatives and Hedging”, requires freestanding contracts that are settled in common stock, including common stock warrants to be designated as an equity instrument, asset or liability. Under the provisions of ASC 815-40-15, a contract designated as an asset or a liability must be carried at fair value until exercised or expired, with any changes in fair value recorded in the results of operations. On July 20, 2016, we issued a warrant to purchase 50,657,894 shares of our common stock to DMRJ LLC at an exercise price of no lower than $0.19 per share with a five-year term, first exercisable on October 31, 2016. The specific exercise price shall be the higher of: (i) $0.19 per share; and (ii) in the event that we sell our existing business (which would not include any assets acquired by us) on or prior to October 31, 2016.

The warrant derivative liability was valued using a binomial option pricing model, with the following assumptions on the following dates:


	Warrant Derivative Liability – Fair Value Calculation
	Warrant Derivative Liability – Fair Value Calculation
	July 20, 2016	September 30, 2016
Shares eligible to be purchased	50,657,894	50,657,894
Exercise price	$ 0.19	$ 0.19
Stock price on date of measurement	$ 0.44	$ 0.37
Expected volatility	61.9%	64.8%
Expected dividend yield	0.0%	0.0%
Risk free interest rate	1.17%	1.13%
Expected life (in years)	5.00	4.81
Fair value	$ 15,703,000	$ 12,664,000

The warrant derivative liability was initially and subsequently measured at fair value with changes in fair value recorded in earnings in each reporting period.

As of the date of grant, we recorded a warrant derivative liability of $15,703,000 and will accrete the fair value of the warrant derivative liability to non-cash interest expense in our condensed consolidated statements of operations over the least of the warrant vesting period or duration of the new note conversion feature. For the three months ended September 30, 2016, we accreted $15,703,000 to non-cash interest expense in our condensed consolidated statement of operations, given the new note conversion amount was converted to shares of our Series H Convertible Preferred Stock in August 2016 (see Note 13 to our condensed consolidated financial statements). At September 30, 2016, we recorded a non-cash benefit of $3,039,000 to recognize the change in the fair value of the warrant as of that date. The fair value is estimated using a binomial option pricing model, which includes variables such as the expected volatility of our share price, interest rates, and dividend yields. These variables are projected based on our historical data, experience, and other factors. Changes in any of these variables could result in material adjustments to the expense / income recognized for changes in the valuation of the warrants liability.

15.

Stockholders’ Deficit

Common Shares Authorized

On July 1, 2015, at an Annual Meeting of Stockholders, our stockholders approved an amendment to the Company’s Restated Articles of Organization to increase the number of authorized shares of common stock by 50,000,000 shares to 250,000,000 shares. ~~We have intentionally delayed the filing of~~ Articles of Amendment to our Restated Articles of Organization with the Commonwealth of Massachusetts were filed on July 20, 2016 to ~~effect~~affect that increase. As a result of the stockholder approval, we are authorized to issue 250,000,000 shares of our common stock.

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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Common Stock Options and Stock Purchase Warrants

In connection with various financing agreements and services provided by consultants, we have issued warrants to purchase shares of our common stock. The fair value of warrants issued is determined using a binomial or Black-Scholes option pricing model.

Common Stock Options

In December 2004, we adopted the 2004 Stock Option Plan (the “2004 Plan”). The 2004 Plan provides for the grant of incentive stock options and non-qualified stock options to employees and affiliates. The exercise price of the options equa1 100% of the fair market value on the date of the grant or 110% of the fair market value for beneficial owners of more than 10% of our stock. Options expire between five and ten years from the date of the option grant and have various vesting periods. Options may be exercised by delivering to the company cash in an amount equal to such aggregate exercise price of the options exercised, or with the consent of the Committee, shares of our common stock having a fair market value equal to such aggregate exercise price, a personal recourse note issued to the company in a principal amount equal to such aggregate exercise price, other acceptable consideration including a cashless exercise/resale procedure, or any combination of the foregoing. A total of 500,000 shares were originally reserved for issuance under the 2004 Plan. In December 2005, our stockholders approved an increase in the 2004 Plan from 500,000 shares to 1,000,000 shares. In December 2007, our stockholders approved an increase in the 2004 Plan from 1,000,000 shares to 2,000,000 shares. In March 2012, our stockholders approved an increase in the 2004 Plan from 2,000,000 shares to 4,000,000. The 2004 Plan expired in May 2014, as such no further options grants may be issued under this plan. In September 2012, our Board of Directors adopted an amendment to our 2004 Stock Option increasing the total number of shares of our common stock issuable thereunder from 4,000,000 shares to 20,000,000 shares. On July 1, 2015, at the 2015 Annual Meeting of Stockholders, the September 2012 amendment was approved by our stockholders.

On July 2, 2014, our Board of Directors adopted the 2014 Stock Option Plan (the “2014 Plan”). The 2014 Plan provides for the grant of incentive stock options and non-qualified stock options to employees and affiliates. The exercise price of the options equa1 100% of the fair market value on the date of the grant or 110% of the fair market value for beneficial owners of more than 10% of our stock. Options expire between five and ten years from the date of the option grant and have various vesting periods. Options may be exercised by delivering to the company cash in an amount equal to such aggregate exercise price of the options exercised, or with the consent of the Committee, shares of our common stock having a fair market value equal to such aggregate exercise price, a personal recourse note issued to the company in a principal amount equal to such aggregate exercise price, other acceptable consideration including a cashless exercise/resale procedure, or any combination of the foregoing. A total of 15,000,000 shares were originally reserved for issuance under the 2014 Plan. The 2014 Plan was approved by our stockholders on July 1, 2015 at the 2015 Annual Meeting of Stockholders. ~~The Company has not filed a form S-8 with the SEC with respect to the 2014 Plan or the options or shares of stock issued or issuable thereunder.~~

As of ~~March~~September 3130, 2016, there were options outstanding to purchase 20,~~651~~488,~~483~~984 shares of our common stock at exercise prices ranging from $0.08 to $2.30.

-We 26issued -no shares and 63,000 shares of common stock during the three months ended September 30, 2016 and 2015, respectively, as a result of the exercise of options by employees and consultants.

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

exercise prices ranging from $0.08 to $2.30.

We issued 7,000 and 2,500 shares of common stock during the three months ended March 31, 2016 and 2015, respectively, as a result of the exercise of options by employees and consultants. We issued 90,000 and 491,499 shares of common stock during the nine months ended March 31, 2016 and 2015, respectively, as a result of the exercise of options by employees and consultants.

Stock Purchase Warrants and Stock Issuances

In ~~June~~May 2015, we ~~issued~~entered ~~550,000~~into ~~shares~~two ofadvisory ~~common~~and ~~stock~~consulting ~~having~~services ~~a value of $412~~agreements,~~000~~ towhich ~~two~~provided ~~advisors,~~for inthe ~~consideration~~issuance of ~~services~~an ~~rendered~~aggregate toof us2,200,000 ~~under~~shares ~~two~~of ~~advisory~~our ~~and~~common ~~consulting~~stock ~~services~~as ~~agreements~~payment. ~~The~~In ~~issued~~June ~~shares~~2015, ~~were~~we ~~valued~~issued at550,000 ~~the~~shares ~~closing stock price~~ of ~~$0.75~~common ~~per~~and ~~share~~the ~~at May 6, 2015. The~~ advisory and services agreements provide for the issuance of anthe ~~additional~~remaining 1,650,000 shares in equal monthly installments of 110,000 shares commencing in September 2015. ~~For~~During the ~~nine~~three months ended ~~March~~September 3130, 2016, we ~~have~~ issued ~~770~~440,000 shares of common stock having a value of $~~579~~183,000 to these two advisors for services rendered under the advisory and consulting services agreement and issued 50,000 shares of our common stock to a third advisor having a value of $20,000.

As of ~~March~~September 3130, 2016, there were warrants outstanding to purchase 352,~~155~~832,~~000~~894, shares of our common stock at exercise prices ranging from $0.5419 to $1.22 expiring at various dates between May 251, ~~2016~~2017 and ~~April~~October 120, 2021.

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IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

16.

Income Taxes

We are required to file federal and state income tax returns in the United States. The preparation of these tax returns requires us to interpret the applicable tax laws and regulations in effect in such jurisdictions, which could affect the amount of tax paid by us. In consultation with our tax advisors, we base our tax returns on interpretations that are believed to be reasonable under the circumstances. The tax returns, however, are subject to routine reviews by the various federal and state taxing authorities in the jurisdictions in which we file tax returns. As part of these reviews, a taxing authority may disagree with respect to the income tax positions taken by us (“uncertain tax positions”) and, therefore, may require us to pay additional taxes. As required under applicable accounting rules, we accrue an amount for our estimate of additional income tax liability, including interest and penalties, which we could incur as a result of the ultimate or effective resolution of the uncertain tax positions. We account for income taxes using the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributed to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences and carry-forwards are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established when necessary to reduce deferred tax assets to amounts expected to be realized.

We account for uncertain income tax positions by accruing for the estimated additional amount of taxes for the uncertain tax positions when the uncertain tax position does not meet the more likely than not standard for sustaining the position. We review and update our accrual as more definitive information becomes available from taxing authorities, upon completion of tax audits, upon expiration of statutes of limitation, or upon occurrence of other events. This requires significant judgment, the use of estimates, and the interpretation and application of complex tax laws. Significant judgment is required in assessing the timing and amounts of deductible and taxable items and the probability of sustaining uncertain tax positions. The benefits of uncertain tax positions are recorded in our consolidated financial statements only after determining a more-likely-than-not probability that the uncertain tax positions will withstand challenge, if any, from tax authorities. When facts and circumstances change, we reassess these probabilities and record any changes in the consolidated financial statements as appropriate.

Deferred tax assets and liabilities are determined based on the differences between the financial statement carrying amounts and the tax basis of the assets and liabilities using the enacted tax rate in effect in the years in which the differences are expected to reverse. A valuation allowance has been recorded against the deferred tax asset as it is more likely than not, based upon our analysis of all available evidence, that the tax benefit of the deferred tax asset will not be realized.

- 27 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

A valuation allowance has been established for our tax assets as their use is dependent on the generation of sufficient future taxable income, which cannot be predicted at this time. Included in the valuation allowance is approximately $800,000 related to certain operating loss carryforwards resulting from the exercise of employee stock options, the tax benefit of which, when recognized, will be accounted for as a credit to additional paid-in capital rather than a reduction in income tax.

As of ~~March~~September 3130, 2016, the Company has the following unused net operating loss and tax credit carryforwards available to offset future federal and state taxable income, both of which expire at various times as noted below:

(In thousands)	Net Operating Losses	Investment AMT & Research Credits	Expiration Dates
Federal	$ ~~107~~115,~~818~~701	$ 1,~~455~~615	2022 to ~~2035~~2036
State	$ 7481,~~879~~872	$ ~~983~~1,099	~~2016~~2017 to ~~2035~~2036

We have recorded a full valuation allowance against our net deferred tax assets of $4952,~~795~~892,000 as of ~~March~~September 3130, 2016, due to uncertainties related to our ability to utilize these assets. The valuation allowance is based on our estimates of taxable income and the period over which our deferred tax assets will be recoverable.

Potential 382 Limitation

Our net operating loss and tax credit carryforwards are subject to review and possible adjustment by the Internal Revenue Service. Our ability to utilize our net operating loss (“NOL”) and alternative minimum tax (“AMT”) and research and development credit (“R&D”) carryforwards may be substantially limited due to ownership changes that may have occurred or that could occur in the future, as required by Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”), as well as similar state provisions. These ownership changes may limit the amount of NOL, AMT and R&D credit carryforwards that can be utilized annually to offset future taxable income and tax, respectively. In general, an ownership change, as defined in Section 382 of the Code, results from a transaction or series of transactions over a three-year period resulting in an ownership change of more than 50% of the outstanding stock of a company by certain stockholders or public groups.

- 32 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

may have occurred or that could occur in the future, as required by Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”), as well as similar state provisions. These ownership changes may limit the amount of NOL, AMT and R&D credit carryforwards that can be utilized annually to offset future taxable income and tax, respectively. In general, an ownership change, as defined in Section 382 of the Code, results from a transaction or series of transactions over a three-year period resulting in an ownership change of more than 50% of the outstanding stock of a company by certain stockholders or public groups.

We have not completed a study to assess whether one or more ownership changes have occurred since we became a loss corporation as defined in Section 382 of the Code, but we believe that it is likely that an ownership change has occurred. If we have experienced an ownership change, utilization of the NOL, AMT and R&D credit carryforwards would be subject to an annual limitation, which is determined by first multiplying the value of our common stock at the time of the ownership change by the applicable long-term, tax-exempt rate, and then could be subject to additional adjustments, as required. Any such limitation may result in the expiration of a portion of the NOL, AMT or R&D credit carryforwards before utilization. Until a study is completed and any limitation known, no amounts are being considered as an uncertain tax position or disclosed as an unrecognized tax benefit under ASC 740. Any carryforwards that expire prior to utilization as a result of such limitations will be removed from deferred tax assets with a corresponding adjustment to the valuation allowance. Due to the existence of the valuation allowance, it is not expected that any potential limitation will have a material impact on our operating results.

From time to time we may be assessed interest or penalties by major tax jurisdictions, namely the states of Massachusetts and California. We adopted the accounting standards related to accounting for uncertainty in income taxes recognized in an enterprise’s financial statements on April 1, 2007. As of ~~March~~June 3130, 2016, we had no material unrecognized tax benefits and no adjustments to liabilities or operations were required. No interest and penalties have been recognized by the Company to date.

Tax years ~~2012~~2013 through ~~2015~~2016 are subject to examination by the federal and state taxing authorities. There are no income tax examinations currently in process.

For the three months ended September 30, 2016 and 2015, we provided for no taxes in our consolidated statement of operations as we have significant net loss carryforwards.

Our net operating loss carryforwards are subject to review and possible adjustment by the Internal Revenue Service and are subject to certain limitations in the event of cumulative changes in the ownership interest of significant stockholders over a three-year period in excess of 50%.

17.

Commitments and Contingencies

On April 1, 2013, we entered into a lease for manufacturing, research and office space in Wilmington, Massachusetts, the lease of which expires on June 30, 2020. Under the terms of the lease, we are responsible for our proportionate share of real estate taxes and operating expenses relating to this facility. We leased research and office space in San Diego, California and leased 300 square feet of office space in Shanghai, China. On March 25, 2015, our Board of Directors approved restructuring actions to better align costs with current and future geographic revenue sources and to improve efficiencies. We have exited from our leases in San Diego, CA and Shanghai, China in November 2015. Total rent expense, including assessments for maintenance and real estate taxes for the three months ended September 30, 2016 and 2015, was $182,000 and $219,000, respectively.

- 28 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

office space in San Diego, California and leased 300 square feet of office space in Shanghai, China. On March 25, 2015, our Board of Directors approved restructuring actions to better align costs with current and future geographic revenue sources and to improve efficiencies. In November, 2015, we exited from our lease in San Diego, CA. Total rent expense, including assessments for maintenance and real estate taxes for the nine months ended March 31, 2016 and 2015, was $573,000 and $753,000, respectively.

License Agreements

We are obligated under one license agreement, assumed in connection with the acquisition of Ion Metrics, whereby we were granted rights to use certain intellectual property for safety, security and narcotic applications, which we intend to incorporate into future security product offerings for certain minimum guaranteed annual payments. The license agreement ~~expires~~expired on September 30, 2016 and as of ~~March~~September 3130, 2016,; we have no obligation under this license agreement for future minimum guaranteed payments.

18.

Financial Information By Segment

Operating segments are defined as components of an enterprise about which separate financial information is available that is regularly evaluated by the chief operating decision maker or decision making group, in determining how to allocate resources and in accessing performance. Our chief operating decision making group is composed of the chief executive officer and members of senior management. Based on qualitative and quantitative criteria, we have determined that we operate within one reportable segment, which is the Security Products Segment.

- 33 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

19.

Legal

On March 23, 2015, Bernard Miller (“Mr. Miller”), individually and on behalf of all others similarly situated shareholders of the company, filed a complaint against Dr. William J. McGann, Messrs. Glenn D. Bolduc, John H. Hassett, John A. Keating, Robert P. Liscouski, Howard Safir and Michael C. Turmelle and the Company in the Suffolk Superior Court of the Commonwealth of Massachusetts, seeking derivative action as a result of director breaches of fiduciary duty and unjust enrichment. Amongst other things, the plaintiff requested that the court compel the Company to hold an annual stockholders’ meeting; subject the September 2012 Amendment to the 2004 Plan to a vote at the next annual stockholders’ meeting; rescind the stock option awards granted under the September 2012 Amendment to 2004 Plan in the event that the amendment is not approved by a majority of our stockholders’; impose a trust, in favor of the Company, for any benefits improperly received; and award costs and expenses, including reasonable attorney fees.

On July 1, 2015 we held our 2015 Annual Meeting of Stockholders. Stockholders approved an amendment to the Company’s 2004 Stock Option Plan to increase the aggregate number of shares of the Company’s common stock, par value $0.001 per share available for issuance under the Plan by 16,000,000 shares to 20,000,000 shares and approved the Company’s Amended and Restated 2014 Stock Option Plan.

On May 22, 2015, a motion to dismiss the Complaint with prejudice was served on the plaintiff and subsequently filed with the Court. On July 21, 2015, the Court endorsed an Order of Stipulation the parties entered into. The Stipulation provides, among other things, that the Complaint is dismissed with prejudice and the Motion to Dismiss is moot. On December 17, 2015, the Court ruled that the Plaintiff’s counsel was entitled to a fee of $70,000 together with costs of approximately $6,000. During the ~~nine~~fiscal ~~months~~year ended ~~March~~June 3130, 2016, we recorded a charge of $76,000 in our condensed consolidated statement of operations and comprehensive loss.

We are not currently a party to any other legal proceedings, other than routine litigation incidental to our business that which we believe will not have a material effect on our business, assets or results of operations. From time to time, we are subject to various claims, legal proceedings and investigations covering a wide range of matters that arise in the ordinary course of our business activities. Each of these matters may be subject to various uncertainties.

20.

Subsequent Events

WeSale ~~have~~of ~~evaluated~~Explosives ~~subsequent~~Detector ~~events~~Assets, ~~after~~Bankruptcy ~~the~~Filing ~~balance sheet date through the date these financial statements were issued for appropriate accounting~~ and ~~disclosure~~Court ~~and~~Order ~~concluded~~Authorizing ~~that there are no subsequent events requiring adjustment or disclosure in these financial statements.~~Sale

On October 10, 2016, we and our subsidiaries entered into an asset purchase agreement to sell the explosives trace detection assets to L-3 29Communications Corporation for $117.5 million in cash, plus the assumption of specified liabilities, subject to adjustment. The asset purchase agreement constitutes a “stalking horse bid” in a sale process being conducted under Section 363 of the U.S. Bankruptcy Code. As the Stalking horse bidder, L-3 will be entitled to a break-up fee and expense reimbursement if it does not prevail as the successful bidder at any subsequent Bankruptcy Court auction. L-3’s role as the stalking horse bidder upon Bankruptcy Court Appeal, and the sale itself, are subject to approval by the Bankruptcy Court. In connection with the sale, on October 10, 2016, Implant Sciences Corporation and its subsidiaries IMX Acquisition Corp., C Acquisition Corp. and Accurel Systems International Corp. (together with the Company, the “Debtors”) filed voluntary relief petitions under Chapter 11 of the Bankruptcy Code with the United States Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”). We will continue to operate our businesses as debtors-in-possession under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of the Bankruptcy Code. On the petition date, the Debtors filed several motions with the bankruptcy court, including a motion to have the Chapter 11 cases jointly administered.

On December 16, 2016, the Bankruptcy Court issued an order authorizing the sale of substantially all of our assets free and clear of liens, claims, encumbrances and other interests; authorized and approved our performance under the asset purchase agreement entered into with L-3; approved the assumption and assignment of certain of our contracts and unexpired leases. In conjunction with this order, on December 16, 2016, we amended the asset purchase agreement with L-3 whereby both parties agreed that the closing date will be January 5, 2017.

Debtor-in-Possession Financing

In connection with the Chapter 11 filings, we filed a motion seeking the approval of the bankruptcy court for a superpriority senior secured loan of $5.7 million (the “DIP Loan”) between the Company and DIP SPV I, L.P., as the debtor-in –possession lender ( the “DIP Lender”) pursuant to a senior secured superpriority debtor-in-possession loan and security agreement entered into by the Debtors and the DIP Lender on October 10, 2016. The DIP loan

- 34 -

IMPLANT SCIENCES CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

would bear interest at 12% and shall pay a one-time closing fee of $199,500 on the closing date of the DIP Loan and an exit fee equal to $427,500, less any interest, other that default interest (which is at a rate of 24%), paid to the DIP Lender as of the termination date of the DIP Loan. The DIP Loan is payable in full upon the consummation of the sale under the asset purchase agreement with L-3 Communications Corporation or a sale to any other winning bidder in the Bankruptcy Court auction. On October 13, 2016, we borrowed $1,500,000 under the DIP Loan.

The use of proceeds from the DIP Loan would be limited to working capital and other general corporate purposes consistent with the budget that the Company presented to the DIP Lender, including payment of costs and expenses related to the administration of the bankruptcy proceedings and payment of other expenses as approved by the bankruptcy court. Unless otherwise extended, the DIP Loan would mature six months from the anniversary date of the agreement, subject to certain provisions that may lead to an earlier termination.

On November 7, 2016, we terminated the Senior Secured, Super-Priority Debtor-in-Possession Loan and Security Agreement, dated as of October 10, 2016 (as amended on November 3, 2016, the “Original DIP Agreement”), with the original lender, DIP SPV I, L.P. (the “Original DIP Lender”). In connection with such termination, we paid $1,610,769 to the Original DIP Lender and its advisors to satisfy outstanding obligations under the Original DIP Agreement, including $74,354 for expense reimbursement for the Original DIP Lender’s advisors.

On November 7, 2016 (the “Effective Date”), we entered into a replacement Senior Secured, Super-Priority Debtor-in-Possession Loan and Security Agreement (the “New DIP Agreement”) with Tannor Partners Credit Fund, LP, the New DIP Lender, which DIP Agreement was approved by the Bankruptcy Court on an interim basis pursuant to an order dated as of the Effective Date for the initial loan amount of $5.7 million. Under the New DIP Agreement, subject to the terms and conditions thereof, the New DIP Lender agreed to lend up to a total of $8.0 million to us, with the initial installment of $5.7 million payable upon the Bankruptcy Court entering the interim order for the New DIP Agreement and the remaining $2.3 million payable upon the Bankruptcy Court entering the final order for the New DIP Agreement. On November 8, 2016, we borrowed $5,700,000 under the New DIP Agreement and borrowed an additional $2,300,000 on November 30, 2016.

Termination of Zapata Industries SAS Letter of Intent

On November 21, 2016, the Letter of Intent (the “LOI”), dated July 18, 2016, between us and Zapata Industries SAS (“Zapata”) was terminated.

Counsel for Zapata filed a Notice of Appearance and Request for Service of Papers with the U.S Bankruptcy Court, District of Delaware, on December 2, 2016. The Company disputes any payment obligations it may have to Zapata in connection with the LOI or the termination thereof.

New DIP Loan Debt Covenant Non-Compliance

On December 8, 2016, we notified the Tannor Partners Credit Fund that our cash collections for the month ended November 30, 2016 were lower than the amounts contained in the DIP Budget. As such we were not in compliance with the New DIP Loan Covenants, which constitutes an event of default under the New DIP Loan. We expect to submit an order of stipulation with the Bankruptcy Court and have agreed to pay an additional $96,000 of interest in full and final satisfaction of any entitlement of Tannor under the New DIP Loan Agreement through January 5, 2017. This additional interest shall not be credited against the exit fee.

Robert Liscouski Agreement

On October 8, 2016, we entered into an agreement with Mr. Robert Liscouski pursuant to which we agreed to pay a success fee of $300,000 upon the completion of the sale of the ETD business and our purchase of Zapata. In the event that the sale of the ETD business is not completed and the Bankruptcy Court does not permit the payment of the success fee, we agreed to pay Mr. Liscouski $300,000 upon the liquidation of our assets.

We have evaluated subsequent events after the balance sheet date through the date these financial statements were issued.

- 35 -

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s discussion and analysis of results of operations and financial condition (“MD&A”) is a supplement to the accompanying condensed consolidated financial statements and provides additional information on Implant Sciences Corporation’s (“Implant Sciences” or the “Company’) business, current developments, financial condition, cash flows and results of operations.

When we say “we,” “us,” “our,” “Company,” or “Implant Sciences,” we mean Implant Sciences Corporation and its subsidiaries.

Please see our Annual Report on Form 10-K for the fiscal year ended June 30, ~~2015~~2016 for a complete description of our business.

Overview

We develop, manufacture and sell sophisticated sensors and systems for the security, safety and defense industries. A variety of technologies are currently used worldwide in security and inspection applications. In broad terms, the technologies focus on detection in two major categories: (i) the detection of “bulk” contraband, which includes materials that would be visible to the eye, such as weapons, explosives, narcotics and chemical agents; and (ii) the detection of “trace” amounts of contraband, which includes trace particles or vapors of explosives, narcotics and chemical agents. Technologies used in the detection of “bulk” materials include computed tomography, transmission and backscatter x-ray, metal detection, trace detection and x-ray, gamma-ray, passive millimeter wave, and neutron analysis. Trace detection techniques used include mass spectrometry, gas chromatography, chemical luminescence, and ion mobility spectrometry.

We have developed proprietary technologies used in explosives and narcotics trace detection (“ETD” and “NTD”, respectively) applications and market and sell handheld ETD and desktop ETD and NTD systems that use our proprietary technologies. Our products are marketed and sold to a growing number of locations domestically and internationally. These systems are used by private companies and government agencies to screen baggage, cargo, other objects and people for the detection of trace amounts of explosives and narcotics.

A significant component of our ability to compete in the markets that we serve ~~are~~is the attainment of regulatory approvals. We have undertaken considerable efforts in the past twelve to eighteen months in this regard and have achieved the following regulatory approvals and customer orders:

Our QS-B220 desktop ETD system successfully completed and passed testing requirements for the TSA’s qualification test for aviation checkpoint and checked baggage and has been placed on the TSA’s Qualified Product List (“QPL”) on August 28, 2014. The QS-B220 is the first ETD with a non-radioactive source to be approved by the TSA for use in U.S. airports for passenger and baggage screening. We are now able to participate in TSA tenders for ETD procurements for aviation checkpoint and checked baggage screening.

On October 6, 2014, the QS-B220 successfully passed the European Civil Aviation Conference's (“ECAC”) Common Evaluation Process of Security Equipment (“CEP”) for airport checkpoint screening of passengers and baggage. The CEP was established to provide standards for security equipment performance across ECAC's 44 member nations.

On October 16, 2014, the U.S. Department of Homeland Security (“DHS”) selected our proposal to develop next generation explosives trace detection screening systems for funding. The project, pending successful negotiations, is potentially worth up to approximately $2 million. Subject to successful conclusion of negotiations with the DHS, we expect the project to commence in the fourth quarter of fiscal 2016.

On November 10, 2014, we entered into an Indefinite Delivery / Indefinite Quantity (“IDIQ”) contract with the United States Transportation Security Administration (“TSA”) for our QS-B220 desktop explosives trace detectors. The IDIQ, a necessary prerequisite for competing for TSA’s annual trace detection procurements and establishes contract terms under which the TSA could purchase up to $162 million of equipment and services.

On November 10, 2014, we received an initial delivery order from the TSA for 1,170 QS-B220 desktop explosives trace detectors ~~and commenced shipments under the delivery order in December 2015~~.

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On December 3, 2015, we announced that our Board of Directors has authorized management to retain financial advisors to explore strategic alternatives to maximize shareholder value.

On April 6, 2016, we amended our credit agreements with DMRJ and Montsant, effective as of March 31, 2016, pursuant to which, amongst other matters, we extended the maturity date of our indebtedness to June 30, 2016 and December 30, 2016, respectively. Further on that date, we amended our credit agreements with BAM, effective as of March 31, 2016, pursuant to which, amongst other matters, we extended the maturity date of all of our indebtedness from March 31, 2016 to June 29, 2016.

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On July 20, 2016 we amended our credit agreements with DMRJ and Montsant, effective as of June 30, 2016, pursuant to which, amongst other matters, we extended the maturity date of our indebtedness to October 31, 2016. Further, on that date, our credit agreements with BAM were automatically extended to October 30, 2016 as a result of the extension of the maturity date of our credit agreements with DMRJ and Montsant.

On July 18, 2016, we entered into a Letter of Intent (the “LOI”) with Zapata Industries SAS (“Zapata”), pursuant to which the we intend to acquire all the issued and outstanding shares of Zapata, or all of Zapata’s business, excluding inventory (with the our having the right to purchase all or a portion of the inventory of Zapata at cost), in exchange for (i) a number of shares of our common stock, par value $0.001 per share, (the “Common Stock”) equal to 60% of the total issued and outstanding shares of Common Stock on a fully-diluted basis (treating any preferred stock on an as converted basis and any warrants on an as exercised basis), (ii) $15,000,000 in cash and (iii) warrants to purchase 50,657,984 shares of Common Stock at an exercise price of $1.50 per share with a four-year term. We terminated the Zapata LOI on November 21, 2016.

On September 13, 2016, we received a delivery order from the TSA for 1,353 QS-B220 desktop explosives trace detectors, with options to increase the delivery order quantity to 3,426 QS-B220 systems. The contract value, including options, aggregates to $71.3 million.

On October 10, 2016, we and our subsidiaries entered into an asset purchase agreement to sell the explosives trace detection assets to L-3 Communications Corporation for $117.5 million in cash, plus the assumption of specified liabilities, subject to adjustment. In connection with the sale, on October 10, 2016, Implant Sciences Corporation and its subsidiaries IMX Acquisition Corp., C Acquisition Corp. and Accurel Systems International Corp. (together with the Company, the “Debtors”) filed voluntary relief petitions under Chapter 11 of the Bankruptcy Code with the United States Bankruptcy Court for the District of Delaware.

Critical Accounting Policies

Our significant accounting policies are summarized in Note 2 to our consolidated financial statements included in Item 7 of our Annual Report on Form 10-K, for the fiscal year ended June 30, ~~2015~~2016. However, certain of our accounting policies require the application of significant judgment by our management, and such judgments are reflected in the amounts reported in our condensed consolidated financial statements. In applying these policies, our management uses judgment to determine the appropriate assumptions to be used in the determination of estimates. Those estimates are based on our historical experience, terms of existing contracts, our observance of market trends, information provided by our strategic partners and information available from other outside sources, as appropriate. Actual results may differ significantly from the estimates contained in our condensed consolidated financial statements.

Results of Operations

Three Months Ended ~~March~~September 3130, 2016 vs. ~~March~~September 3130, 2015

Revenues

	For the Three Months Ended March 31, 2016		For the Three Months Ended March 31, 2015
	For the Three Months Ended September 30, 2016		For the Three Months Ended September 30, 2015
(In thousands)	Amount	Mix	Amount	Mix	Change
Product
QS-B220	$ 95,~~343~~776	8571.6%	$ 112,~~989~~491	6086.28%	~~369~~(53.78%)
QS-H150	~~669~~990	612.13%	~~1,088~~687	324.97%	~~(38~~44.51%)
Parts and supplies	~~736~~1,125	614.70%	~~160~~646	4.85%	~~360~~174.01%
	10,748	98.4%	3,237	97.9%	232.0%
	7,891	97.9%	13,824	96.0%	(42.9%)
Services	~~175~~171	12.61%	68569	24.10%	~~157~~(69.49%)
Total	$ 108,~~923~~062	100.0%	$ 314,~~305~~393	100.0%	~~230~~(44.50%)

Revenues for the three months ended ~~March~~September 3130, 2016 were $108,~~923~~062,000 as compared with $314,~~305~~393,000 for the comparable prior year period, ana ~~increase~~decrease of $76,~~618~~331,000, or ~~230~~44.50%. The ~~increase~~decrease in revenue is due primarily to a ~~664~~46.65% ~~increase~~decrease in the number of QS-B220 desktop units sold in the three months ended ~~March~~September 3130, 2016, due to ~~the~~decreased shipments ~~under our delivery order with the U.S. Transportation Security Administration, shipments~~ to ~~the Canadian Air~~European ~~Transport~~airports ~~Security Authority and increased shipments to Asia~~ in the current three month period, ~~offset~~and ~~partially~~ by a 3813.6% decrease in the average unit sales prices, which resulted in a ~~369~~53.78% ~~increase~~decrease in QS-B220 revenues. Sales of our QS-B220 were favorably impacted in the comparable prior period due the European Civil Aviation Conference (“ECAC”) Common Evaluation Process of Security Equipment for airport checkpoint screening of passengers and baggage, which mandated the installation of ETD equipment in larger international airports by no later than September 1, 2015. Factors impacting our average unit sales prices are mainly due to the competitive market conditions in Europe and ~~$25~~Asia,~~000~~ increased sales to agencies of the U.S. Government and foreign government agencies, offset partially by a decrease in early payment discounts to certain distributors to hasten collection of our accounts receivable, which discounts amounted to $210,000 in the three months ended ~~March~~September 3130, ~~2016~~2015.

Sales of our QS-H150 handheld ~~units~~systems ~~sold~~increased 44.1% in the three months ended ~~March~~September 3130, 2016, ~~decreased~~due ~~32.7~~to a 54.5% increase in the number of QS-H150 handheld units sold in the three months ended September 30, 2016, compared to the prior period, due to ~~decreased~~increased shipments to ~~Europe~~Asia and Africa, which is partially offset by ana 8.6.7% decrease in the average unit sales prices~~, which resulted in a 38~~.~~5% decrease in QS-H150 revenues.~~

Sales of parts and supplies ~~and service revenues~~ increased ~~360~~174.01% ~~and~~ ~~157.4%, respectively,~~ in the three months ended ~~March~~September 3130, 2016, due primarily to increased sales of consumables and other supplies ~~that~~due ~~shipped~~to ~~with~~ the increased QS-B220 ~~desktop~~install ~~units~~base, ~~and increased training and warranty revenue~~ in the current three month period.

~~Sales~~Service ofrevenues ~~QS-B220~~decreased ~~were~~69.9% ~~favorably impacted~~ in the ~~current~~three ~~period~~months ended September 30, 2016, due to ~~the~~decreased ~~acceptance~~service ofrevenues ~~the~~under ~~QS-B220~~our ~~into~~initial delivery order with the ~~“Qualified”~~TSA. ~~section~~Included ofin the ~~TSA’s~~prior ~~Air~~comparable ~~Cargo~~period ~~Screening~~were ~~Technology~~service ~~List~~revenues related to system improvements and ~~achieving~~training ~~European~~related ~~Civil~~documentation ~~Aviation~~required ~~Conference~~under ~~(“ECAC”)~~the ~~Common~~TSA ~~Evaluation~~delivery ~~Process~~order. ofDuring ~~Security~~the ~~Equipment~~three ~~for~~months ~~airport~~ended ~~checkpoint~~September ~~screening~~30, of2016, ~~passengers~~we ~~and~~commenced ~~baggage.~~activities ~~Competitive~~under ~~market~~a ~~conditions~~cost-plus ~~are~~fixed-fee ~~expected~~contract towith ~~continue~~the toU.S. ~~have~~Department aof ~~negative~~Homeland ~~impact~~Security (“DHS”), effective on ~~our~~August ~~average~~24, ~~unit~~2016, to ~~sales~~develop ~~prices~~next ~~for~~generation ~~the~~explosives ~~foreseeable~~trace ~~future~~detection screening systems.

Sales of QS-B220 31were favorably impacted in the comparable prior period due to the acceptance of the QS-B220 into the “Qualified” section of the TSA’s Air Cargo Screening Technology List and achieving European Civil Aviation Conference (“ECAC”) Common Evaluation Process of Security Equipment for airport checkpoint screening of passengers and baggage. Competitive market conditions are expected to continue to have a negative impact on our average unit sales prices for the foreseeable future.

Cost of Revenues

Cost of revenues for the three months ended ~~March~~September 3130, 2016 ~~were~~was $75,~~691~~590,000 as compared with $28,~~129~~136,000 for the comparable prior year period, ana ~~increase~~decrease of $52,~~562~~546,000 or ~~261~~31.23%. The ~~increase~~decrease in cost of revenues recorded in the three months ended ~~March~~September 3130, 2016 is primarily due to ~~increased~~decreased unit sales of our QS-B220 desktop units, ~~and~~offset anpartially ~~increase~~by inincreased ~~manufacturing~~unit ~~overhead~~sales ~~costs~~of our QS-H150 handheld units.

Gross Margin

Gross margin for the three months ended ~~March~~September 3130, 2016 was $32,~~232~~472,000 or 2930.67% of revenues as compared with $16,~~176~~257,000 or 3543.65% of revenues for the comparable prior year period. The decrease in gross margin as a percent of revenues is primarily due to a 13.6% decrease in the average unit sales price on sales of our QS-B220 ~~units~~in the current three month period, due to competitive market conditions in Europe and Asia, increased sales to agencies of 38the U.6%S. Government and foreign government agencies at lower average unit sales prices, decreased manufacturing overhead absorption, due to decreased QS-B220 unit volume and partially offset by a 8.6.7% ~~decrease~~increase in the average unit sales price on sales of our QS-H150, ~~and an increase in manufacturing overhead costs~~units.

Research and Development Expense

Research and development expense for the three months ended ~~March~~September 3130, 2016 was $1981,~~040,~~000 as compared with $1,~~347~~083,000 for the comparable prior year period, a decrease of $~~307~~102,000 or 229.84%. The decrease in research and development expense is ~~due~~ primarily due to a $~~104~~62,000 decrease in stock-based compensation ~~expense~~, a $4835,000 decrease in ~~materials~~occupancy ~~and~~costs ~~prototype~~due ~~expense,~~to the ~~relocation~~closing of ~~the~~our San Diego, CA ~~advanced technology~~ office, ~~which~~a ~~resulted~~$26,000 decrease in travel expenses, a $7819,000 decrease in ~~rent~~engineering consulting expense, a $36,000 decrease in tools and supplies, offset partially by a $5279,000 ~~decrease~~increase in payroll and related fringe ~~benefits~~benefit expense. We continue to expend funds to further the development of new products in the areas of explosives and narcotics detection, and to obtain the necessary approvals from the TSA and other non-U.S. government approvals. Spending on research and development will ~~likely~~ increase in the next ~~six~~three to twelve months due to the ongoing development of the QS-B220 desktop detector, the development of the QS-H150E ~~portable explosives and narcotics detector and continued development of a hyphenated system employing conventional ion mobility, differential mobility and quadrupole mass spectrometry.~~

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portable explosives and narcotics detector and continued development of a hyphenated system employing conventional ion mobility, differential mobility and quadrupole mass spectrometry.

Selling, General and Administrative Expenses

Selling, general and administrative expenses for the three months ended ~~March~~September 3130, 2016 were $3,~~811~~765,000 as compared with $3,~~318~~538,000 for the comparable prior year period, an increase of $~~493~~227,000, or 146.94%. The increase in selling, general and administrative expenses is due primarily to a $~~640~~536,000 increase in ~~payroll and related benefits due primarily to the provision of $487,000 for incentive compensation, a $284,000 increase in~~ consulting expenses due to the issuance of shares of our common stock to ~~two~~ advisors for services rendered under the advisory and consulting services agreements and investment banker advisor fees and increased fees incurred in support of the TSA equipment deployment, a $~~263~~440,000 increase in legal fees attributable to ~~our~~the ~~ongoing~~negotiation ~~review~~and execution of ~~strategic~~the ~~alternatives,~~asset apurchase ~~$183~~agreement with L-3,~~000~~ ~~increase~~legal infees ~~variable~~incurred ~~selling~~with ~~expenses,~~respect ~~and~~to athe ~~$142,000~~voluntary ~~increase~~relief inpetitions ~~travel~~filed ~~expenses,~~under ~~partially~~Chapter ~~offset~~11 byof athe ~~$680,000~~Bankruptcy ~~decrease~~Code inwith ~~stock-based~~the ~~compensation~~United onStates ~~employee~~Bankruptcy ~~stock~~Court ~~options,~~for ~~due~~the ~~primarily~~District toof ~~additional~~Delaware ~~stock-based~~and ~~compensation~~legal ~~expense~~fees ~~resulting~~associated ~~from~~with the ~~amendments~~Zapata toletter ~~Mr.~~of ~~Bolduc’s~~intent, ~~existing~~a ~~vested~~$78,000 ~~stock~~increase ~~options~~in ~~and~~travel expenses incurred to support QS-B220 system installations with the ~~accelerated~~TSA, ~~vesting~~a of$50,000 ~~certain~~increase ~~options~~in ~~issued~~credit oncard ~~July~~processing 2fees due to significantly higher utilization, ~~2014~~a $15,000 increase in ~~the~~stock-based ~~prior~~compensation ~~year~~on ~~period~~employee stock options, offset partially by a $~~274~~593,000 ofdecrease ~~charges~~in ~~incurred~~payroll ~~pursuant~~and benefit costs, due to ~~our~~the ~~Letter~~provision ~~Agreement~~of ~~with~~$680,000 ~~Luveti~~for incentive compensation recorded in the comparable prior ~~year~~ period and a $52325,000 decrease in ~~rent~~variable ~~expense.~~selling expenses due to decreased revenues.

Other Expense

For the three months ended ~~March~~September 3130, 2016, other expense was $224,~~477~~910,000 as compared with other expense of $2,~~242~~547,000, for the comparable prior year period, an increase of $~~235~~22,~~000~~363,000. orFor ~~10.5%.~~the ~~The~~three ~~increase~~months isended ~~due~~September to30, ~~increased~~2016 interest expense increased $25,402,00 to $27,949,000. We recorded non-cash interest charges of $9,217,000 and $15,703,000 in our condensed consolidated statements of operations on ~~higher~~the ~~borrowings~~note ~~under~~conversion beneficial conversion feature and warrant derivative liability, respectively, both of which are related to our July 20, 2016 amendment to our credit ~~facilities~~facility with DMRJ and Montsant. In addition, toat aSeptember ~~lesser~~30, ~~extent~~2016, ~~the~~we 1%recorded ~~increase~~a innon-cash benefit of $3,039,000 to adjust the ~~BAM~~fair ~~interest~~value ~~rate~~of ~~which~~the ~~took~~warrant ~~effect~~derivative onliability ~~April~~as 1,of ~~2015~~that date.

Interest expense on our debt obligations increased $482,000 to $3,029,000 in the three months ended September 30, 2016 from $2,547,000 in the prior year, due to higher borrowings under our credit facility with DMRJ, due to the March 31, 2016, amendment to our credit facility with DMRJ and Montsant whereby we further amended each of our credit instruments with DMRJ and Montsant, which were entered into on April 6, 2016 and effective March 31, 2016, pursuant to which we agreed to prepay the interest due on each of the March 2009 Note, the September 2012 Note and the February 2013 Notes from the date of the amendment through June 30, 2016 by increasing the outstanding aggregate principal amount under each such Note and, to a lesser extent, interest incurred under our Purchase Agreement with RCA.

Net Loss

Our net loss for the three months ended ~~March~~September 3130, 2016 was $427,~~096~~184,000 as compared with a net loss of $5911,~~731,~~000 for the comparable prior year period, a decrease of $126,~~635~~273,000~~, or 28~~.~~5%.~~ The ~~decrease~~increase in the net loss is primarily due to ~~increased~~non-cash ~~revenues~~interest charges of $9,217,000 and ~~gross~~$15,703,000 ~~margin~~recorded in the current period in our condensed consolidated statements of operations on the note conversion beneficial conversion feature and warrant derivative liability, ~~partially~~decreased ~~offset~~revenues byand gross margin, increased operating expenses and an increase in interest expense, offset partially by the non-cash benefit of $3,039,000 recorded to adjust the fair value of the warrant derivative liability.

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Nine Months Ended March 31, 2016 vs. March 31, 2015

Revenues

	For the Nine Months Ended March 31, 2016		For the Nine Months Ended March 31, 2015
(In thousands)	Amount	Mix	Amount	Mix	Change
Product
QS-B220	$ 29,391	82.5%	$ 3,906	53.4%	652.5%
QS-H150	3,081	8.7%	2,879	39.3%	7.0%
Parts and supplies	2,261	6.3%	370	5.1%	511.1%
	34,733	97.5%	7,155	97.8%	385.4%
Services	875	2.5%	160	2.2%	446.9%
Total	$ 35,608	100.0%	$ 7,315	100.0%	386.8%

Revenues for the nine months ended March 31, 2016 were $35,608,000 as compared with $7,315,000 for the comparable prior year period, an increase of $28,293,000, or 386.8%. The increase in revenue is due primarily to a 1,010.2% increase in the number of QS-B220 desktop units sold in the nine months ended March 31, 2016, due to increased shipments to European airports, shipments under our delivery order with the U.S. Transportation Security Administration, shipments to the Canadian Air Transport Security Authority and increased shipments to Asia, Africa and South America in the current nine month period, offset partially by a 32.2% decrease in the average unit sales prices, which resulted in a 652.5% increase in QS-B220 revenues. Factors impacting our average unit sales prices are mainly due to the competitive market conditions and our decision to offer early payment discounts to certain distributors to hasten collection of our accounts receivable, which discounts in the aggregate amounted to $325,000 in the nine months ended March 31, 2016.

QS-H150 handheld units sold in the nine months ended March 31, 2016, increased 12.6 %, compared to the prior period, due to increased shipments to Asia and Africa, which is partially offset by a 4.9% decrease in the average unit sales prices, which resulted in a 7.0% increase in QS-H150 revenues.

Sales of parts and supplies and service revenues increased 511.1% and 446.9%, respectively, in the nine months ended March 31, 2016, due primarily to increased sales of consumables and other supplies that shipped with the QS-B220 desktop units and increased training and warranty in the current nine month period.

Sales of QS-B220 were favorably impacted in the current period due to the acceptance of the QS-B220 into the “Qualified” section of the TSA’s Air Cargo Screening Technology List and achieving European Civil Aviation Conference (“ECAC”) Common Evaluation Process of Security Equipment for airport checkpoint screening of passengers and baggage. Competitive market conditions are expected to continue to have a negative impact on our average unit sales prices for the foreseeable future.

Cost of Revenues

Cost of revenues for the nine months ended March 31, 2016 were $22,266,000 as compared with $5,157,000 for the comparable prior year period, an increase of $17,109,000 or 331.8%. The increase in cost of revenues recorded in the nine months ended March 31, 2016 is primarily due to increased unit sales of our QS-B220 desktop units and, to a lesser extent, increased unit sales of our QS-H150 handheld units and an increase in manufacturing overhead costs.

Gross Margin

Gross margin for the nine months ended March 31, 2016 was $13,342,000 or 37.5% of revenues as compared with $2,158,000 or 29.5% of revenues for the comparable prior year period. The increase in gross margin as a percent of revenues is primarily due to increased manufacturing overhead absorption, due to increased QS-B220 unit volume and lower material costs for the QS-B220 due to volume purchasing price reductions, partially offset by a 32.2% decrease in the average unit sales price on sales of our QS-B220 units and by a decrease in the average unit sales price on sales of our QS-H150 units of 4.9%, and an increase in manufacturing overhead costs.

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Research and Development Expense

Research and development expense for the nine months ended March 31, 2016 was $3,024,000 as compared with $3,919,000 for the comparable prior year period, a decrease of $895,000 or 22.8%. The decrease in research and development expense is due primarily to the relocation of the San Diego, CA advanced technology office, which resulted in a $303,000 decrease in payroll and benefit costs, a $200,000 decrease in materials and prototype expenses, a $215,000 decrease in stock-based compensation, a $62,000 decrease in regulatory testing expenses, and a $93,000 decrease in rent expense, offset partially by a $41,000 increase in travel expenses incurred in support of the ECAC system deployments in the current period. We continue to expend funds to further the development of new products in the areas of explosives and narcotics detection, and to obtain the necessary approvals from the TSA and other non-U.S. government approvals. Spending on research and development will likely increase in the next six to twelve months due to the ongoing development of the QS-B220 desktop detector, the development of the QS-H150E portable explosives and narcotics detector and continued development of a hyphenated system employing conventional ion mobility, differential mobility and quadrupole mass spectrometry.

Selling, General and Administrative Expenses

Selling, general and administrative expenses for the nine months ended March 31, 2016 were $11,067,000 as compared with $9,188,000 for the comparable prior year period, an increase of $1,879,000, or 20.5%. The increase in selling, general and administrative expenses is due primarily to a $1,931,000 increase in payroll and benefit costs, due to the provision of $1,440,000 for incentive compensation and a $200,000 sign on bonus for Mr. Liscouski, our President, a $1,041,000 increase in variable selling expenses due to increased revenues, a $872,000 increase in consulting expenses due to the issuance of shares of our common stock to two advisors for services rendered under the advisory and consulting services agreements and investment banker advisor fees, a $221,000 increase in travel expense incurred to support QS-B220 system installations domestically and in Europe, the $76,000 charge recorded for the plaintiff’s counsel fee and expenses, resulting from the Miller litigation, a $255,000 increase in legal fees attributable to our ongoing review of strategic alternatives and an $86,000 increase in business insurance, due to increased revenues, offset partially by separation benefits of $725,000 provided to our former CEO due to his resignation in the prior year period, a $1,086,000 decrease in stock-based compensation on employee stock options, due primarily to additional stock-based compensation expense resulting from the amendments to Mr. Bolduc’s existing vested stock options and to the accelerated vesting of certain options issued on July 2, 2014 in the prior year period, $274,000 of charges incurred pursuant to our Letter Agreement with Luveti in the prior year period, a $207,000 decrease in stock-based compensation expense on non-employee warrants, a $54,000 decrease in bad debt expense, and a $98,000 decrease in rent expense.

Other Expense

For the nine months ended March 31, 2016, other expense was $7,571,000 as compared with other expense of $6,401,000, for the comparable prior year period, an increase of $1,170,000, or 18.3%. The increase is due to increased interest expense on higher borrowings under our credit facilities with DMRJ and, to a lesser extent, the 1% increase in the BAM interest rate which took effect on April 1, 2015.

Net Loss

Our net loss for the nine months ended March 31, 2016 was $8,320,000 as compared with a net loss of $17,350,000 for the comparable prior year period, a decrease of $9,030,000, or 52.0%. The decrease in the net loss is primarily due to increased revenues and gross margin, partially offset by increased operating expenses and an increase in interest expense.

Liquidity and Capital Resources

As of ~~March~~September 3130, 2016 and June 30, ~~2015~~2016, we had cash and cash equivalents of $~~280~~1,282,000 and $1,~~985~~338,000, respectively. We will be required to repay all unpaid principal and interest under borrowings from DMRJ and Montsant, in the aggregate amount of $60,038,000 as of May 6, 2016 under (i) a senior secured promissory note dated July 1, 2009 and (ii) a credit agreement dated September 4, 2009, on June 30, 2016 and will be required to repay our borrowings to (i) Montsant under an amended and restated senior secured convertible promissory note dated March 12, 2009 (the “March 2009 Note”), (ii) DMRJ under a senior secured convertible promissory note dated September 5, 2012 (the “September 2012 Note”) and (iii) to DMRJ under a senior secured convertible promissory note dated February 28, 2013 (the “February 2013 Note” and together with the March 2009 Note, the July 2009 Note, the September 2012 Note, the “Notes”), on December 30, 2016. Our obligations to DMRJ and

In connection with the Chapter 11 filings, we entered into a $5,700,000 senior secured superpriority debtor-in-possession 34loan and security agreement with DIP SPV I, L.P., as the debtor-in-possession lender (the “DIP Lender”) on October 10, 2016. The DIP loan would bear interest at 12% and included a one-time closing fee of $199,500 on the closing date of the DIP Loan and an exit fee equal to $427,500, less any interest, other that default interest (which is at a rate of 24%), paid to the DIP Lender as of the termination date of the DIP Loan. The DIP Loan is payable in full upon the consummation of the sale under the asset purchase agreement with L-3 Communications Corporation or a sale to any other winning bidder in the Bankruptcy Court auction. On October 13, 2016, we borrowed $1,500,000 under the DIP Loan.

~~Montsant~~- ~~are~~39 ~~secured by security interests in substantially all of our assets.~~-

~~Further~~On November 7, 2016, we ~~will~~terminated bethe ~~required~~Senior toSecured, ~~repay~~Super-Priority ~~unpaid~~Debtor-in-Possession ~~principal~~Loan and ~~interest~~Security ~~under~~Agreement ~~our~~and ~~borrowings~~entered ~~from~~into a ~~group~~replacement ofSenior ~~institutional~~Secured, ~~investors~~Super-Priority ~~for~~Debtor-in-Possession ~~which~~Loan ~~BAM~~and ~~Administrative~~Security ~~Services~~Agreement ~~LLC~~ (the “~~BAM~~New DIP Agreement”) ~~acts~~with, asTannor ~~administrative~~Partners ~~agent~~Credit Fund, inLP, the ~~aggregate~~New DIP Lender, which DIP Agreement was approved by the Bankruptcy Court on an interim basis pursuant to an order dated as of the Effective Date for the initial loan amount of $215.7 million. Under the New DIP Agreement,~~920~~ subject to the terms and conditions thereof,~~000~~ the New DIP Lender agreed to lend up to a total of $8.0 million to us, aswith the initial installment of ~~May~~$5.7 6million payable upon the Bankruptcy Court entering the interim order for the New DIP Agreement and the remaining $2.3 million payable upon the Bankruptcy Court entering the final order the New DIP Agreement. On November 8, 2016, we borrowed $5,700,000 under the New DIP Agreement and borrowed $2,300,000 on ~~June~~November 2930, 2016. As ~~Our~~of ~~obligations~~December to9, ~~BAM~~2016, ~~are~~our ~~secured~~obligations byunder athe ~~security~~New ~~interest~~DIP inAgreement ~~substantially~~for ~~all~~principal ofand ~~our~~for ~~assets.~~accrued ~~DMRJ~~interest were $8,000,000 and ~~Montsant~~$25,600, ~~agreed~~respectively. toThe ~~subordinate~~New ~~their~~DIP ~~security~~Agreement ~~interest~~is insubstantially ~~all~~identical ofto ~~our~~the ~~assets~~Original toDIP Agreement, except for the ~~security~~amounts ~~interest~~of ~~held~~the byclosing ~~BAM~~fee ~~(See~~and ~~Note~~the ~~13)~~exit fee.

AsWe ofwere ~~March~~required ~~31,~~to ~~2016,~~repay ~~our~~all ~~principal~~of ~~obligations~~our toborrowings from DMRJ ~~under~~and ~~each~~Montsant ofon ~~the~~October ~~three~~31, ~~promissory~~2016 ~~notes~~ and from a ~~revolving~~group ~~line~~ of ~~credit~~institutional ~~approximated~~investors ~~$18,970,000,~~for ~~$17,523,000,~~which ~~$1,000,000~~BAM ~~and~~Administrative ~~$17,662,000,~~Services ~~respectively.~~LLC ~~Further,~~(“BAM”) acts as ofadministrative ~~March~~agent, 31on October 30, 2016,. ~~our~~Our ~~obligation~~obligations to ~~DMRJ~~BAM ~~for~~are ~~accrued~~secured by a security interest ~~under~~in ~~these~~substantially ~~instruments~~all ~~approximated~~of ~~$4,603,000~~our assets. DMRJ and isMontsant ~~included~~agreed into ~~accrued~~subordinate ~~expenses~~their security interest in all of our assets to the security interest held by BAM (See Note 12 to the condensed consolidated financial ~~statements~~statement).

AsThe payment of ~~May 6, 2016,~~ our ~~principal~~indebtedness ~~obligations~~ to DMRJ, ~~under~~Montsant ~~each of the three promissory notes~~ and aBAM ~~revolving~~are ~~line~~stayed ofpending ~~credit~~the ~~approximated~~conclusion ~~$18,970,000, $17,523,000, $1,000,000 and $17,662,000, respectively. Further, as~~ of ~~May~~the 6,bankruptcy ~~2016, our obligation to DMRJ for accrued interest under these instruments approximated $4,883,000~~proceedings.

AsOur obligations to DMRJ are secured by security interests in substantially all of ~~March~~our ~~31,~~assets. ~~2016~~As ~~and~~of ~~May~~September 630, 2016, our ~~principal~~ obligations to ~~Montsant~~DMRJ under aeach of the three promissory ~~note~~notes and a revolving line of credit approximated $511,~~284~~970,000., ~~Further~~$17,523,000, as$1,000,000 ofand ~~March~~$17,662,000, 31respectively. Further, ~~2016~~as ~~and~~of ~~May~~September 630, 2016, our obligation to ~~Montsant~~DMRJ for accrued interest under ~~this~~these ~~instrument~~instruments ~~was~~approximated $07,282,000 and is included in current liabilities in the consolidated financial statements.

As of ~~March~~September 3130, 2016, our ~~principal~~ obligations ~~under~~to ~~the~~Montsant ~~senior~~under ~~secured~~a promissory ~~notes~~note ~~for~~approximated ~~which BAM is the agent were~~ $205,~~000~~284,000. Further, as of ~~March~~September 3130, 2016, our obligation ~~under~~to ~~such~~Montsant ~~notes~~ for accrued interest ~~amounted~~under tothis ~~approximately~~instrument approximated was $1203,~~600,~~000 ~~and is included in accrued expenses in the condensed consolidated financial statements~~.

As of ~~May~~December 69, 2016, our ~~principal~~ obligations to DMRJ under ~~the~~each ~~senior~~of ~~secured~~the three promissory notes ~~for~~and ~~which~~a ~~BAM~~revolving isline ~~the~~of ~~agent~~credit ~~were~~approximated $2011,970,000, $17,523,000, $1,000,000 and $17,662,000, respectively. Further, as of ~~May~~December 69, 2016, our obligation ~~under~~to ~~such~~DMRJ ~~notes~~ for accrued interest ~~amounted~~under tothese ~~approximately~~instruments approximated $18,~~920~~687,000. Please refer to Note 14 to the condensed consolidated financial statements for a discussion of the August 2016 conversions of principal indebtedness by DMRJ.

~~Each~~As of ~~these~~December ~~notes~~9, ~~and~~2016, ~~the~~our ~~credit~~obligations ~~facility~~to ~~are~~Montsant ~~described~~under ina ~~Note~~promissory 13note approximated $5,284,000. Further, as of ~~the~~December ~~Notes~~9, 2016, our obligation to ~~Condensed~~Montsant ~~Consolidated~~for ~~Financial~~accrued ~~Statements,~~interest ~~accompanying~~under this ~~Quarterly~~instrument ~~Report~~approximated $328,000.

OnOur ~~December~~obligations ~~11,~~to ~~2015,~~a wegroup ~~entered~~of ~~into~~institutional aninvestors ~~Accounts~~for ~~Receivable~~which ~~Purchase~~BAM ~~Agreement~~acts ~~(the~~as ~~“Purchase~~administrative ~~Agreement”)~~agent ~~with~~are ~~Republic~~secured ~~Capital~~by ~~Access,~~security ~~LLC~~interests ~~(“RCA”),~~in ~~pursuant~~substantially toall ~~which we~~of ~~may~~our ~~sell eligible accounts receivables relating to U~~assets.S. ~~government~~As ~~prime~~of ~~contracts~~September or30, ~~subcontracts~~2016, ~~(as~~our ~~defined~~obligations inunder the ~~Purchase~~senior ~~Agreement,~~secured ~~“Eligible~~promissory ~~Receivables”)~~notes tofor ~~RCA. The~~which ~~total~~BAM ~~amount of Eligible Receivables that we may sell to RCA~~ is ~~subject~~the toagent awere ~~maximum limit of~~ $220,000,000 ~~of outstanding receivables at any given time~~. ~~The~~ ~~Purchase~~Further, ~~Agreement~~as ~~terminates~~of onSeptember ~~November~~ 30, 2016~~. On April 11~~, ~~2016,~~our weobligation ~~amended~~under ~~the~~such ~~Purchase~~notes ~~Agreement~~for ~~(the~~accrued ~~“Amended~~interest ~~Purchase~~amounted ~~Agreement”). As amended, the total amount of Eligible Receivables that we may sell~~ to ~~RCA~~approximately ~~is subject to a maximum limit of~~ $3,~~500~~200,000 ofand ~~outstanding~~is ~~receivables~~included atin ~~any~~current ~~given~~liabilities ~~time~~in the consolidated financial statements.

~~Pursuant~~As ~~to the terms~~ of ~~the~~December ~~Purchase Agreement~~9, ~~we will receive from RCA~~2016, ~~within~~our ~~two~~obligations ~~business~~under ~~days of~~ the ~~submission~~senior ofsecured ~~the~~promissory ~~applicable~~notes ~~invoice,~~for anwhich ~~initial~~BAM ~~payment~~is ~~equal to 90% of~~ the ~~face~~agent ~~value~~were ~~of an Eligible Receivable purchased by RCA~~$20,000,000. ~~Following~~ ~~payment of such Eligible Receivable to RCA by the relevant customer~~Further, ~~RCA~~as ~~shall pay the Company the residual 10%~~ of ~~such~~December ~~receivable~~9, ~~fewer~~2016, ~~fees~~our ~~payable~~obligation tounder ~~RCA~~such bynotes ~~the~~for ~~Company~~accrued ~~pursuant~~interest amounted to ~~the~~approximately ~~Purchase Agreement~~$3,802,000.

WeEach have paid, or will pay, as applicable, the following fees, as applicable, to RCA pursuant to the Purchase Agreement: (i) an initial enrollment fee equal to $5,000.00; (ii) a discount factor equal to 0.35%, for U.S. government contracts (or 0.53% for U.S. government subcontracts), of ~~the~~these ~~amounts~~notes ofand ~~purchased receivables; (iii) a program access fee equal to 0.017% of~~ the ~~daily~~credit ~~ending~~facility ~~account balance for each day that receivables~~ are ~~outstanding;~~described ~~(iv)~~in aNote ~~commitment~~12 ~~fee equal~~ to ~~1% of Maximum Amount minus~~ the ~~amount~~condensed ofconsolidated ~~purchased~~financial ~~receivables; and (v) expenses relating to the negotiation of the Purchase Agreement~~statements, ~~which~~accompanying ~~amount~~this isQuarterly ~~not expected to exceed $1,000~~Report. ~~As of March 31, 2016, RCA has purchased $2,931,000 of our receivables pursuant to the Purchase Agreement.~~

~~BAM~~During ~~Administrative~~the ~~Services~~three ~~LLC~~months ~~and~~ended ~~DMRJ~~September ~~Group~~30, ~~LLC~~2016, ~~consented~~we had net cash outflows of $40,000 from operating activities as compared to net cash outflows from operating activities of $1,268,000 for the ~~transactions~~comparable ~~contemplated~~prior year period. The $1,228,000 decrease in net cash outflows used in operating activities during the three months ended September 30, 2016, as compared to the prior year period, was due to the following changes in working capital: (i) a $2,119,000 decrease in accounts receivable, compared to a $1,799,000 increase in the prior period, due to increased product shipments during the latter part of the quarter ended September 30, 2015; (ii) a $1,427,000 increase in inventories compared to a $2,126,000 increase in the prior period, due primarily to improved inventory management, compared to the prior period; (iii) an increase in accrued expenses of $1,658,000, compared to a $4,012,000 increase in the prior period, by an increase in accrued expenses in the ~~Purchase~~prior ~~Agreement.~~period due to provisions for

~~During~~- ~~the~~40 nine months ended March 31, 2016, we had net cash outflows of $2,607,000 from operating activities as compared to net cash outflows from operating activities of $9,282,000 for the comparable prior year -

-incentive 35compensation -recorded in the three months ended September 30, 2015 and the payment of incentive compensation in the three months ended September 30, 2016, and, to a lesser extent, an increase in our accrued interest due to higher borrowings under our credit facilities with DMRJ and the increase in the BAM interest rate; (iv) a $589,000 increase in deferred revenue, compared to a $2,190,000 decrease in deferred revenue in the prior year period, due primarily to the application of ECAC customer advance deposits received in the quarter ended June 30, 2015, against accounts receivables resulting from shipments in the three months ended September 30, 2015; and, (v) a $1,723,000 increase in accounts payable, compared to a $1,630,000 increase in the prior period, due to increased inventory related payables.

~~period.~~During ~~The $6,675,000 decrease in net cash outflows used in operating activities during~~ the ~~nine~~three months ended ~~March~~September 3130, 2016, aswe ~~compared~~had tonet ~~the~~cash ~~prior~~outflows ~~year~~of ~~period, was due to the following changes in working capital: (i) a~~ $512,~~590,~~000 ~~increase~~from ininvesting ~~accounts~~activities ~~receivable,~~as compared to anet ~~$803,000~~cash ~~increase~~outflows ~~in the prior period, due to increased product shipments during the latter part~~ of ~~the quarter ended March 31, 2016; (ii) a~~ $~~737~~63,000 ~~increase~~from ininvesting ~~inventories~~activities ~~compared~~for ~~to a $468,000 increase in~~ the prior ~~period,~~year ~~due primarily to increased customer order backlog, compared to the prior~~ period;. ~~(iii)~~The ~~an increase in accrued expenses of~~ $951,~~880,~~000, ~~compared~~decrease ~~to a $6,047,000 increase~~ in ~~the~~net ~~prior~~cash ~~period,~~used ~~due to primarily to an increase~~ in ~~our~~investing ~~accrued~~activities ~~interest,~~during ~~due to higher borrowings under our credit facilities with DMRJ and~~ the ~~increase~~three ~~in the BAM interest rate, and to a lesser extent, by an increase in accrued expenses in the current period due provisions for incentive compensation recorded in the nine~~ months ended ~~March~~September 3130, 2016 ~~and an increase in our provision for product warranty costs~~, ~~due~~as ~~to increased unit shipments of our QS-B220 desktop units; (iv) a $2,087,000 decrease in deferred revenue,~~ compared to ~~a $1,317,000 increase in deferred revenue in~~ the prior year period, ~~due~~was primarily due to ~~the~~decreased ~~application~~purchases of ~~ECAC~~equipment ~~customer advance deposits received~~ in the ~~quarter~~three ~~ended June 30, 2015, against accounts receivables resulting from shipments in the nine~~ months ended ~~March~~September 3130, 2016~~; and, (v) a $2,122,000 increase in accounts payable, compared to a $615,000 decrease in the prior period, due to increased inventory related payables~~.

During the ~~nine~~three months ended ~~March~~September 3130, 2016, we had net cash outflows of $~~117~~4,000 from ~~investing~~financing activities as compared to net cash ~~outflows~~inflows of $~~341~~224,000 ~~from investing activities~~ for the comparable prior year period. The $~~224~~228,000 decrease in net cash ~~used~~from infinancing ~~investing~~ activities during the ~~nine~~three months ended ~~March~~September 3130, 2016, as compared to the prior year period, was primarily due to ~~increased~~$200,000 ~~purchases~~in ofborrowings ~~equipment~~under our credit facility with DMRJ in the ~~nine~~comparable prior period, compared to no borrowings in the three months ended ~~March~~September 3130, ~~2015~~2016, a $34,000 decrease in proceeds received due to the exercise of stock options, and a $6,000 decrease in principal repayments of capital lease obligations.

During the nine months ended March 31, 2016 we had net cash inflows of $1,001,000 from financing activities as compared to net cash inflows of $11,145,000 for the comparable prior year period. The $10,144,000 decrease in net cash from financing activities during the nine months ended March 31, 2016, as compared to the prior year period, was primarily due to $1,000,000 in borrowings under our credit facility with DMRJ, compared to a borrowings of $10,917,000 in the prior fiscal year, and, to a lesser extent, a $225,000 decrease in proceeds received due to the exercise of stock options and warrants.

Credit Facilities with DMRJ Group LLC, Montsant Partners LLC and BAM Administrative Services LLC

In December 2008, we entered into a note and warrant purchase agreement with DMRJ, pursuant to which we issued a senior secured convertible promissory note in the principal amount of $5,600,000 and a warrant to purchase 1,000,000 shares of our common stock. Thereafter, we entered into a series of amendments, waivers and modifications of this facility. The notes matured on October 31, 2016, but payment has been stayed pending conclusion of bankruptcy.

On May 4, 2015, we entered into an assignment agreement with DMRJ and Montsant, wherein DMRJ assigned its rights, title and interest in the senior secured promissory note dated December 10, 2008 and appointed DMRJ as its collateral agent under the promissory note agreement. ~~DMRJ~~The ~~and~~note ~~Montsant~~matured ~~are~~on ~~funds~~October ~~managed~~31, by2016, ~~Platinum~~but ~~Partners~~payment ~~Value~~has ~~Arbitrage~~been ~~Fund~~stayed LPpending conclusion of bankruptcy.

~~We will be required to repay all of our borrowings from~~ DMRJ and Montsant ~~under~~ ~~(i)~~are afunds ~~senior~~managed ~~secured~~by ~~promissory~~Platinum ~~note~~Partners ~~dated~~Value ~~July~~Arbitrage 1,Fund 2009 and (ii) a credit agreement dated September 4, 2009, on June 30, 2016 and will be required to repay our borrowings to (i) Montsant under an amended and restated senior secured convertible promissory note dated March 12, 2009 (the “March 2009 Note”), (ii) DMRJ under a senior secured convertible promissory note dated September 5, 2012 (the “September 2012 Note”) and (iii) to DMRJ under a senior secured convertible promissory note dated February 28, 2013 (the “February 2013 Note” and together with the March 2009 Note, the July 2009 Note, the September 2012 Note, the “Notes”), on December 30, 2016LP.

In March, 2014, we entered into a note purchase agreement with a group of institutional investors and BAM, an administrative agent for the investors, pursuant to which we issued senior secured promissory notes in the aggregate principal amount of $20,000,000. The notes bear interest at 16% per annum and mature on ~~June~~October 2930, 2016. We used all of the proceeds from the sale of the notes to repay (i) $17,624,000 of our outstanding indebtedness to DMRJ under revolving promissory note (ii) $1,809,000 of interest outstanding under that facility and (iii) $567,000 of interest outstanding under our senior secured convertible promissory note.

~~Further,~~The wepayment ~~will be required to repay all~~ of our ~~borrowings~~indebtedness ~~from~~to aDMRJ, ~~group~~Montsant ofand ~~institutional investors for which~~ BAM ~~Administrative~~are ~~Services~~stayed ~~LLC~~pending ~~(“BAM”)~~the ~~acts~~conclusion asof ~~administrative~~the ~~agent,~~bankruptcy ~~on June 29, 2016~~proceedings.

-See 36Note -12 to the condensed consolidated financial statements, accompanying this Quarterly Report. There can be no assurance that we will be successful in refinancing or extending our obligations to our secured lenders or reorganize the indebtedness under bankruptcy.

~~See~~Our ~~Note~~ability 13to comply with our debt covenants in the depends on our ability to control expensesand may require that we seek additional capital through private financing sources. The payment of ~~Notes~~our secured obligations with DMRJ and Montsant will be stayed until such time that the Official Committee of Equity Holders has concluded their activities to ~~Condensed~~assert ~~Consolidated~~certain ~~Financial~~estate ~~Statements~~claims and causes of action and challenge the validity, ~~accompanying~~enforceability, ~~this~~and ~~Quarterly~~perfection ~~Report~~of certain prepetition secured claims, which challenge period was extended by the bankruptcy court up to and including January 23, 2017. Interest on our debt obligations with DMRJ and Montsant will continue to accrue until such time that the obligations are paid by us.There can be no ~~assurance~~assurances that we will beachieve ~~successful~~our inforecasted ~~refinancing~~financial results or ~~extending~~that ~~our~~we ~~obligations~~will be able to raise additional capital to operate our ~~secured~~business. Any ~~lenders~~such failure would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely. Further, upon the occurrence of an event of default under certain provisions of our credit agreements with DMRJ, Montsant and BAM, we could be required to pay default rate interest equal to the lesser of 2.5% per month and the maximum applicable legal rate per annum on the outstanding principal balance. The

Our ability to comply with our debt covenants in the future depends on our ability to generate sufficient sales and to control expenses, and will require that we seek additional capital through private financing sources. There can be no assurances that we will achieve our forecasted financial results or that we will be able to raise additional capital to operate our business. Any such failure would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely. Further, upon the occurrence of an event of default under certain provisions of our credit agreements, we could be required to pay default rate interest equal to the interest rate per annum under each term note increased by an additional fourteen percent (14%) per annum (pro-~~rated~~ ~~for~~41 partial years), not to exceed the maximum legal rate per annum on the outstanding principal balance outstanding as permitted by applicable New York law. The failure to refinance or otherwise negotiate further extensions of our obligations to our secured lenders would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws. -

~~Based~~occurrence onof ~~current~~an ~~sales,~~event ~~operating expense and cash flow projections, and the cash available from our line~~ of ~~credit,~~default ~~management~~under ~~believes~~certain ~~there~~provisions ~~are plans in place to sustain operations, provided that our credit facilities are extended. These plans depend on a substantial increase in sales~~ of our ~~handheld~~New ~~trace~~DIP ~~explosives~~Loan ~~detector~~would ~~product~~require ~~and~~us ~~our~~to ~~desktop~~pay ~~explosives~~default ~~and~~interest ~~narcotics~~equal ~~trade~~to ~~detector~~24% ~~product~~per ~~and~~annum on the ~~extension~~outstanding ofprincipal ~~the~~loan ~~maturity date of our credit facilities with DMRJ, BAM and Montsant~~balance. ~~However,~~ ~~there~~The ~~can~~failure beto nocure ~~assurances~~an ~~that~~event ~~sales~~of ~~will~~default ~~materialize as forecasted, and/~~or ~~that~~negotiate ~~management~~further ~~will~~extensions beof ~~successful in refinancing or extending~~ our obligations to our secured lenders, ~~which~~would ~~mature~~have ona ~~various~~material ~~dates~~adverse ~~between~~impact ~~June~~on ~~29,~~our ~~2016~~liquidity and ~~December~~financial ~~30,~~condition ~~2016.~~and Tocould ~~further~~force ~~sustain~~ us, ~~improve our cash position, and enable us~~ to ~~grow~~curtail ~~while~~or ~~reducing~~discontinue ~~debt,~~operations ~~management~~entirely ~~plans~~and/or tocould ~~continue~~require tous ~~seek additional capital through private financing sources. However, there can be no assurance that management will be successful in executing these plans. Management will continue~~ to ~~closely~~convert ~~monitor and attempt to control~~ our ~~costs~~voluntary ~~and~~filing ~~actively~~under ~~seek~~bankruptcy ~~needed~~laws ~~capital~~from ~~through~~Chapter ~~sales~~11 ofto ~~our~~Chapter ~~products,~~7. ~~equity infusions, government grants and awards, strategic alliances, and through our lending institutions~~.

~~Despite~~Based ~~our~~on ~~current~~projected ~~sales~~cash flows, ~~expense~~ and the cash ~~flow~~available ~~projections~~from ~~and~~under $1the New DIP Loan,~~582,000~~ inmanagement ~~cash~~believes ~~available~~there ~~from~~are ~~our~~plans ~~line~~in ofplace ~~credit~~to ~~with~~sustain ~~DMRJ,~~operations atduring ~~May~~the 6,bankruptcy ~~2016~~process, toprovided ~~fund~~that our ~~operations~~credit ~~and~~facilities ~~continue~~are ~~the~~maintained. These ~~development,~~plans ~~commercialization~~depend ~~and~~on ~~marketing~~a substantial increase in sales of our ~~products~~handheld ~~will~~trace ~~require~~explosives ~~that~~detector weproduct ~~extend~~and our ~~credit~~desktop ~~facilities~~explosives ~~with~~and ~~DMRJ,~~narcotics ~~BAM~~trade detector product and ~~Montsant~~the prudent management of our resources. However, ~~There~~there can be no ~~assurance~~assurances that ~~DMRJ~~sales will ~~continue~~materialize toas ~~make~~forecasted, ~~advances~~and/or ~~under~~that management will be successful in refinancing or extending our ~~revolving~~obligations ~~line~~to ofour ~~credit~~secured lenders, which matured between October 30, 2016 and October 31, 2016. ~~Our~~To ~~failure~~further tosustain ~~achieve~~us, improve our ~~projections~~cash position, and~~/or~~ ~~obtain~~enable ~~sufficient~~us to grow while reducing debt, management plans to continue to seek additional capital onthrough ~~acceptable~~private ~~terms~~financing ~~would~~sources. ~~have~~However, athere ~~material~~can ~~adverse~~be ~~effect~~no onassurance ~~our~~that ~~liquidity~~management ~~and~~will ~~operations~~be ~~and~~successful ~~could~~in ~~require~~executing usthese toplans ~~file~~or ~~for~~that ~~protection~~we ~~under~~would receive permission from the New DIP Lender, BAM, DMRJ, Montsant or the bankruptcy ~~laws~~court to obtain additional capital. Management ~~These~~will ~~conditions~~continue ~~raise~~to ~~substantial~~closely ~~doubt~~monitor asand attempt to control our ~~ability~~costs toand ~~continue~~actively asseek aneeded ~~going~~capital ~~concern~~through sales of our products, government grants and awards and through our lending institutions.

Our failure to achieve our projections, to obtain sufficient additional capital on acceptable terms or successfully complete the sale of our ETD business to L-3 would have a material adverse effect on our liquidity and operations and could require us to convert our voluntary filing under bankruptcy laws from Chapter 11 to Chapter 7. Furthermore, we are incurring and will incur increased legal and financial adviser cost associated with the activities of the Official Committee of Equity Holders appointed by the U.S. Trustee and increased legal and administrative cost associated with the bankruptcy proceedings following the anticipated successful completion of the ETD asset sale to L-3. These conditions raise substantial doubt as to our ability to continue as a going concern.

Off-Balance Sheet Arrangements

As of ~~March~~September 3130, 2016, we had one irrevocable standby letter of credit outstanding in the approximate amount of $297,000. The letter of credit provides warranty performance security equal to 5% of the contract amount with the India Ministry of Defence. We have amended the letter of credit, extending the expiration date to April 15, 2017.

As of ~~March~~September 3130, 2016, we did not have any other off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our consolidated financial condition, results of operations, liquidity, capital expenditures or capital resources.

Recent Accounting Pronouncements

In May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which supersedes the revenue recognition requirements in ASC 605, “Revenue Recognition”. The FASB issued ASU 2014-09 to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and International Financial Reporting Standards. The core principle of this updated guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The new rule also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. This guidance is effective for annual reporting periods beginning after December 15, 2017, including interim reporting periods therein, which is effective for our fiscal year beginning July 1, 2018, the first day of our 2019 fiscal year. We are currently evaluating the impact of this accounting guidance and do not expect any significant impact on our consolidated financial statements.

In June 2014, the FASB issued Accounting Standards Update 2014-12, 37Compensation-Stock Compensation (“ASU 2014-12”). The FASB issued ASU 2014-12 to provide specific guidance on share-based payment awards

~~for~~- ~~our~~42 fiscal year beginning July 1, 2018, the first day of our 2019 fiscal year. We are currently evaluating the impact of this accounting guidance and do not expect any significant impact on our consolidated financial statements. -

In June 2014, the FASB issued Accounting Standards Update 2014-12, Compensation-Stock Compensation (“ASU 2014-12”). The FASB issued ASU 2014-12 to provide specific guidance on share-based payment awards that provide for achievement of a specific performance target that could be achieved after the requisite service period. ASU 2014-12 requires that a performance target that affects vesting and that could be achieved after the requisite service period should be treated as a performance condition. As such, the performance target should not be reflected in estimating the grant-date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. This guidance is effective for annual periods and interim periods within those annual periods beginning after December 15, 2015, which is effective for our fiscal year beginning July 1, 2016, the first day of our 2017 fiscal year. Earlier adoption is permitted. ASU 2014-12 may be applied prospectively to all awards granted or modified after the effective date or retrospectively to all awards with performance targets that are outstanding as of the beginning of the earliest annual period presented in the financial statements and to all new or modified awards thereafter. If retrospective transition is adopted, the cumulative effect of applying this guidance should be recognized in the financial statements as an adjustment to the opening retained earnings balance at that date. WeThe ~~are~~adoption ~~currently evaluating the impact~~ of ~~this~~ASU ~~accounting~~2014-12 ~~guidance~~did ~~and do~~ not ~~expect~~have ~~any~~a ~~significant~~material impact on our consolidated financial statements.

In August 2014, the FASB issued Accounting Standards Update 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40) (“ASU 2014-15”). ASU 2014-15 provides guidance to U.S. GAAP about management’s responsibility to evaluate whether there is a substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. This new rule requires management to assess an entity’s ability to continue as a going concern by incorporating and expanding upon certain principles currently in U.S. auditing standards. Specifically, ASU 2014-15 (1) defines the term substantial doubt, (2) requires an evaluation of every reporting period including interim periods, (3) provides principles for considering the mitigating effect of management’s plan, (4) requires certain disclosures when substantial doubt is alleviated as a result of consideration of management’s plans, (5) requires an express statement and other disclosures when substantial doubt is not alleviated, and (6) requires an assessment for a period of one year after the date that the financial statements are issued. This guidance is effective for annual periods ending after December 15, 2016, which is effective for our fiscal year beginning July 1, 2016, the first day of our 2017 fiscal year. WeThe ~~are~~adoption ~~currently evaluating the impact~~ of ~~this~~ASU ~~accounting~~2014-15 ~~guidance~~did ~~and do~~ not ~~expect~~have ~~any~~a ~~significant~~material impact on our consolidated financial statements.

- 38 -

Cautionary Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q contains certain statements that are “forward-looking” within the meaning of the federal securities laws. These forward looking statements and other information are based on our beliefs as well as assumptions made by us using information currently available.

The words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “will,” “should” and similar expressions, as they relate to us, are intended to identify forward-looking statements. Such statements reflect our current views with respect to future events, are subject to certain risks, uncertainties and assumptions, and are not guaranties of future performance. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove ~~incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated, expected, intended or using other similar expressions.~~

~~We are making investors aware that such forward~~-~~looking~~ ~~statements,~~43 ~~because they relate to future events, are by their very nature subject to many important factors that could cause actual results to differ materially from those contemplated by the forward~~-looking statements contained in this Report. Important factors that could cause actual results to differ from our predictions include those discussed under this “Management’s Discussion and Analysis” and under “Risk Factors,” as well as those discussed under “Risk Factors,” “Management’s Discussion and Analysis” and “Business” in our Annual Report on Form 10-K for the fiscal year ended June 30, 2015. Although we have sought to identify the most significant risks to our business, we cannot predict whether, or to what extent, any of such risks may be realized, nor can there be any assurance that we have identified all possible issues which we might face. In addition, assumptions relating to budgeting, marketing, product development and other management decisions are subjective in many respects and thus susceptible to interpretations and periodic revisions based on actual experience and business developments, the impact of which may cause us to alter our marketing, capital expenditure or other budgets, which may in turn affect our financial position and results of operations. For all of these reasons, the reader is cautioned not to place undue reliance on forward-looking statements contained herein, which speak only as of the date hereof. We assume no responsibility to update any forward-looking statements as a result of new information, future events, or otherwise except as required by law. We urge readers to review carefully the risk factors described in this Quarterly Report, in our Annual Report on Form 10-K for the fiscal year ended June 30, 2015 and in the other documents that we file with the Securities and Exchange Commission. You can read these documents at www.sec.gov.

incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated, expected, intended or using other similar expressions.

We are making investors aware that such forward-looking statements, because they relate to future events, are by their very nature subject to many important factors that could cause actual results to differ materially from those contemplated by the forward-looking statements contained in this Report on Form 10-Q. Important factors that could cause actual results to differ from our predictions include those discussed under this “Management’s Discussion and Analysis” and under “Risk Factors,” as well as those discussed under “Risk Factors,” “Management’s Discussion and Analysis” and “Business” in our Annual Report on Form 10-K for the fiscal year ended June 30, 2016. Although we have sought to identify the most significant risks to our business, we cannot predict whether, or to what extent, any of such risks may be realized, nor can there be any assurance that we have identified all possible issues which we might face. In addition, assumptions relating to budgeting, marketing, product development and other management decisions are subjective in many respects and thus susceptible to interpretations and periodic revisions based on actual experience and business developments, the impact of which may cause us to alter our marketing, capital expenditure or other budgets, which may in turn affect our financial position and results of operations. Our expectations regarding the potential sale of the assets of the explosives detection business and our intent to acquire another business. For all of these reasons, the reader is cautioned not to place undue reliance on forward-looking statements contained herein, which speak only as of the date hereof. We assume no responsibility to update any forward-looking statements as a result of new information, future events, or otherwise except as required by law.

We urge readers to review carefully the risk factors described in this Quarterly Report, in our Annual Report on Form 10-K for the fiscal year ended June 30, 2016 and in the other documents that we file with the Securities and Exchange Commission. You can read these documents at www.sec.gov.

Item 4.

Controls and Procedures

The certifications of our Chief Executive Officer and Chief Financial Officer attached as Exhibits 31.1 and 31.2 to this Quarterly Report on Form 10-Q include, in paragraph 4 of such certifications, information concerning our disclosure controls and procedures, and internal control over financial reporting. Such certifications should be read in conjunction with the information contained in this Item 4 for a more complete understanding of the matters covered by such certifications.

Disclosure Controls and Procedures.

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of ~~March~~September 3130, 2016. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by the company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported, within the time periods specified in the rules and forms of the Securities and Exchange Commission. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions to be made regarding required disclosure. It should be noted that any system of controls and procedures, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met and that management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

-As 39a result of material weaknesses described in our Annual Report on Form 10-K for the year ended June 30, 2016, our Chief Executive Officer and Chief Financial Officer concluded that, we did not maintain effective internal control over financial reporting as of September 30, 2016 and further concluded that, as of such date, our disclosure controls and procedures were not effective at the reasonable assurance level.

~~accumulated and communicated to the company’s management~~Furthermore, ~~including~~this ~~its~~Quarterly ~~Chief~~Report ~~Executive~~on ~~Officer~~Form ~~and~~10-Q ~~Chief~~is ~~Financial~~being ~~Officer,~~filed aslate ~~appropriate,~~due to ~~allow~~the ~~timely~~added ~~decisions~~responsibilities ~~to be made regarding required disclosure. It should be noted that any system~~ of ~~controls~~our ~~and~~finance ~~procedures,~~staff ~~however~~related ~~well~~to ~~designed~~bankruptcy ~~and~~reporting operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met and that management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and proceduresobligations.

As a result of material weaknesses described in our Annual Report on Form 10-K for the year ended June 30, 2015, our Chief Executive Officer and Chief Financial Officer concluded that, we did not maintain effective internal control over financial reporting as of March 31, 2016 and further concluded that, as of such date, our disclosure controls and procedures were not effective at the reasonable assurance level.

Remediation

We are committed to remediating the material weaknesses identified in internal controls over financial reporting and have begun the process to remediate these material weaknesses, however the timing of completing our remediation efforts is uncertain. Our efforts ~~will~~have ~~focus~~focused on instituting mitigating controls to address segregation of duties and undertake a thorough review of the finance functions position responsibilities and the hiring of additional staff; implement additional controls to address system access deficiencies; establish independent review and verification procedures for our vendor and customer master files; enhance the documentation to support review occurrences and approval procedures; and, commence regular periodic reviews of our internal controls over financial reporting with our Board of Directors and Audit Committee to address the inadequate risk oversight function and institute procedures to evaluate and report on risks to financial reporting, including the documentation and completion of a comprehensive risk assessment to identify all potential risk areas and evaluate the adequacy of our controls to mitigate these risks.

- 44 -

occurrences and approval procedures; and, commence regular periodic reviews of our internal controls over financial reporting with our Board of Directors and Audit Committee to address the inadequate risk oversight function and institute procedures to evaluate and report on risks to financial reporting, including the documentation and completion of a comprehensive risk assessment to identify all potential risk areas and evaluate the adequacy of our controls to mitigate these risks.

Changes in Internal Control Over Financial Reporting

During the three months ended ~~March~~September 3130, 2016, we have implemented additional controls to address system access deficiencies, hired additional finance staff and have begun instituting mitigating controls to address segregation of duty issues. The addition of additional staff will allow us to address the insufficient segregation of duties, oversight of work performed and allow us to continue to institute additional compensating or mitigating controls and will also allow us to document internal control support occurrences and approval procedures. We have instituted systems access controls and mitigating controls to system access. There are no other changes that have materially affected, or isare reasonably likely to materially affect our internal controls over financial reporting.

PART II.

OTHER INFORMATION

Item 1.

Legal Proceedings

On July 1, 2015 we held our 2015 Annual Meeting of Stockholders. Stockholders approved an amendment to the Company’s 2004 Stock Option Plan to increase the aggregate number of shares of the Company’s common stock, par value $0.001 per share available for issuance under the Plan by 16,000,000 shares to 20,000,000 shares and ~~approve~~approved the Company’s Amended and Restated 2014 Stock Option Plan.

On May 22, 2015, a motion to dismiss the Complaint with prejudice was served on the plaintiff and subsequently filed with the Court. On July 21, 2015, the Court endorsed an Order of Stipulation the parties entered into. The Stipulation provides, among other things, that the Complaint is dismissed with prejudice and the Motion to Dismiss is moot. On December 17, 2015, the Court ruled that the Plaintiff’s counsel was entitled to a fee of $70,000 together with costs of approximately $6,000. During the ~~three~~fiscal ~~and~~year ~~nine months~~ ended ~~March~~June 3130, 2016, we recorded a charge of $76,000 in our condensed consolidated statement of operations and comprehensive loss.

We ~~may,~~are ~~from~~not ~~time~~currently a party to ~~time,~~any beother ~~involved~~legal inproceedings, other ~~actual~~than orroutine ~~potential~~litigation ~~proceedings~~incidental to our business that which we ~~consider~~believe towill benot inhave ~~the~~a ~~normal~~material ~~course~~effect ofon our business, assets or results of operations. WeFrom dotime ~~not~~to ~~believe~~time, ~~that~~we ~~any~~are ofsubject ~~these~~to various claims, legal proceedings ~~will~~and ~~have~~investigations covering a ~~material~~wide ~~adverse~~range ~~effect~~of matters that arise in the ordinary course of our business activities. Each of these matters may be subject to various uncertainties.

-We 40may, -from time to time, be involved in other actual or potential proceedings that we consider to be in the normal course of our business. We do not believe that any of these proceedings will have a material adverse effect on our business. We are not a party to any other legal proceedings, other than ordinary routine litigation incidental to our business, which we believe will not have a material effect on our business, assets or results of operations.

on our business. We are not a party to any other legal proceedings, other than ordinary routine litigation incidental to our business, which we believe will not have a material effect on our business, assets or results of operations.

Item 1A.

Risk Factors

Other than as set forth below, there have not been any material changes from the risk factors previously disclosed under Item 1A of our Annual Report on Form 10-K, for the fiscal year ended June 30, ~~2015~~2016.

We ~~will~~may not be ~~required~~able to ~~repay~~achieve ~~substantially all of~~ our ~~secured~~strategic ~~borrowings on~~objectives, ~~various~~including ~~dates~~the ~~between~~sale ~~June~~of ~~29,~~the ~~2016~~ETD business and ~~December~~the ~~30,~~acquisition ~~3016~~of toanother ~~DMRJ, Montsant and BAM~~business.

WeWith ~~will~~respect ~~be required~~ to ~~repay~~acquisitions ~~all of our borrowings from DMRJ~~ and ~~Montsant under~~divestitures, ~~(i)~~we amay ~~senior~~not ~~secured~~achieve ~~promissory~~expected ~~note~~returns ~~dated~~and ~~July~~other 1,benefits ~~2009~~as ~~and (ii)~~ a ~~credit~~result ~~agreement~~of ~~dated~~various ~~September 4~~factors, ~~2009,~~including onintegration ~~June 30, 2016~~ and ~~will~~challenges beof ~~required~~assimilating topersonnel ~~repay our borrowings to (i) Montsant under an amended~~ and ~~restated~~technology. When ~~senior~~we ~~secured~~decide ~~convertible~~to ~~promissory~~sell ~~note~~assets ~~dated~~or ~~March~~a 12business, ~~2009~~we ~~(the~~may ~~“March~~encounter ~~2009~~difficulty ~~Note”),~~in ~~(ii)~~finding ~~DMRJ~~buyers ~~under~~or aexecuting ~~senior~~alternative ~~secured~~exit ~~convertible~~strategies ~~promissory~~in ~~note dated September 5, 2012 (the “September 2012 Note”) and (iii) to DMRJ under~~ a senior secured convertible promissory note dated February 28, 2013 (the “February 2013 Note” and together with the March 2009 Note, the July 2009 Note, the September 2012 Note, the “Notes”), on December 30, 2016;

~~Further,~~- we45 will be required to repay all of our borrowings from a group of institutional investors for which BAM Administrative Services LLC (“BAM”) acts as administrative agent, on June 29, 2016. Our obligations to BAM are secured by a security interest in substantially all of our assets. DMRJ and Montsant agreed to subordinate their security interest in all of our assets to the security interest held by BAM (See Note 13).-

~~Our~~timely ~~obligations~~manner, towhich ~~DMRJ~~could ~~are~~delay ~~secured~~the byaccomplishment ~~security~~of ~~interests~~our inobjectives. Alternatively, ~~substantially~~we ~~all~~may dispose of ~~our~~a business or assets. Asat ofa ~~March~~price ~~31,~~or ~~2016,~~on ~~our~~terms ~~obligations~~that toare ~~DMRJ~~less ~~under~~than ~~each~~we ofanticipated. After reaching an agreement with a buyer or seller, the ~~three~~acquisition ~~promissory~~or ~~notes~~sale ~~and~~of a ~~revolving~~business, ~~line~~such as the proposed sale of ~~credit~~the ~~approximated~~ETD ~~$18,970,000,~~business ~~$17,523,000,~~or $1a potential acquisition,~~000,000~~ may be subject to regulatory and ~~$17,662,000,~~governmental ~~respectively.~~approval ~~Further,~~and asthe satisfaction of ~~March~~pre-closing 31conditions, ~~2016,~~which ~~our~~may ~~obligation~~prevent us from completing the transaction. We may not have the resources to ~~DMRJ~~successfully ~~for~~conclude ~~accrued~~an ~~interest~~acquisition. ~~under~~The ~~these~~sale ~~instruments~~of ~~approximated~~a $4business or assets may involve guarantees,~~603,000~~ ~~and~~indemnities isor ~~included~~other infinancial ~~accrued~~obligations. Under ~~expenses~~these inarrangements, the ~~condensed~~performance ~~consolidated~~of the divested business or other conditions outside of our control could affect our future financial ~~statements~~results.

AsOur ofsecured ~~May~~borrowings 6,matured ~~2016,~~on ~~our~~October ~~principal obligations to DMRJ under each of the three promissory notes and a revolving line of credit approximated $18~~30,~~970,000,~~ ~~$17,523,000,~~2016 ~~$1,000,000~~ and ~~$17,662,000,~~October ~~respectively. Further~~31, ~~as of May 6,~~ 2016~~, our obligation to DMRJ for accrued interest under these instruments approximated $4,883,000~~.

AsAll of ~~March~~our ~~31,~~borrowings ~~2016~~from DMRJ and ~~May~~Montsant under 6(i) a senior secured promissory note dated July 1, ~~2016~~2009 with DMRJ, ~~our~~(ii) ~~principal~~a ~~obligations~~credit agreement dated September 4, 2009 with DMRJ, (iii) to Montsant under aan amended and restated senior secured convertible promissory note ~~approximated~~dated ~~$5,284,000.~~March ~~Further~~12, as2009 of(the “March 312009 Note”), ~~2016~~(iv) ~~and~~to ~~May~~DMRJ 6,under ~~2016~~a senior secured convertible promissory note dated September 5, ~~our~~2012 ~~obligation~~(the to“September ~~Montsant~~2012 ~~for~~Note”) ~~accrued~~and ~~interest~~(v) to DMRJ under ~~this~~a ~~instrument~~senior ~~was~~secured ~~$0.~~convertible promissory note dated February 28, 2013 (the “February 2013 Note”) matured on October 31, 2016.

Our ~~obligations~~secured toborrowings ~~the~~from ~~investors~~a ~~are~~group ~~secured~~of byinstitutional ~~security~~investors ~~interests~~for inwhich ~~substantially~~BAM ~~all~~Administrative ofServices ~~our~~LLC ~~assets.~~(“BAM”) Asacts ofas ~~March~~administrative ~~31,~~agent ~~2016,~~matured ~~our~~on ~~principal~~October ~~obligations~~30, ~~under~~2016 ~~the~~and ~~senior~~our secured ~~promissory~~borrowings ~~notes~~with ~~for~~DMRJ ~~which~~and ~~BAM~~Montsant, ismatured ~~the~~on ~~agent~~October ~~were $20~~31,~~000,000~~ 2016. ~~Further,~~DMRJ asand ofMontsant ~~March~~agreed ~~31,~~to ~~2016,~~subordinate ~~our~~their ~~obligation~~security ~~under~~interest ~~such~~in ~~notes~~all ~~for~~of ~~accrued~~our ~~interest~~assets ~~amounted~~ to ~~approximately~~the ~~$1,600,000~~security ~~and~~interest isheld ~~included~~by inBAM ~~accrued~~(See ~~expenses~~Note in12 to the condensed consolidated financial statements).

AsThe payment of ~~May 6, 2016,~~ our ~~principal~~indebtedness ~~obligations~~to ~~under~~DMRJ, ~~the~~Montsant ~~senior~~and ~~secured~~BAM ~~promissory~~are ~~notes~~stayed ~~for~~pending ~~which BAM is~~ the ~~agent~~conclusion ~~were $20,000,000. Further, as~~ of ~~May~~the 6,bankruptcy ~~2016, our obligation under such notes for accrued interest amounted to approximately $1,920,000~~proceedings.

IfOur weobligations to DMRJ are ~~unable~~secured toby ~~repay~~a ~~these~~security ~~amounts~~interests asin ~~required~~substantially all of our assets. As of September 30, ~~refinance~~2016, our obligations to DMRJ, ~~BAM~~under ~~and~~each ~~Montsant~~of orthe ~~negotiate~~three ~~extensions~~promissory notes and a revolving line of ~~these~~credit ~~obligations~~approximated $11,970,000, ~~DMRJ~~$17,523,000, ~~BAM~~$1,000,000 and ~~Montsant~~$17,662,000, ~~may~~respectively. ~~seize~~Further, ~~our~~as ~~assets~~of ~~and~~September we30, ~~may~~2016, beour ~~forced~~obligation to ~~file~~DMRJ for ~~protection~~accrued interest under ~~bankruptcy~~these ~~laws~~instruments approximated $7,282,000 and tois ~~curtail~~included orin ~~discontinue~~current ~~operations~~liabilities ~~entirely~~in the condensed consolidated financial statements.

~~Pursuant~~As toof ~~our~~September ~~amended~~30, ~~credit~~2016, ~~instruments~~our ~~with~~obligations ~~DMRJ,~~to Montsant ~~and~~under ~~BAM~~a ~~all~~promissory ofnote ~~our~~approximated ~~indebtedness~~$5,284,000. ~~shall~~Further, ~~become~~as ~~immediately~~of ~~due~~September ~~and~~30, ~~payment~~2016, ifour weobligation ~~receive~~to anMontsant ~~offer~~for ~~from~~accrued ~~another~~interest ~~person~~under ~~with~~this ~~respect~~instrument toapproximated awas ~~Major Transaction~~$203,000.

~~All~~As ~~outstanding~~of ~~amounts~~December ~~due~~9, 2016, our obligations to DMRJ, ~~Montsant~~under ~~and~~each ~~BAM~~of ~~shall~~the bethree ~~immediately~~promissory ~~due~~notes and ~~payable if (~~a) werevolving ~~receive~~line anof ~~offer~~credit ~~from~~approximated ~~another person or entity with respect to a Major Transaction~~$11, ~~(b) DMRJ~~970,000, ~~Montsant or BAM notifies us that such offer is satisfactory to DMRJ~~$17,523,000, ~~Montsant or BAM (in their sole discretion)~~$1,000,000 and ~~(c)~~$17,662,000, ~~either~~respectively. ~~(i)~~Further, ~~our~~as ~~Board~~ of ~~Directors~~December ~~does~~9, ~~not~~2016, ~~approve~~our ~~such~~obligation ~~transaction~~to ~~within~~DMRJ ~~ten~~for ~~(10)~~accrued ~~days~~interest ofunder ~~our~~these ~~receipt~~instruments ofapproximated ~~such notice from DMRJ~~$8, ~~Montsant or BAM~~687,000. ~~(ii)~~Please ifrefer ~~such~~to ~~transaction~~Note is14 ~~subject~~ to ~~stockholder~~the ~~approval,~~condensed weconsolidated dofinancial ~~not~~statements ~~file~~for a ~~preliminary~~discussion ~~proxy~~of ~~statement with~~ the ~~SEC~~August ~~within~~2016 ~~fifteen~~conversions ~~(15) days~~ of ~~the~~principal ~~receipt~~indebtedness ofby ~~such notice from~~ DMRJ~~, Montsant or BAM or (iii) if such transaction is subject to stockholder approval, our stockholders do not approve such transaction within ninety~~ .

-As 41of -December 9, 2016, our obligations to Montsant under a promissory note approximated $5,284,000. Further, as of December 9, 2016, our obligation to Montsant for accrued interest under this instrument approximated $328,000.

~~(90)~~Our ~~days~~obligations to a group of ~~the receipt~~institutional investors for which BAM acts as administrative agent are secured by security interests in substantially all of ~~such~~our ~~notice~~assets. ~~from~~As ~~DMRJ~~of September 30, ~~Montsant~~2016, orour obligations under the senior secured promissory notes for which BAM, ~~that~~is wethe ~~shall~~agent bewere ~~obligated~~$20,000,000. toFurther, ~~immediately~~as ~~forward~~of toSeptember ~~DMRJ~~30, ~~Montsant~~2016, orour ~~BAM any~~obligation ~~offer~~under ~~that~~such wenotes ~~receive~~for ~~with~~accrued ~~respect~~interest amounted to ~~any~~approximately ~~Major~~$3,200,000 ~~Transaction.~~and is included in current liabilities in the condensed consolidated financial statements

WeAs ~~will~~of ~~require~~December ~~additional~~9, ~~capital~~2016, toour ~~fund~~obligations ~~operations~~under ~~and~~the ~~continue~~senior ~~the~~secured ~~development,~~promissory ~~commercialization~~notes ~~and~~for ~~marketing~~which ofBAM ~~our~~is ~~product~~the agent were $20,000,000. ~~Our~~Further, ~~failure~~as toof ~~raise~~December ~~capital~~9, ~~could~~2016, ~~have~~our aobligation ~~material~~under ~~adverse~~such ~~effect~~notes onfor ~~our~~accrued ~~business~~interest amounted to approximately $3,802,000.

~~Management~~If ~~continually~~we ~~evaluates~~are ~~operating~~unable ~~expenses and plans~~ to ~~increase~~sell ~~sales~~our ~~and~~business ~~increase~~to ~~cash~~L-3 ~~flow~~which ~~from~~will ~~operations.~~enable ~~Despite~~us ~~our~~to ~~current~~repay ~~sales,~~these ~~expense~~amounts ~~and~~as ~~cash flow projections and $1~~required,~~582,000~~ inrefinance ~~cash available from~~ our ~~line~~obligations ofto ~~credit with~~ DMRJ, atMontsant ~~May 6, 2016, to fund our operations~~ and/or ~~continue~~ the ~~development~~other institutional investors, ~~commercialization~~or ~~and~~negotiate ~~marketing~~extensions of ~~our~~these ~~products~~obligations, ~~will require that we extend our credit facilities with~~ DMRJ, ~~BAM~~Montsant and/or ~~Montsant.~~BAM ~~There~~or ~~can~~reorganize bethe noCompany ~~assurance~~in ~~that~~Bankruptcy ~~DMRJ~~and ~~will~~have ~~continue~~a toreorganization ~~make~~Plan ~~advances~~approved ~~under~~by ~~our~~the ~~revolving~~Bankruptcy ~~line~~Court, ~~of credit. Our failure to achieve~~ our ~~projections~~creditors ~~and/or~~may ~~obtain~~seize ~~sufficient additional capital on acceptable terms would have a material adverse effect on~~ our ~~liquidity~~assets and ~~operations~~we ~~and~~may ~~could~~be ~~require~~forced us to file ~~for~~amend ~~protection~~our voluntary petition under bankruptcy laws. ~~These~~from ~~conditions~~Chapter ~~raise~~11 ~~substantial doubt as~~ to ~~our~~Chapter ~~ability~~7 and to ~~continue~~curtail asor adiscontinue ~~going~~operations ~~concern~~entirely.

Management continually evaluates operating expenses and plans to increase sales and increase cash flow from operations. Despite our projected sales, expense and cash flow projections and the cash available from our New DIP

- 46 -

Loan, we may not have sufficient capital to continue our operations. There can be no assurance that DMRJ will continue or is able to make advances under our revolving line of credit. Our failure to achieve our projections, to obtain sufficient additional capital on acceptable terms or successfully complete the sale of our ETD business to L-3 would have a material adverse effect on our liquidity and operations and could require us to file for protection under Chapter 7 of the U.S. bankruptcy laws. Furthermore, we are incurring increased legal costs and financial adviser costs associated with the activities of the Official Committee of Equity Holders appointed by the U.S. Trustee. These conditions raise substantial doubt as to our ability to continue as a going concern.

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

~~During~~On ~~the~~August ~~three months ended March 31~~19, 2016, we issued 330,000 shares of our common stock, having a value of ~~approximately~~ $~~248~~139,000, to two advisors, in consideration of services rendered to us under ~~two~~ advisory and consulting services agreements. The issuance of these shares was exempt from registration under the Securities Act pursuant to an exemption provided by Section 4(2) of the Securities Act.

-On 42September -26, 2016, we issued 160,000 shares of our common stock, having a value of $64,000, to three consultants, in consideration of services rendered to us under advisory and consulting services agreements. The issuance of these shares was exempt from registration under the Securities Act pursuant to an exemption provided by Section 4(2) of the Securities Act.

Between August 16, 2016 and August 23, 2016, DMRJ converted $7,000,000 of principal under the September 2012 Note into 7,000 shares of our Series H Convertible Preferred Stock.

- 47 -

Item 6.

Exhibits

Exhibit No.		Description
3.1		Articles of Amendment to the Restated Articles of Organization of Implant Sciences Corporation, adopted April 6, 2016 (incorporated herein by reference to Exhibit 3.1 to Implant Sciences Corporation’s Current Report on Form 8-K dated April 8, 2016 and filed on April 8, 2016).
2.1		Asset Purchase Agreement, dated as of October 10, 2016, by and among Implant Sciences Corporation, C Acquisition Corp., Accurel Systems International Corporation, IMX Acquisition Corp. and L-3 Communications Corporation (incorporated herein by reference to Exhibit 2.1 to Implant Sciences Corporation’s Current Report on Form 8-K dated October 10, 2016 filed October 10, 2016).
10.1		Consent and Second Omnibus Amendment to Secured Term Notes, dated as of April 6, 2016 and effective March 31, 2016, between Implant Sciences Corporation, the Guarantors named therein, certain Investors and BAM Administrative Services, LLC, as Agent (incorporated herein by reference to Exhibit 10.1 to Implant Sciences Corporation’s Current Report on Form 8-K dated April 8, 2016 and filed on April 8, 2016).
2.2		Amendment No. 1 to Asset Purchase Agreement, dated as of October 20, 2016, by and among Implant Sciences Corporation, C Acquisition Corp., Accurel Systems International Corporation, IMX Acquisition Corp. and L-3 Communications Corporation (incorporated herein by reference to Exhibit 2.1 to Implant Sciences Corporation’s Current Report on Form 8-K dated October 28, 2016 filed November 4, 2016).
10.2		Omnibus Fourteenth Amendment to Credit Agreement and Sixteenth Amendment to Note and Warrant Purchase Agreement, dated as of April 6, 2016 and effective March 31, 2016, among Implant Sciences Corporation, the Guarantors named therein, DMRJ Group LLC and Montsant Partners LLC (incorporated herein by reference to Exhibit 10.2 to Implant Sciences Corporation’s Current Report on Form 8-K dated April 8, 2016 and filed on April 8, 2016).
2.3		Amendment No. 2 to Asset Purchase Agreement, dated as of October 28, 2016, by and among Implant Sciences Corporation, C Acquisition Corp., Accurel Systems International Corporation, IMX Acquisition Corp. and L-3 Communications Corporation (incorporated herein by reference to Exhibit 2.2 to Implant Sciences Corporation’s Current Report on Form 8-K dated October 28, 2016 filed November 4, 2016).
10.3		Comfort Letter, dated March 31, 2016, between the Company, DMRJ Group LLC and Montsant Partners LLC (incorporated herein by reference to Exhibit 10.4 to Implant Sciences Corporation’s Current Report on Form 8-K dated April 8, 2016 and filed on April 8, 2016).
10.1		Senior Secured, Super-Priority Debtor-in-Possession Loan and Security Agreement, dated as of October 10, 2016, by and among Implant Sciences Corporation, C Acquisition Corp., Accurel Systems International Corporation, IMX Acquisition Corp. and DIP SPV I, L.P. (incorporated herein by reference to Exhibit 10.1 to Implant Sciences Corporation’s Current Report on Form 8-K dated October 10, 2016 filed October 10, 2016).
10.4		First Amendment to Accounts Receivable Purchase Agreement, dated as of April 11, 2016, between Implant Sciences Corporation and Republic Capital Access, LLC.
10.2		First Amendment to Senior Secured, Super-Priority Debtor-in-Possession Loan and Security Agreement, dated as of November 3, 2016, by and among Implant Sciences Corporation, C Acquisition Corp., Accurel Systems International Corporation, IMX Acquisition Corp. and DIP SPV I, L.P. (incorporated herein by reference to Exhibit 10.1 to Implant Sciences Corporation’s Current Report on Form 8-K dated October 28, 2016 filed November 4, 2016).
10.3		Senior Secured, Super-Priority Debtor-in-Possession Loan and Security Agreement, dated as of November 7, 2016, by and among Implant Sciences Corporation, C Acquisition Corp., Accurel Systems International Corporation, IMX Acquisition Corp. and Tannor Partners Credit Fund, LP (incorporated herein by reference to Exhibit 10.1 to Implant Sciences Corporation’s Current Report on Form 8-K dated November 7, 2016 filed November 14, 2016).
10.4*		Agreement between the Company and Robert Liscouski, dated October 8, 2016.
31.1		Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Certification of the Chief Executive Officer Pursuant to 18 U.S.C. 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.**
32.2		Certification of the Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.**
101.INS		XBRL Instance Document.
101.SCH		XBRL Taxonomy Extension Schema Document.
101.CAL		XBRL Taxomony Extension Calculation Linkbase Document.
101.LAB		XBRL Taxonomy Extension Label Linkbase Document.
101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document.
101.DEF		XBRL Taxonomy Extension Definition Linkbase Document.

Indicates a management contract of compensatory plan or arrangement.

In accordance with Item 601(b)(32)(ii) of Regulation S-K, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-Q and will not be deemed to be “filed” for purposes of Section 18 of the Exchange Act. Such certifications will not be deemed to be incorporated by reference into any filings under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.

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	*	Indicates a management contract or compensatory plan or arrangement.
	**	In accordance with Item 601(b)(32)(ii) of Regulation S-K, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-K and will not be deemed to be “filed” for purposes of Section 18 of the Exchange Act. Such certifications will not be deemed to be incorporated by reference into any filings under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	Implant Sciences Corporation
	By:	/s/ William J. McGann
		William J. McGann Chief Executive Officer (Principal Executive Officer)
	By:	/s/ Roger P. Deschenes
		Roger P. Deschenes Vice President, Finance and Chief Financial Officer (Principal Financial Officer and Chief Accounting Officer)
Dated: May 16, 2016
Dated: December 23, 2016

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