Quarterly Report (10-q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 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 June 30, 2014

Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from ____ to ____

Commission file number: 000-28238

APPLIED VISUAL SCIENCES, INC.

(Exact name of registrant as specified in its charter)


Delaware		54-1521616
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

525K East Market Street, # 116, Leesburg, Virginia 20176

(Address of principal executive offices and zip code)

(703) 539-6190

(Registrant’s telephone number, including area code)

Not Applicable

(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 ü No __

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, 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 ü 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 definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [ ] Smaller reporting company [ü]

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

At August 19, 2014, the Registrant had 103,977,612 shares of Common Stock, $0.001 par value, outstanding.

NOTE REGARDING FORWARD-LOOKING STATEMENTS

Our disclosure and analysis in this Report contains forward-looking statements which provide our current expectations or forecasts of future events. Forward-looking statements in this Report include, without limitation:

information concerning possible or assumed future results of operations, trends in financial results and business plans, including those related to earnings, earnings growth, revenue and revenue growth;

statements about the level of our costs and operating expenses relative to our revenues, and about the expected composition of our revenues;

statements about expected future sales trends for our products;

statements about our future capital requirements and the sufficiency of our cash, cash equivalents, and available bank borrowings to meet these requirements;

information about the anticipated release dates of new products;

other statements about our plans, objectives, expectations and intentions;

and other statements that are not historical fact.

Forward-looking statements generally can be identified by the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “intends, “plans,” “should,” “seeks,” “pro forma,” “anticipates,” “estimates,” “continues,” or other variations thereof (including their use in the negative), or by discussions of strategies, plans or intentions. Such statements include but are not limited to statements under Part I, Item 1A - Risk Factors of our Form 10-K for the year ended December 31, 2013, Part I, Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Report, and elsewhere in this Report. A number of factors could cause results to differ materially from those anticipated by such forward-looking statements, including those discussed under Part II, Item 1A - Risk Factors of this Report. The absence of these words does not necessarily mean that a statement is not forward-looking. Forward-looking statements are subject to known and unknown risks and uncertainties and are based on potentially inaccurate assumptions that could cause actual results to differ materially from those expected or implied by the forward-looking statements. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including factors described in Part I, Item 1A - Risk Factors of our Form 10-K for the year ended December 31, 2013, and Part II, Item 1A – Risk Factors of this Report. You should carefully consider the factors described in Part I, Item 1A - Risk Factors of our Form 10-K for the year ended December 31, 2013, and Part II, Item 1A – Risk Factors of this Report in evaluating our forward-looking statements.

You should not unduly rely on these forward-looking statements, which speak only as of the date of this Report. We undertake no obligation to publicly revise any forward-looking statement to reflect circumstances or events after the date of this Report, or to reflect the occurrence of unanticipated events. You should, however, review the factors and risks we describe in the reports we file from time to time with the Securities and Exchange Commission (“SEC”).

APPLIED VISUAL SCIENCES, INC.

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Condensed Consolidated Statements of Operations and Comprehensive Income

Condensed Consolidated Statements of Cash Flows

Notes to Condensed Consolidated Financial Statements

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 21

CONSOLIDATED RESULTS OF OPERATIONS

LIQUIDITY AND CAPITAL RESOURCES

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

ITEM 4. CONTROLS AND PROCEDURES

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

ITEM 1A. RISK FACTORS

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

ITEM 3. DEFAULT UNDER OUR SERIES A DEBENTURES

ITEM 5. OTHER INFORMATION

ITEM 6. INDEX TO EXHIBITS

SIGNATURES

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CONDENSED CONSOLIDATED BALANCE SHEETS


APPLIED VISUAL SCIENCES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS

		June 30	December 31
		2014	2013
		(Unaudited)
ASSETS
Current Assets
	Cash	$ 10,753	$ 1,108
	Prepaid expenses	8,098	1,115
	Total current assets	18,851	2,223

Fixed Assets, net		37,688	55,018

Other Assets
	Intangible assets, net	303,790	315,855
	Total assets	$ 360,329	$ 373,096

LIABILITIES AND STOCKHOLDERS' (DEFICIT)
Current Liabilities
	Accounts payable	$ 1,732,024	$ 1,689,147
	Accrued wages and related	8,492,878	8,099,945
	Other accrued liabilities	187,937	144,579
	Notes payable and advances, related parties	80,500	80,500
	Notes payable, net of discount	767,471	718,930
	Convertible debentures	2,025,846	2,025,846
	Derivative liabilities	270,113	540,226
	Total current liabilities	13,556,769	13,299,173

Stockholders' (Deficit)
	Convertible preferred stock, $0.20 par value; authorized 1,000,000 shares
	Shares issued and outstanding at June 30, 2014 - none
	Shares issued and outstanding at December 31, 2013 - none	-	-
	Common stock, $0.001 par value; authorized 200,000,000 shares
	Shares issued and outstanding at June 30, 2014 - 103,327,612
	Shares issued and outstanding at December 31, 2013 - 102,531,612	103,328	102,532
	Additional paid-in capital	82,890,251	82,856,886
	Accumulated comprehensive income	63,354	63,354
	Accumulated deficits	(96,253,373)	(95,948,849)
	Total stockholders' (deficit)	(13,196,440)	(12,926,077)
	Total liabilities and stockholders' (deficit)	$ 360,329	$ 373,096

See notes to condensed consolidated financial statements.

Condensed Consolidated Statements of Operations and Comprehensive Income


APPLIED VISUAL SCIENCES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME



	Three Months Ended		Six Months Ended
	June 30		June 30
	2014	2013	2014	2013

Net revenues	$ -	$ -	$ -	$ -

Cost of sales	-	-	-	-

Gross profit	-	-	-	-

Selling, general and administrative expense	232,234	631,813	515,738	1,237,126

Operating loss	(232,234)	(631,813)	(515,738)	(1,237,126)

Other income (expense)
Gain (loss) on disposal of fixed asset	-	-	-	8,338
Interest expense	(24,913)	(17,814)	(43,358)	(35,243)
Debt discount amortization	(5,537)	(61)	(15,541)	(3,063)
Financing costs	-	-	-	(225)
Reevaluation of derivative liabilities	135,056	(270,113)	270,113	(337,641)
Other income (expense)	104,606	(287,988)	211,214	(367,834)

Net loss before income taxes	(127,628)	(919,801)	(304,524)	(1,604,960)
Provision for income taxes	-	-	-	-

Net loss	$ (127,628)	$ (919,801)	$ (304,524)	$(1,604,960)

Net loss per common share
Basic	$ (0.00)	$ (0.01)	$ (0.00)	$ (0.02)

Weighted average common shares outstanding
Basic	103,138,601	101,026,612	102,948,463	100,322,940

Comprehensive income
Comprehensive income - beginning of period	$ 63,354	$ 63,354	$ 63,354	$ 63,354
Cumulative translation adjustments	-	-	-	-

Comprehensive income - end of period	$ 63,354	$ 63,354	$ 63,354	$ 63,354

See notes to condensed consolidated financial statements.

Condensed Consolidated Statements of Cash Flows


APPLIED VISUAL SCIENCES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


	Six Months Ended June 30
	2014	2013
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss	$ (304,524)	$ (1,604,960)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization	29,395	37,368
Amortization of debt discounts	15,541	3,063
Stock-based compensation expense	10,279	514,337
Revaluation derivative instrument (income) expense	(270,113)	337,641
(Gain) / loss on disposal of fixed assets	-	(8,338)
Changes in operating assets and liabilities:
Decrease (increase) in prepaid expenses	(6,983)	(1,770)
Decrease in other noncurrent assets	-	11,122
Increase in accounts payable	42,877	44,850
Increase in accrued wages and related	416,815	481,924
Increase in other accrued liabilities	43,358	35,244
Net cash flows used in operating activities	(23,355)	(149,519)

CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sale of fixed assets and intangible assets, net of additions	-	28,934
Net cash provided by investing activities	-	28,934

CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from short-term notes payable, net	33,000	135,000
Reduction of short-term notes payable, net of additional notes, related party	-	(8,500)
Net cash flows provided by financing activities	33,000	126,500

Net increase in cash	9,645	5,915
Cash at beginning of the period	1,108	3,445
Cash at end of the period	$ 10,753	$ 9,360

Supplemental disclosure of cash flow information:
Cash items paid during the period:
Interest expense	$ -	$ -
Income taxes	-	-
Noncash items during the period:
Conversion of accounts payable to common stock	-	5,150
Conversion of accrued wages to common stock	-	25,000
Conversion of accrued wages for exercise of employee stock options	23,880	-

See notes to condensed consolidated financial statements.

Notes to Condensed Consolidated Financial Statements

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(1)

Description of Business

Overview

Applied Visual Sciences, Inc. was incorporated under the name Guardian Technologies International, Inc., in the Commonwealth of Virginia in 1989 and reincorporated in State of Delaware in February 1996. We changed our name to Applied Visual Sciences, Inc., on July 9, 2010. The Company, previously an operating stage company, became a development stage company on April 1, 2012. Applied Visual Sciences, Inc. and its subsidiaries are collectively referred to herein as the “Company,” “Applied Visual Sciences, Inc.,” “Applied Visual,” “us,” “we,” or “our.”

Applied Visual Sciences is a software technology company that designs and develops imaging informatics solutions for delivery to its target markets, aviation/homeland security and healthcare. Our two product lines are offered through our two operating subsidiaries as follows: Guardian Technologies International, Inc. for aviation/homeland security products, and Signature Mapping Medical Sciences, Inc., for healthcare, which has a wholly owned subsidiary Instasis Imaging, Inc., for the development, marketing, and sales of a suite of imaging analytic applications for the automated detection of breast cancer. We may engage in one or more acquisitions of businesses that are complementary, and may form wholly-owned subsidiaries to operate within defined vertical markets products.

The Company utilizes imaging technologies and analytics to create integrated information management technology products and services that address critical problems experienced by corporations and governmental agencies in healthcare and homeland security. Each product and service can improve the quality and response time of decision-making, organizational productivity, and efficiency within the enterprise. Our product suite integrates, streamlines, and distributes business and clinical information and images across the enterprise.

Our Business Strategy

Our strategic vision is to position our core technology as the de facto standard for digital image analysis, knowledge extraction, and detection. Our strategy is based upon the following principal objectives:

Maintain product development and sales/marketing focus on large, underserved, and rapidly growing markets with a demonstrated need for intelligent imaging informatics.

Leverage Applied Visual Sciences, Inc.’s technology, experienced management team, research and development infrastructure.

Focus our talents on solving highly challenging information problems associated with digital imaging analysis.

Establish an international market presence through the development of a significant OEM/Reseller network.

Build and maintain a strong balance sheet to ensure the availability of capital for product development, acquisitions, and growth.

Seek to broaden our investment appeal to large institutions.

To achieve our strategic vision, we are aware of the need to exercise the financial and operational discipline necessary to achieve the proper blend of resources, products and strategic partnerships. These efforts can accelerate our ability to develop, deploy and service a broad range of intelligent imaging informatics solutions directly to our target markets and indirectly through OEM/value added reseller (“VAR”) partners. During 2014, we continued implementing changes across the spectrum of our business. We refined our marketing strategy for PinPoint™ and Signature Mapping™, and enhanced our Signature Mapping™ product offerings.

We may engage in one or more acquisitions of businesses that are complementary, and may form wholly-owned subsidiaries to operate within defined vertical markets.

Our Core Technology

Our core technology is an “intelligent imaging informatics” (“3i™”) engine that is capable of extracting embedded knowledge from digital images, and has the capacity to analyze and detect image anomalies. The technology is not limited by type of digital format. It can be deployed across divergent digital sources such as still images, x-ray images, video and hyper-spectral imagery. To date, the technology has been tested in the area of threat detection for baggage scanning at airports, for bomb squad applications and the detection of tuberculosis by analyzing digital images of stained sputum slides captured through a photo microscopy system. Varying degrees of research and development have been conducted in the areas of detection for cargo scanning, people scanning, military target acquisition in a hyper-spectral environment, satellite remote sensing ground surveys and mammography CAD products and

radiologists’ diagnostic imaging tools, and while product development in these areas is ongoing, there can be no assurance that we will successfully develop product offerings in these areas.

We are currently focused on providing software technology solutions and services in two primary markets - aviation/homeland security with PinPoint™ and healthcare technology with Signature Mapping™ solutions. However, as new or enhanced solutions are developed, we expect to expand into other markets such as military and defense utilizing hyper-spectral technology, and imaging diagnostics for the medical industry.

(2)

Basis of Presentation

The unaudited condensed consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). The accompanying unaudited condensed consolidated financial statements do not include complete footnotes and financial statement presentations. As a result, these unaudited condensed consolidated financial statements should be read along with the audited consolidated financial statements and notes thereto for the year ended December 31, 2013, included in our 2013 Annual Report on Form 10-K. In our opinion, the unaudited condensed consolidated financial statements reflect all adjustments, including normal recurring adjustments, necessary for a fair presentation of the financial position, results of operations and cash flows for those periods presented. The preparation of financial statements in conformity with United States (U.S.) generally accepted accounting principles requires management to make estimates and assumptions that affect reported assets, liabilities, revenues and expenses, as well as disclosure of contingent assets and liabilities. Actual results could differ from those estimates and assumptions. Moreover, the results of operations for the interim periods presented are not necessarily indicative of the results that may be expected for the entire year.

The Company maintains a website at www.appliedvs.com, which makes available free of charge our recent annual report and other filings with the SEC. In addition to its website, the Company also disseminates material non-public information on Facebook at https://www.facebook.com/appliedvs and on Twitter at https://mobile.twitter.com/appliedvs.

These unaudited condensed consolidated financial statements have been prepared assuming that the Company will continue as a going concern and, accordingly, do not include any adjustments that might result from the outcome of this uncertainty. Our independent registered public accounting firm’s reports on the consolidated financial statements included in our annual report on Form 10-K for the year ended December 31, 2013, contains an explanatory paragraph wherein it expressed an opinion that there is substantial doubt about our ability to continue as a going concern. Accordingly, careful consideration of such opinion should be given in determining whether to continue or become our stockholder.

Summary of Significant Accounting Policies

Development Stage Company

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries, Guardian Technologies International, Inc., Signature Mapping Medical Sciences, Inc., Instasis Imaging, Inc., RJL Marketing Services, Guardian Healthcare Systems UK, Ltd., and Wise Systems Ltd., in which it has the controlling interest. Subsidiaries acquired are consolidated from the date of acquisition. All significant intercompany balances and transactions have been eliminated. Certain amounts in the consolidated financial statements of prior periods have been reclassified to conform to current period presentation.

Estimates

The preparation of these consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements. Changes in these estimates and assumptions may have a material impact on the consolidated financial statements. Certain estimates and assumptions are particularly sensitive to change in the near term, and include estimates of net realizable value for long-lived and intangible assets, the valuation allowance for deferred tax assets and the assumptions used for measuring stock-based payments and derivative liabilities.

The Company reviews the terms of convertible debt and equity securities for indications requiring bifurcation, and separate accounting, for the derivative liability feature. Under guidelines of ASC 815-40, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock,” public companies that are required, or that could be required, to deliver shares of common stock as part of a physical settlement or a net-share settlement, under a freestanding financial instrument, are required to initially measure the contract at fair value (or allocate on a fair value basis if issued as part of a debt financing), and report the value in permanent equity. However, in certain circumstances (e.g. the company could not ascertain whether sufficient authorized shares exist to settle the contract), permanent equity classification should be reassessed. The classification of the contract as permanent equity should be reassessed at each balance sheet date and, if necessary, reclassified as a liability on the date of the event causing the reclassification. If a reclassification occurs from permanent equity to a liability, the fair value of the financial instrument should be removed from permanent equity as an adjustment to stockholders’ deficit. Any portion of the contract that could be net-share settled as of the balance sheet date would remain classified in permanent equity. Subsequent to the initial reclassification event, changes in fair value of the instrument are charged to expense until the conditions giving rise to the reclassification are resolved. When a company has more than one contract subject to reclassification, it must determine a method of reclassification that is systematic, rational, and consistently applied. The Company adopted a reclassification policy that reclassifies contracts with the latest inception date first. To the extent that changes in fair value of equity instruments relates to financings since November 8, 2006 (the date of first closing under the debenture financing with reset provisions that made the number of potentially issuable shares indeterminable), the increase or decrease in the fair value of the warrants is charged or credited to interest expense. To the extent the equity instruments relate to other transactions (e.g. consulting expense), the increases or decreases are charged or credited based on the nature of the transaction. The number of additional shares potentially issuable under the November 8, 2006, outstanding convertible debentures and related outstanding warrants and other subsequent warrants issued was determinable as of the debentures’ final milestone reset date on May 20, 2008, and, therefore, the outstanding fair value of the warrants issued to the debenture holders, other subsequent warrants issued through May 20, 2008, and the warrants’ related beneficial conversion feature were reclassified as stockholders’ deficit in accordance with currently effective generally accepted accounting principles.

Reclassifications

Certain reclassifications of previously reported amounts have been made to conform to the current period presentation. These classifications had no effect on the previously reported net loss.

Segment Data and Related Information

ASC 280-10, “Disclosures about Segments of an Enterprise and Related Information,” establishes standards for the manner in which public companies report information about operating segments in annual and interim financial statements. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. The method for determining what information to report is based on the way management organizes the operating segments within the Company for making operating decisions and assessing financial performance. The Company’s chief operating decision-maker is considered to be the Company’s chief executive officer (“CEO”). The CEO reviews financial information presented on an entity level basis accompanied by disaggregated information about revenues by product type and certain information about geographic regions for purposes of making operating decisions and assessing financial performance. The entity level financial information is identical to the information presented in the accompanying consolidated statements of operations.

The Company has two groups of products and services - Security (PinPoint™) and Healthcare (Signature Mapping™ Medical Computer Aided Detection (“Medical CAD”)). The Company has determined that as a result of no revenue generated for the six months ended June 30, 2014 and 2013, we operate under one business unit in The America’s, and have pursued one product line, Healthcare’s Tuberculosis Detection (“TBDx™”) software in Africa.

Stock-Based Compensation

The Company has two active equity compensation plans which include the Amended and Restated 2003 Stock Incentive Plan and the 2009 Stock Compensation Plan (collectively, the “Plans”). A total of 50,000,000 shares were reserved for issuance under these Plans in the form of stock-based awards to employees, non-employee directors and outside consultants of the Company, of which 185,000 shares remain available for issuance thereunder as of June 30, 2014. The grant of awards under the Plans require approval by the Compensation Committee of the Board of Directors of the Company (or the Board of Directors, in the absence of such a committee) (the “Committee”), and the Committee is authorized under the Plans to take all actions that it determines to be necessary or appropriate in connection with the administration of the Plans.

The Company adopted the provisions of ASC 718-10, “Share-Based Payment” to account for its share-based payments. ASC 718-10 requires all share-based payments to employees, or to non-employee directors as compensation for service on the Board of Directors, to be recognized as compensation expense in the consolidated financial statements based on the estimated fair values of such options as calculated using the Black-Scholes model, and the related expense is recognized on a straight-line basis over the service period to vesting for each grant, net of estimated forfeitures. The Company’s estimated forfeiture rates are based on its historical experience within separate groups of employees. In accordance with ASC 718-10, the Company recognized total stock-based compensation expense for employees and non-employee members of the Board of Directors for the six months ended June 30, 2014 and 2013, of $10,279, and $508,837, respectively.

The Company accounts for stock options granted to non-employees in accordance with ASC 718-10 and ASC 505-50, “Accounting For Equity Instruments That Are Issued To Other Than Employees For Acquiring, Or In Conjunction With Selling, Goods Or Services.” ASC 505-50 establishes the measurement principles for transactions in which equity instruments are issued in exchange for the receipt of goods or services. The Company has relied upon the guidance provided under ASC 505-50 to determine the measurement date and the fair value re-measurement principles to be applied, and recognizes as an expense the estimated fair value of such options as calculated using the Black-Scholes model. The fair value is remeasured during the service period at each balance sheet date, and is amortized over the remaining service period to vesting for each option or the remaining term of the recipient’s contractual arrangement, whichever is shorter. The Company recognizes compensation costs, net of an estimated forfeiture rate, on a pro rata basis over the requisite service period of each vesting tranche of each award. The Company considers voluntary termination behavior as well as trends of actual option forfeitures when estimating the forfeiture rate. Total stock-based compensation expense for consultants during the six months ended June 30, 2014, and 2013 was $0, and $5,500, respectively.

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are not transferable. The fair value of each option granted was estimated on the date of grant using the Black-Scholes Merton option pricing model (Black-Scholes model) with the following weighted-average assumptions.


Black-Scholes Model Assumptions		2014	2013
Risk-free interest rate (1)		2.48%	0.66%
Expected volatility (2)		184.8%	189.1%
Dividend yield (3)		0.0%	0.0%
Expected life (4)		7.2 years	4.5 years

(1)	The risk-free interest rate is based on US Treasury debt securities with maturities similar to the expected term of the option.
(2)	Expected volatility is based on historical volatility of the Company*s stock factoring in daily share price observations.
(3)	No cash dividends have been declared on the Companys common stock since the Companys inception, and the Company currently does not anticipate paying cash dividends over the expected term of the option.
(3)
(4)	The expected term of stock option awards granted is derived from historical exercise experience under the Company*s stock option plan and represents the period of time that stock option awards granted are expected to be outstanding. The expected term assumption incorporates the contractual term of an option grant, which is usually ten years, as well as the vesting period of an award, which is generally pro rata vesting over two years.

The Amended and Restated 2003 Stock Incentive Plan

The Board of Directors adopted the 2003 Stock Incentive Plan on August 29, 2003 and terminated on August 29, 2013. The termination of the plan does not affect the outstanding options granted without the consent of the optionee. The Board of Directors amended and restated the plan on December 2, 2003. The Amended and Restated 2003 Stock Incentive Plan (“2003 Plan”) was approved by the shareholders on February 13, 2004, pursuant to which it grants stock-based compensation in the form of options, which could result in the issuance of up to an aggregate of 30,000,000 shares of the Company’s common stock. The aggregate number of shares and the number of shares in an award (as well as the option price) may be adjusted if the outstanding shares of the Company are increased, decreased or exchanged through merger or other stock transaction. The Plan provides for options which qualify as Incentive Stock Options under Section 422 of the Internal Revenue Code of 1986, as well as the issuance of Non-Qualified Options, which do not so qualify. Pursuant to the terms of the 2003 Plan, the Company, as determined by the Board of Directors or a committee appointed by the Board, may grant Non-Qualified Stock Options (“NQSOs”) to its executive officers, non-employee directors, or consultants of the Company and its subsidiaries at any time, and from time to time. The 2003 Plan also provided for Incentive Stock Options (“ISOs”) to be granted to any officer or other employee of the Company or its subsidiaries at any time, and from time to time, as determined by the Compensation Committee. Such stock options granted allow a grantee to purchase a fixed number of shares of the Company’s common stock at a fixed exercise price not be less than the quoted market price (or 110% thereof for Incentive Stock Options issued to a holder of 10% or greater beneficial ownership) of the shares on the date granted. The options may vest on a single date or over a period of time, but normally they do not vest unless the grantee is still employed by, or a director of, the Company on the vesting date. Generally for all employees, the options vest 50% after the first year from the date of grant and the remaining 50% after the second year from the date of grant. Stock options granted to independent board of directors vest 100% after the service period, which generally is one year from the date of grant.

Factors considered in granting stock options included: (i) the general policy during the past five, and in the foreseeable future, of not increasing base salaries of all employees, (ii) the performance of employees, (iii) the employees’ increasing responsibilities in a dynamic, and shrinking organization, and (iv) the accomplishments achieved by the Company during the prior year. The 2003 Plan has been the principal method for our employees and executive officers to acquire equity interests in the Company. We believe that the annual aggregate value of these awards should be set near competitive median levels for comparable companies. We may provide a greater portion of total compensation to our executives and employees through stock options given the general policy of not increasing base salaries in the foreseeable future. Our Compensation Committee administers the 2003 Plan based on the above factors, and there were no stock options granted to employees during the six months ended June 30, 2014. The Compensation Committee, based on management’s recommendation and discussions with the Committee, may grant stock options to new employees. There were no stock options granted to new employees during the six months ended June 30, 2014, since there were no new employees hired during this period.

Options granted under the Plan must be evidenced by a stock option agreement in a form consistent with the provisions of the 2003 Plan. Each option shall expire on the earliest of (a) ten (10) years from the date it is granted, (b) sixty (60) days after the optionee dies or becomes disabled, (c) immediately upon the optionee's termination of employment or service or cessation of Board service, whichever is applicable, or (d) such date as the Committee shall determine, as set forth in the relevant option agreement; provided, however, that no ISO which is granted to an optionee who, at the time such option is granted, owns stock possessing more than ten (10) percent of the total combined voting power of all classes of stock of the Company or any of its subsidiaries, shall be exercisable after the expiration of five (5) years from the date such option is granted.

To exercise an option, the 2003 Plan participant, in accordance with the relevant option agreement, must provide the Company a written notice setting forth the number of options being exercised and their underlying shares, and tender an amount equal to the total exercise value of the options being exercised. The right to purchase shares is cumulative so that once the right to purchase any shares has vested; those shares or any portion of those shares may be purchased at any time thereafter until the expiration or termination of the option. ISOs and NQSOs that are not exercised in accordance with the terms and provisions of the stock option agreement, or as amended, will expire as to any then unexercised portion. Stock options that expire, are cancelled, or forfeited will again become available for issuance under the 2003 Plan as described below. The aggregate number of shares and the number of shares in an award (as well as the option price) may be adjusted if the outstanding shares of the Company are increased, decreased or exchanged through merger or other stock transaction. The shares issued by the Company under the 2003 Plan may be either treasury shares or authorized but unissued shares as the Company’s board of directors or the Compensation Committee may determine from time to time. Except as specifically provided in an option agreement, options granted under the 2003 Plan may not be sold, pledged, transferred or assigned in any way, except by will or by the laws of descent and distribution, and during the lifetime of a participant to whom the ISOs is granted, and the ISOs may only be exercised by the participant.

As of June 30, 2014, the Company has reserved under the 2003 plan 22,997,992 shares to be issued upon exercise of outstanding options granted to all employees, including its named executives, and 2,033,353 unissued options were cancelled upon termination of the 2003 Plan on August 29, 2013, making no shares of common stock that remain available for future awards. Compensation expense for stock options granted is recognized over the requisite service period, which is typically the period over which the stock-based compensation awards vest. Stock-based compensation expense recognized during the six months ended June 30, 2014 was $10,279, and $508,837 during he same period in 2013.

Stock Options Exercised under the 2003 Plan

During the six months ended June 30, 2014, the Company issued 796,000 shares of common stock to an employee who exercised 796,000 stock options, using accrued salaries. Common stock was increased by $796 for the par value of the shares, and paid-in capital was increased by $23,084, and accrued salaries were reduced by $23,880.

Summary of stock option activity under the 2003 Plan for the six months ended June 30, 2014 issued to employees, non-employee members of the Board of Directors and consultants is as follows:


Fiscal Year and Activity	Weighted- Average Exercise Price	Number of Options



Outstanding December 31, 2013	$ 0.14	25,422,347

Fiscal 2014 activity
Granted	-	-
Exercised	0.03	(796,000)
Cancelled	0.30	(1,628,355)
Outstanding June 30, 2014	0.14	22,997,992

Reserved for future issuance at June 30, 2014 (the 2003 Plan expired on August 29, 2013)		-

The following table summarizes additional information about the 2003 Plan stock options outstanding at June 30, 2014:


Issued and Outstanding				Exercisable
Type of Option and Range of Exercise Prices	Number of Options	Weighted-Average Remaining Contractual Life (Yrs)	Weighted-Average Exercise Price	Number of Options	Weighted-Average Price
Nonqualified Stock Options $0.30 (1) (4)	25,000	1.2	0.30	25,000	0.30
Incentive Stock Options $0.15 - $4.05 (2)	649,300	3.3	0.98	649,300	0.98
Incentive Stock Options $0.03 - $0.30 (3) (4)	22,323,692	7.1	0.11	22,323,692	0.11
Total	22,997,992	7.0	$ 0.14	22,997,992	$ 0.14

(1) Initially issued to directors below fair value during the period of February 2004 through September 2005.
(2) Issued to consultants at fair value.
(3) Issued to directors and employees at fair value, or above fair value for those individuals with greater than 10% beneficial ownership.
(4) The exercise price reflects the repricing of stock options as approved by the Compensation Committee on April 24, 2010, and subsequent issuances at fair value on date of grant.

The 2009 Stock Compensation Plan

On June 4, 2009, the Board of Directors adopted the 2009 Stock Compensation Plan (“2009 Plan) which provides for the grant or issuance of up to an aggregate of 20,000,000 shares of the Company’s common stock pursuant to non-qualified stock options (“NQSOs”), restricted stock awards (“RSAs”), restricted stock rights (“RSRs”), or common stock awards (“Common Stock Awards”) (a NQSO, RSA, RSR or Common Stock Award, individually, an “Award;” collectively, “Awards”). Our Board of Directors has delegated its authority to administer the 2009 Plan to the Compensation Committee. The exercise price of NQSOs may not be less than 100% of the fair market value of the stock on the date of the option grant, and may only be exercised at such times as may be specified by the Committee and provided for in an award agreement, but may not be exercised after ten years from the date on which it was granted. RSAs and RSRs consist of a specified number of shares of the Company’s Common Stock that are, or may be, subject to restrictions on transfer, conditions of forfeiture, and any other terms and conditions for periods determined by the Committee. Generally, unless the Committee determines otherwise, once the restricted stock vests, the shares of Common Stock specified in the Award will be free of restriction, subject to any applicable lock up period. Prior to the termination of the restrictions, under a RSA (but not a RSR), a participant may vote and receive dividends on the restricted stock unless the Committee determines otherwise, but may not sell or otherwise transfer the shares. Common Stock Awards under the plan may be issued free of restriction and may vest immediately; however, the Committee may impose vesting and other restrictions related to the grant of such common stock Awards. Compensation expense for these Awards is recognized over the period they vest, although generally Common Stock Awards vest immediately, while the RSAs, RSRs and NQSOs will have a vesting period.

The purpose of the 2009 Plan is to foster our success and the success of our subsidiaries and affiliates by providing incentives to employees, directors, officers and consultants to promote our long-term financial success. The Plan complements our 2003 Amended and Restated Stock Incentive Plan (the “2003 Plan”) and provides greater flexibility to us in that it permits us to compensate and award employees, directors, officers and consultants through the issuance of certain options, RSAs, RSRs, and stock awards in addition, or as an alternative, to the incentive and non-qualified stock options that may be awarded under the 2003 Plan. The 2009 Plan terminates on June 4, 2019, and no award may be made after that date, however, awards made before that date may extend beyond that date. If an award under the 2009 Plan is cancelled, expires, forfeited, settled in cash or otherwise terminates without being exercised in full, the shares of common stock not acquired pursuant to the award will again become available for issuance under the 2009 Plan. The Board may amend, terminate, or modify the 2009 Plan at any time, without shareholder approval, unless required by the Internal Revenue Code of 1986, pursuant to Section 16 under the Securities Exchange Act of 1934, as amended, or by any national securities exchange or system on which our common stock is then listed or reported, or by any regulatory body.

Subject to the provisions of the 2009 Plan, the Compensation Committee has the power to:

Prescribe, amend, and rescind rules and regulations relating to the 2009 Plan and to define terms not otherwise defined therein;

Determine which persons are eligible to participate, to which of such participants, if any, awards shall be granted, and the timing of any such awards;

Grant awards to participants and determine the terms and conditions thereof, including the number of shares subject to awards and the exercise or purchase price of such shares and the circumstances under which awards become exercisable or vested or are forfeited or expire;

Establish any performance goals or other conditions applicable to the grant, issuance, exercisability, vesting and/or ability to retain any award;

Prescribe and amend the terms of the agreements or other communications evidencing awards made under the 2009 Plan (which need not be identical) and the terms or form of any document or notice required to be delivered to us by participants under the 2009 Plan;

Determine the appropriate adjustment, if any, required as a result of any reorganization, reclassification, combination of shares, stock split, reverse stock split, spin-off or dividend (other than regular, quarterly cash dividends), or other changes in the number or kind of outstanding shares or any stock or other securities into which such shares shall have been exchanged;

Interpret and construe the 2009 Plan, any rules and regulations under the 2009 Plan and the terms and conditions of any award granted thereunder, and to make exceptions to any such provisions in good faith and for the benefit of the Company; and

Make all other determinations deemed necessary or advisable for the administration of the 2009 Plan.

Unless the Board expressly provides otherwise prior to a change of control or in an award agreement, in the event of a change of control of the Company, all outstanding options under the 2009 Plan vest and become exercisable on the date immediately before the change of control and all restrictions under RSAs and RSRs shall lapse or be deemed satisfied on the date immediately prior to the change of control. A change of control is deemed to have occurred upon the occurrence of one of the following events: (i) any person or group of persons becomes the beneficial owner of shares of the Company to which 50% or more of the total number of votes for the election of directors may be cast; (ii) as a result of a cash tender offer, exchange offer, merger or other business combination, sale of assets or contested election, persons who were directors immediately prior to the event cease to constitute a majority of the board; (iii) stockholders approve an agreement providing either that the Company will cease to be an independent publicly owned corporation or for sale or other disposition of all or substantially all the assets of the Company; or (iv) a tender offer or exchange offer is made for shares of our common stock (other than one made by us) and shares of common stock are acquired.

The Compensation Committee determines all awards to non-employee directors and such awards are not subject to management’s discretion. From time to time, the committee will set the amount and the type of award that will be granted to non-employee directors on a periodic, nondiscriminatory basis, including pursuant to any plan adopted by the Compensation Committee or Board for the compensation of non-employee directors. The committee may set additional awards to be granted to non-employee directors also on a periodic, nondiscriminatory basis based on one or more of the following criteria: (i) service as the chair of a Board committee; (ii) service as chairman of the Board; (iii) the number or type of Board committees on which a director serves; or (iv) the first selection or appointment of an individual to the Board.

Non-qualified stock options may be granted pursuant to non-qualified stock option award agreements and certificates adopted by the Board, as amended by the Compensation Committee. The Compensation Committee determines the terms of each stock option granted under the 2009 Plan, including the number of shares covered by an option, exercise price and means of payment, the vesting and exercisability of the option, and restrictions on transfer and the term. The exercise price of an option granted under the Plan may not be less than the fair market value on the date of option grant and may only be exercised at such times as may be specified by the Committee and provided for in an award agreement. The options expire on the earliest of ten years after the date of grant, 90 days after the death or disability of the recipient, immediately upon termination of employment or service other than by death or disability, or such date as the Compensation Committee determines. The Compensation Committee, in its sole discretion, may change by agreement the post-termination rights of a recipient, including accelerating the date or dates on which the option becomes vested and is exercisable following termination of employment or service, or extend the period. Options granted under the plan may be exercised by delivering cash, a cashless exercise, or by delivering to us the proceeds of shares of our common stock issuable under an option. Compensation expense for non-qualified stock options is recognized over the period they vest.

An award of restricted stock consists of a specified number of shares of our common stock that are, or may be, subject to restrictions, forfeiture conditions, and any other terms and conditions for periods determined by the Committee. The Compensation Committee has discretion to determine the terms of any award of restricted stock, including the number of shares subject to the award, and the minimum period over which the award may vest, and the acceleration of any vesting in the event of death, disability or change of control. RSAs are not transferable or assignable unless provided otherwise by the Compensation Committee with respect to certain specified family-related transfers. Unless the Committee determines otherwise, once the restricted stock vests, the shares of common

stock specified in the Award will be free of restriction, subject to any applicable lock up period. Prior to the termination of the restrictions under a RSA, a participant may vote and receive dividends on the restricted stock unless the Committee determines otherwise, but may not sell or otherwise transfer the shares until such time as the restrictions of the award have been satisfied. Compensation expense for restricted stock awards is recognized over the period they vest.

An award of restricted stock rights entitles a participant to receive a specified number of shares of our common stock that are, or may be, subject to restrictions, forfeiture conditions, and any other terms and conditions for periods determined by the Committee. It may also include the right to dividend equivalents if and as so determined by the committee. The Compensation Committee has discretion to determine the terms of any award of restricted stock or RSRs, including the number of shares subject to the award, and the minimum period over which the award may vest, and the acceleration of any vesting in the event of death, disability or change of control. RSRs are not transferable or assignable unless provided otherwise by the Compensation Committee with respect to certain specified family-related transfers. Unless the committee determines otherwise, once a RSR vests, the shares of common stock specified in the award will be issued to the participant. A participant who has been awarded RSRs may not vote the shares of common stock subject to the rights until the shares are issued. Until the vesting period applicable to a RSRs award expires and the shares are issued, the participant also may not transfer or encumber any interest in the RSRs or in any related dividend equivalents. Compensation expense for restricted stock rights is recognized over the period they vest.

The Compensation Committee may also make stock awards of common stock without restrictions, except that if the award is in lieu of salary, service fee, cash bonus or other cash compensation, the number of shares covered by an award shall be based on the fair market value of such shares on the date of grant. Common Stock Awards under the plan may be issued free of restriction and may vest immediately; however, the Committee may impose vesting and other restrictions related to the grant of such common stock awards. Compensation expense for common stock awards is recognized over the period they vest, although generally the awards vest immediately.

The following is a summary of the number and type of awards granted to, or exercised or forfeited by, employees, non-employee members of the Board of Directors and consultants pursuant to the Company’s 2009 Stock Compensation Plan for the six months ended June 30, 2014:


	Weighted- Average Grant or Exercise Price Per Share


Fiscal Year and Activity		Number of Shares
Reserved for future issuance as of December 31, 2013		185,000

Fiscal 2014 activity:
Common stock awards	$ -	-
Restricted stock awards	-	-
Restricted stock rights	-	-
Non-qualified stock options	-	-
Issued during 2014	-	-

Reserved for future issuance as of June 30, 2014		185,000

Stock options or restricted stock rights outstanding		-

Stock Issued under the 2009 Plan

There were no stock options, restricted stock awards, restricted stock rights, or common stock awards issued under the 2009 Plan during the six months ended June 30, 2014

Property and Equipment

Property and equipment are carried at cost less accumulated depreciation. For financial statement purposes, depreciation is provided on the straight-line method over the estimated useful life of the asset ranging from 3 to 10 years.


	(Unaudited)
Asset (Useful Life)	June 30, 2014	December 31, 2013
Software (3 years)	$ 84,224	$ 84,224
Computer equipment (3 - 5 years)	329,861	329,861
Furniture and fixtures (7 - 10 years)	231,033	231,033
Equipment (7 - 10 years)	80,727	80,727
Fixed assets, gross	725,845	725,845
Less accumulated depreciation	688,157	670,827
Fixed assets, net	$ 37,688	$ 55,018

Depreciation expense for property and equipment was $17,330 and $20,913 in the six months ended June 30, 2014, and the same period in 2013, respectively, and is reflected in selling, general and administrative expenses in the accompanying consolidated statements of operations and comprehensive income.

During fiscal 2013, the Company received proceeds in the amount of $28,934 from the sale of furniture. The book value of the assets sold during this period was $20,596 (gross cost of $92,606 and accumulated depreciation of $72,010), resulting in a gain on the sale of fixed assets during the period of $8,338. There was no such sale of furniture during the six months ended June 30, 2014.

Goodwill and Other Intangible Assets

Intangible Assets – Intangible assets consist of acquired software and patents. The Company incurs costs for intangible assets related to our patents. Under ASC 350, “Goodwill and Other Intangible Assets,” such assets acquired including software technology is considered to have a finite life. Patent acquisition costs pertaining to PinPoint™ and Signature Mapping™ (products not acquired through acquisition) have been capitalized, and are being amortized on a straight-line basis over the expected 20-year legal life of the patents. The Company evaluates the periods of amortization continually to determine whether later events or circumstances require revised estimates of useful lives. In addition, ASC 985-20, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed,” requires the Company to consider whether or not the software technology is impaired on a quarterly basis. We evaluate the carrying value of long-lived assets for impairment, whenever events or changes in circumstances indicate that the carrying value of an asset within the scope of ASC 360-10, “Accounting of the Impairment or Disposal of Long-Lived Assets” may not be recoverable. Our assessment for impairment of intangible assets involves estimating the undiscounted cash flows expected to result from use of the asset and its eventual disposition. An impairment loss recognized is measured as the amount by which the carrying amount of the asset exceeds the fair value of the asset, and considers year-end the date for its annual impairment testing. The Company prepared this analysis as of June 30, 2014, and the same period of 2013, and concluded that the intangible assets are not impaired. Therefore, there was no impairment expense during the six months ended June 30, 2014, or 2013.


	Six months ended June 30, 2014
	Beginning Period Cost			Net Book Value
	Beginning Period Cost	Additions	Reductions	Net Book Value
Intangibles with finite lives:
Patent acquisition costs	$ 315,855	$ 0	$ 12,065	$ 303,790

We anticipate incurring additional patent acquisition costs during the year ending December 31, 2014 (Fiscal 2014). Based on the net book value of patents acquisition costs at June 30, 2014, the Company estimates amortization expense for intangible assets to be $24,130 for each of the Fiscal years 2014 through 2019, and $171,075 thereafter.

Excess of Purchase Price over Net Assets Acquired (Goodwill) – The Company follows the provisions of ASC 805-10, “Business Combinations” and ASC 350-10, “Goodwill and Other Intangible Assets.” These statements establish financial accounting and reporting standards for acquired goodwill. Specifically, the standards address how acquired intangible assets should be accounted for both at the time of acquisition and after they have been recognized in the financial statements. Effective January 1, 2002, with the adoption of ASC 350-10, goodwill must be evaluated for impairment and is no longer amortized. Excess of purchase price over net assets acquired (“goodwill”) represents the excess of acquisition purchase price over the fair value of the net assets acquired. To the extent possible, a portion of the excess purchase price is assigned to identifiable intangible assets. We determine impairment by comparing the fair value of the goodwill, using the undiscounted cash flow method, with the carrying amount of that goodwill. Impairment is tested annually or whenever indicators of impairment arise. There was no goodwill on the consolidated balance sheet of the Company during the six months ended June 30, 2014, or during the same period in 2013, as a net realizable value analysis was made for goodwill in prior years during the Company’s operating stage and such asset was fully impaired during those prior years.

Impairment of Excess Purchase Price over Net Assets Acquired – The Company follows the provisions of ASC 350-10 “Goodwill and Other Intangible Assets” for the impairment of goodwill. The Company determines impairment by comparing the fair value of the goodwill, using the undiscounted cash flow method, with the carrying amount of that goodwill. Impairment is tested annually or whenever indicators of impairment arise. There was no goodwill on the consolidated balance sheet of the Company for the six months

ended June 30, 2014, or during Fiscal 2013 and, as a net realizable value analysis was made for goodwill in prior years and such asset was considered fully impaired during those prior years.

Impairment of Long-Lived Assets – The Company evaluates the carrying value of long-lived assets for impairment, whenever events or changes in circumstances indicate that the carrying value of an asset within the scope of ASC 360-10, “Accounting of the Impairment or Disposal of Long-Lived Assets” may not be recoverable. The Company’s assessment for impairment of assets involves estimating the undiscounted cash flows expected to result from use of the asset and its eventual disposition. An impairment loss recognized is measured as the amount by which the carrying amount of the asset exceeds the fair value of the asset, and considers year-end the date for its annual impairment testing.

Uncertainty in Income Taxes

In June 2006, ASC 740-10 was established regarding the uncertainty in income taxes. ASC 740-10 establishes a recognition threshold and measurement for income tax positions recognized in an enterprise’s financial statements in accordance with accounting for income taxes. ASC 740-10 also prescribes a two-step evaluation process for tax positions. The first step is recognition and the second step is measurement. For recognition, an enterprise judgmentally determines whether it is more-likely-than-not that a tax position will be sustained upon examination, including resolution of related appeals or litigation processes, based on the technical merits of the position. If the tax position meets the more-likely-than-not recognition threshold, it is measured and recognized in the financial statements as the largest amount of tax benefit that is greater than 50% likely of being realized. If a tax position does not meet the more-likely-than-not recognition threshold, the benefit of the position is not recognized in the financial statements.

Tax positions that meet the more-likely-than-not recognition threshold, at the effective date of ASC 740-10, may be recognized or, continued to be recognized, upon adoption of ASC 740-10. The cumulative effect of applying the provision of ASC 740-10 shall be reported as an adjustment to the opening balance of retained earnings for that fiscal year. ASC 740-10 applies to fiscal years beginning after December 15, 2006 with earlier adoption permitted. The Company has determined that additional accrual for income taxes is not necessary.

Recently Adopted Accounting Pronouncement

In June 2014, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance which eliminated the requirements for development stage entities (ASU 2014-10) to (1) present inception-to-date information in the statements of income, cash flows, and shareholders equity, (2) label the financial statements as those of a development stage entity, (3) disclose a description of the development stage activities in which the entity is engaged, and (4) disclose in the first year in which the entity is no longer a development stage entity that in prior years it had been in the development stage. The effective date for public entities is for annual reporting periods beginning after December 15, 2014, and interim periods therein. The public entity may adopt the guidance early for those financial statements not yet issued. The Company adopted the guidance with the issuance of its fiscal 2014 second quarter and the adoption of this disclosure-only guidance is not expected to have an impact on the Company's consolidated financial statements.

In February 2013, the FASB issued authoritative guidance requiring an entity to present, in a single location either parenthetically on the face of the financial statements or in a separate note, significant amounts reclassified from each component of accumulated other comprehensive income (loss) (“AOCI”) and the income statement line items affected by the reclassification. An entity is not permitted to provide this information parenthetically on the face of the income statement if it has items that are not required to be reclassified in their entirety to net income. Instead of disclosing the income statement line affected, a cross reference to other disclosures that provide additional details on these items is required. This guidance became effective prospectively for the Company’s fiscal 2014 first quarter and the adoption of this disclosure-only guidance is not expected to have an impact on the Company's consolidated financial statements.

In July 2012, the FASB amended its authoritative guidance related to testing indefinite-lived intangible assets for impairment. Under the revised guidance, entities testing their indefinite-lived intangible assets for impairment have the option of performing a qualitative assessment before performing further impairment testing. If entities determine, on the basis of qualitative factors, that it is more-likely-than-not that the asset is impaired, a quantitative test is required. The guidance became effective in the beginning of the Company's fiscal 2014.

In December 2011, the FASB issued authoritative guidance that creates new disclosure requirements about the nature of an entity’s rights of offset and related arrangements associated with its financial instruments and derivative instruments. This revised guidance helps reconcile differences in the offsetting requirements under U.S. GAAP and International Financial Reporting Standards (“IFRS”). These requirements mandate that entities disclose both gross and net information about instruments and transactions eligible for offset in the statement of financial position as well as instruments and transactions subject to an agreement similar to a master netting arrangement. The Company currently does not hold any financial or derivative instruments that are subject to an enforceable master netting arrangement. However, the Company currently utilizes the right of offset when netting certain negative cash balances in its statement of financial position. This disclosure-only guidance became effective for the Company’s fiscal 2013 third quarter, with retrospective application required, and did not have a material impact on the Company’s consolidated financial statements.

In June 2011, the FASB amended its authoritative guidance related to the presentation of comprehensive income, requiring entities to present items of net income and other comprehensive income either in one continuous statement or in two separate consecutive statements. This guidance also required entities to present reclassification adjustments for each component of accumulated other comprehensive income in both net income and other comprehensive income on the face of the financial statements. In December 2011, the FASB issued an update to this guidance deferring the requirement to present reclassification adjustments on the face of the financial statements. However, the Company is still required to present reclassification adjustments on either the face of the financial statement where comprehensive income is reported or disclose the reclassification adjustments in the notes to the financial statements. This guidance, including the deferral, becomes effective for the Company’s fiscal 2013 first quarter, with early adoption permitted and full retrospective application required. The guidance did not have a material impact on the Company’s consolidated financial statements.

Recently Issued Accounting Pronouncement

In April 2014, the FASB issued authoritative guidance which changes the criteria for a disposal to qualify as a discontinued operation. This revised standard defines a discontinued operation as (i) a component of an entity or group of components that has been disposed of or is classified as held for sale that represents a strategic shift that has or will have a major effect on an entity’s operations and financial results or (ii) an acquired business or nonprofit activity that is classified as held for sale on the date of acquisition. The standard also requires expanded disclosures related to discontinued operations and added disclosure requirements for individually material disposal transactions that do not meet the discontinued operations criteria. This guidance becomes effective prospectively for the Company’s fiscal 2016 first quarter, with early adoption permitted, but only for disposals (or classifications as held for sale) that have not been reported in financial statements previously issued or available to be issued. The Company will apply this new guidance when it becomes effective and the adoption of this guidance is not expected to have a significant impact on its consolidated financial statements.

In July 2013, the FASB issued authoritative guidance that requires an entity to present an unrecognized tax benefit, or a portion of an unrecognized tax benefit, in the financial statements as a reduction to a deferred tax asset for a net operating loss (“NOL”) carryforward, a similar tax loss, or a tax credit carryforward. If either (i) an NOL carryforward, a similar tax loss, or tax credit carryforward is not available as of the reporting date under the governing tax law to settle taxes that would result from the disallowance of the tax position or (ii) the entity does not intend to use the deferred tax asset for this purpose (provided that the tax law permits a choice), an entity should present an unrecognized tax benefit in the financial statements as a liability and should not net the unrecognized tax benefit with a deferred tax asset. This guidance becomes effective prospectively for unrecognized tax benefits that exist as of the Company’s fiscal 2015 first quarter, with retrospective application and early adoption permitted. The Company is currently evaluating the timing of adoption and the impact of this balance sheet presentation guidance but does not expect it to have a significant impact on the Company’s consolidated financial statements.

Other ASU’s that have been issued or proposed by the FASB ASC that do not require adoption until a future date and are not expected to have a material impact on the financial statements upon adoption.

(3)

Financial Condition, Going Concern Uncertainties and Events of Default

The Company, previously an operating stage company, became a development stage company on April 1, 2012. A development stage company, as defined by ASC-915-10 “Accounting and Reporting by Development Stage Enterprise”, is an entity that devotes substantially all of its efforts to establish a business and either of the following conditions exists: 1) the principal operations have not commenced, or 2) the principal operations have commenced, but there has been no significant revenue therefrom. During the six months ended June 30, 2014, Applied Visual Sciences’ revenue generating activities have not produced sufficient funds for profitable operations and we have incurred operating losses since inception. In view of these matters, realization of certain of the assets in the accompanying consolidated balance sheet is dependent upon continued operations, which in turn is dependent upon our ability to meet our financial requirements, raise additional financing on acceptable terms, and the success of future operations. Our independent registered public accounting firm’s report on the consolidated financial statements included herein, and in our Annual Report on Form 10-K for the year ended December 31, 2013, contains an explanatory paragraph wherein they expressed an opinion that there is substantial doubt about our ability to continue as a going concern. Accordingly, careful consideration of such opinion should be given in determining whether to continue or become our stockholder.

As of June 30, 2014, the Company has outstanding trade and accrued payables of $1,732,024, other accrued liabilities of $187,937, and accrued salaries and related expenses due to our employees and management of $8,492,878. Also, the Company has an outstanding noninterest-bearing loan from its previous Chief Executive Officer of $80,500, and $772,500 short-term notes from thirteen (13) investors, which has debt discount outstanding of $5,029.

reached any agreement with the debenture holders with regard to any such repayment, repurchase or extension. Our ability to repay or repurchase the debentures is contingent upon our ability to raise additional financing, of which there can be no assurance. Also, as a condition to any such extension, debenture holders may seek to amend or modify certain other terms of the debentures. When an event of default occurs under the debentures, the debenture holders may elect to require us to make immediate repayment of the mandatory default amount, which equals the sum of (i) the greater of either (a) 120% of the outstanding principal amount of the debentures, or (b) the outstanding principal amount unpaid divided by the conversion price on the date the mandatory default amount is either (1) demanded or otherwise due or (2) paid in full, whichever has the lower conversion price, multiplied by the variable weighted average price of the common stock on the date the mandatory default amount is either demanded or otherwise due, whichever has the higher variable weighted average price, and (ii) all other amounts, costs, expenses, and liquidated damages due under the debentures. In anticipation of such election by the debenture holders, due to the nonpayment of principal amount on the due date of July 1, 2011, we measured the mandatory default at approximately $337,641 and subsequently on each balance sheet date, which is reflected in the carrying value of the debentures and also recognized as interest expense. We remeasured the mandatory default amount as of June 30, 2014 at approximately $337,641. As of the date of this report, the debenture holders have not made an election requiring immediate repayment of the mandatory amount, although there can be no assurance they will not do so. The Company currently has insufficient funds to repay the outstanding amount in the event the debenture holders make a demand for payment.

As of June 30, 2014, we had a cash balance of $10,753. Subsequently and through August 19, 2014, the Company sold to an accredited investor an aggregate of 200,000 shares of common stock, of which 185,000 shares were issued under the 2009 Stock Compensation Plan. Management believes these funds to be insufficient to fund our operations for the next twelve months absent any cash flow from operations or funds from the sale of our equity or debt securities. Currently, will require an aggregate of approximately we are spending or incurring (and accruing) expenses of approximately $190,000 per month on operations and the continued research and development of our 3i technologies and products, including with regard to salaries and consulting fees. Management believes that we will require an aggregate of approximately $2,280,000 to fund our operations for the next 12 months and to repay certain outstanding trade payables and accrued expenses. This assumes that holders of our outstanding debentures convert such debt into shares of our common stock or that we are able to extend the term of the debentures, of which there can be no assurance. In the event we are unable to extend the term of the debentures beyond their new maturity date, the debenture holders do not convert such debt or require payment of principal, partially convert such debt, or effect the buy-in provision related to the debentures, we shall be required to raise additional financing. Also, this assumes that we are able to continue to defer the amounts due to our employees for accrued and unpaid salaries and that we are able to continue to extend or defer payment of certain amounts due to our trade creditors, of which there can be no assurance.

The Company has relied and continues to rely substantially upon equity and debt financing to fund its ongoing operations, including the research and development conducted in connection with its products and conversion of accounts payable for stock. The proceeds from our financings have been and continue to be insufficient to fund our operations, pay our trade payables, and repay our unconverted debentures or accrued and unpaid wages to our employees. Therefore, the debentures holders, our employees, or trade creditors may seek to enforce payment of amounts due to them, and our results of operations and financial condition could be materially and adversely affected and we may be unable to continue our operations. Also, in the event we continue to be unable to pay our employees, we may suffer further employee attrition. There can be no assurances that we will be successful in our efforts to raise any additional financing, any bank borrowing, and research or grant funding. Moreover, in view of the current market price of and limited trading volume in our stock, we may have limited or no access to the capital markets. Furthermore, under the terms of our agreements with the debenture holders, we are subject to restrictions on our ability to engage in any transactions in our securities in which the conversion, exercise or exchange rate or other price of such securities is below the current conversion price or is based upon the trading price of our securities after initial issuance or otherwise subject to re-set. In view of the foregoing, we may be required to curtail operations significantly, or obtain funds through entering into arrangements with collaborative partners or others that may require us to relinquish rights to certain of our technologies or products.

During the six months ended June 30, 2014, our total stockholders’ deficit increased by $270,363 to $13,196,440, and our consolidated net loss for the period was $304,524, or a decrease of $1,300,436 (81.0%) in net loss from the same period in 2013. Notwithstanding the foregoing discussion of management’s expectations regarding future cash flows, Applied Visual Sciences’ insolvency continues to increase the uncertainties related to its continued existence. Both management and the Board of Directors are carefully monitoring the Company’s cash flows and financial position in consideration of these increasing uncertainties and the needs of both creditors and stockholders.

(4)

Stockholders’ Equity

Common Stock Issued Including Exercises of Warrants and Options

During the six months ended June 30, 2014, a company employee exercised 796,000 stock options for 796,000 shares of common stock using accrued and unpaid wages. The shares were issued under the 2003 Stock Incentive Plan. Common stock was increased by $796 for the par value of the shares, paid-in capital was increased by $32,084, and accrued wages was reduced by the total exercise price of $32,880.

Other Common Stock Purchase Warrants Issued, Expired, or Forfeited

During the six months ended June 30, 2014, an aggregate of 5,592,101 common stock purchase warrants expired, of which 4,377,274 Class L warrants, 742,000 Class M warrants, and 200,000 Class Q warrants issued to investors, and 272,827 to placements agents.

The Company has issued warrants as compensation to its note holders, placement agents and other consultants, as well as to incentivize investors in each of the Company’s private placement financings. The table below shows by category, the warrants issued and outstanding at June 30, 2014.


Common Stock Purchase Warrants	Number of Warrants Outstanding and Exercisable	Date Warrants are Exercisable	Exercise Price	Date Warrants Expire
Note and debenture holders	10,000	December 2007	$ 0.70	December 2014
	150,000	January 2010	0.25	January 2015
	78,750	September 2010	0.25	September 2015
	238,750

Private placement investors	214,285	March 2008	0.75	December 2014
	100,000	July 2009	0.25	July 2014
	3,881,973	July to August 2009	0.25	December 2018
	2,099,007	Oct to Dec 2009	0.25	Oct to December 2014
	400,000	November 2009	0.25	December 2016
	200,000	March 2010	0.25	December 2016
	2,499,568	March to June 2010	0.25	March to June 2015
	750,752	May to Aug 2010	0.25	December 2018
	3,731,155	July to Sept 2010	0.25	July to September 2015
	5,301,345	Oct to Dec 2010	0.25	Oct to December 2015
	400,000	February 2011	0.25	August 2015
	800,000	February 2011	0.25	February 2016
	88,000	October 2011	0.25	October 2015
	300,000	March 2012	0.25	March 2015
	20,766,085

Placement agents	108,000	July 2009	0.25	July 2014
	205,000	December 2009	0.28	December 2014
	72,000	February 2011	0.25	February 2016
	385,000

Consultants	21,000	August 2009	0.25	August 2014
	200,000	December 2009	0.25	December 2014
	14,000	August 2010	0.28	August 2015
	14,000	September 2010	0.25	September 2015
	249,000

Total Warrants Issued/Outstanding	21,638,835

As of June 30, 2104, approximately 4,843,973 of the above warrants may be exercised pursuant to the cashless exercise provisions of such warrants and, if so exercised, the shares may be subsequently resold under the provisions of Rule 144 under the Securities Act. Increased sales volume of the Company’s common stock could cause the market price of the Company’s common stock to drop.

(5)

Subsequent Events

Subsequent events are reported by the Company to disclose events that have occurred after the balance sheet date, but before the financial statements are issued. Such events may be to provide additional information about conditions that existed at the date of the balance sheet, or conditions that did not exist at the balance sheet date. The Company has evaluated subsequent events through the date of this report.

On July 1, 2014, the Company issued 200,000 shares of common stock to a consultant as compensation for business advisory services. Common stock was increased by $200 for the par value of the shares, $7,800 to paid-in capital, with an offset to deferred compensation for the fair value on the date of issuance of $8,000. The Company will record consulting expense over the three-month

service period in accordance with ASC 505-50 “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.”

On July 18, 2014, the Company received $50,000 from an accredited investor and issued an aggregate of 200,000 shares of common stock, of which 185,000 shares were issued under the 2009 Stock Compensation Plan. Common stock was increased by $200 for the par value of the shares and $49,800 to paid-in capital.

On July 29, 2014, a company employee exercised 200,000 stock options for 200,000 shares of common stock using accrued and unpaid wages. The shares were issued under the 2003 Stock Incentive Plan. Common stock was increased by $200 for the par value of the shares, paid-in capital was increased by $5,800, and accrued wages was reduced by the total exercise cost of $6,000.

(6)

Fair Value Measurement

The Company records its financial assets and liabilities at fair value, which is defined as the price that would be received to sell the asset or paid to transfer a liability, in the principal or most advantageous market for the asset or liability, in an orderly transaction between market participants at the measurement date. The fair value measurement of these liabilities is consistent with ASC 820, "Fair Value Measurements", whereby the Company is required to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The three levels of inputs that may be used to measure fair value are as follows:

Level 1:

Inputs based on quoted market prices for identical assets or liabilities in active markets at the measurement date.

Level 2:

Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets and liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3:

Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. The inputs are unobservable in the market and significant to the instrument’s valuation.

The following table presents the Company’s hierarchy for its financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2014:


	Level 1	Level 2	Level 3	Total
Assets
Cash	$ 10,753	$ -	$ -	$ 10,753

Liabilities
Convertible debentures	$ -	$ -	$ 2,025,846	$ 2,025,846
Derivative liabilities	-	-	270,113	270,113
Notes payable, net of discount	-	-	767,471	767,471
Notes payable and advances, related parties	80,500	-	-	80,500
Total	$ 80,500	$ -	$ 3,063,430	$ 3,143,930

The following table presents the Company’s hierarchy for its financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2013:


	Level 1	Level 2	Level 3	Total
Assets
Cash	$ 1,108	$ -	$ -	$ 1,108

Liabilities
Convertible debentures	$ -	$ -	$ 2,025,846	$ 2,025,846
Derivative liabilities	-	-	540,226	540,226
Notes payable, net of discount	-	-	718,930	718,930
Notes payable and advances, related parties	80,500	-	-	80,500
Total	$ 80,500	$ -	$ 3,285,002	$ 3,365,502

The estimated fair values of the Company’s derivative liabilities are as follows:


	Convertible	Derivative	Notes Payable
Liabilities Measured at Fair Value	Debentures (1)	Liabilities (2)	(3)	Total
Beginning balance as of December 31, 2012	$ 2,025,846	$ 202,585	$ 559,704	$ 2,788,135


Revaluation (gain)/loss in interest expense	-	337,641	-	337,641
Issuances, net of discount	-	-	148,400	148,400
Amortization of discount	-	-	10,826	10,826
Balance as of December 31, 2013	$ 2,025,846	$ 540,226	$ 718,930	$ 3,285,002
Revaluation (gain)/loss in interest expense	-	(270,113)	-	(270,113)
Issuances, net of discount	-	-	33,000	33,000
Amortization of discount	-	-	15,541	15,541
Ending balance as of June 30, 2014	$ 2,025,846	$ 270,113	$ 767,471	$ 3,063,430

Total (gain)/loss from revaluation of derivatives and event of default included in earnings for the period and reported as an adjustment to interest is as follows:


For fiscal 2013	$ -	$ 337,641	$ 10,826	$ 348,467
For six months ended June 30, 2014	-	(270,113)	15,541	(254,572)

(1) The balance as of June 30, 2014 and December 31, 2013, includes $1,688,205 for the outstanding convertible debentures issued November 8, 2006 and April 12, 2007, and an additional amount of $337,641 for the event of default provision under the debentures October 15, 2010 amendment agreement.

(2) Represents the conversion feature of outstanding convertible debentures issued November 8, 2006 and April 12, 2007. The fair value of the conversion feature since May 20, 2009, the final milestone reset date of the debentures, was determined using market quotation.

(3) The balance represents the outstanding short-term notes payable issued since October 2011, less remaining notes discount for the fair value of common stock when issued in conjunction with the notes. The note discount is being amortized over the original term of the notes. The outstanding notes payable at June 30, 2014 and December 31, 2013, is $772,500 and $739,500, respectively, and the outstanding notes discount at June 30, 2014 and December 31, 2013, is $5,029 and $20,570, respectively.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

You should read the following summary together with the more detailed information and consolidated financial statements and notes thereto and schedules appearing elsewhere in this report. Throughout this report when we refer to the “Company,” “Applied Visual Sciences,” “we,” “our” or “us,” we mean Applied Visual Sciences, Inc., and its subsidiaries.

This discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our critical accounting policies and estimates, including those related to revenue recognition, intangible assets, and contingencies. We base our estimates on historical experience, where available, and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions and conditions.

Except for historical information, the statements and other information contained in this Management’s Discussion and Analysis is forward-looking. Our actual results could differ materially from the results discussed in the forward-looking statements, which include certain risks and uncertainties. These risks and uncertainties include the rate of market development and acceptance of our “intelligent imaging informatics” (“3i™”) technology (particularly for our PinPoint™ and Signature Mapping™ products), the unpredictability of our sales cycle, the limited revenues and significant operating losses generated to date, and the possibility of significant ongoing capital requirements.

Our independent registered public accounting firm’s report on the consolidated financial statements included in our Annual Report Form 10-K for the year ended December 31, 2013, contains an explanatory paragraph wherein they expressed an opinion that there is substantial doubt about our ability to continue as a going concern. Accordingly, careful consideration of such opinion should be given in determining whether to continue or become our stockholder.

Our Business

Applied Visual Sciences is a software technology company that designs and develops imaging informatics solutions for delivery to its target markets, aviation/homeland security and healthcare. Our two product lines are offered through our two operating subsidiaries as follows: Guardian Technologies International, Inc. for aviation/homeland security products and Signature Mapping Medical Sciences, Inc., for healthcare, which has a wholly owned subsidiary Instasis Imaging, Inc., for the development, marketing, and sales of a suite of imaging analytic applications for the automated detection of breast cancer. We may engage in one or more acquisitions of businesses that are complementary, and may form wholly-owned subsidiaries to operate within defined vertical markets products.

Our Business Strategy

Maintain product development and sales/marketing focus on large, underserved, and rapidly growing markets with a demonstrated need for intelligent imaging informatics.

Leverage Applied Visual Sciences, Inc.’s technology, experienced management team, research and development infrastructure.

Focus our talents on solving highly challenging information problems associated with digital imaging analysis.

Establish an international market presence through the development of a significant OEM/Reseller network.

Build and maintain a strong balance sheet to ensure the availability of capital for product development, acquisitions, and growth.

Seek to broaden our investment appeal to large institutions.

We may engage in one or more acquisitions of businesses that are complementary, and may form wholly-owned subsidiaries to operate within defined vertical markets.

Our Core Technology

Aviation/Homeland Security Technology Solution - PinPoint™

Through our wholly-owned subsidiary, Guardian Technologies, we market our PinPoint™ product, which is an “intelligent imaging informatics” (3i™) technology for the detection of guns, explosives, and other threat items contained in baggage in the airport environment or for building security applications. PinPoint™ can identify threat items, notify screeners of the existence of threat items, and speed the security process by eliminating unnecessary baggage checks, provide the screener with an instantaneous second opinion, and reduce processing time spent on false positives (baggage selected for security review that contains no threat items). We market and seek to license the PinPoint™ product primarily to the United States Transportation Services Administration (TSA) for use

in airports, the Federal Protection Services for use in federal buildings and to foreign governments and airport authorities. We compete with manufacturers of baggage screening, luggage and large parcel screening, people screening for weapons and explosive detection, container and vehicle screening, and cargo screening equipment and certain software companies and academic institutions that are developing solutions to detect threat items. It is also our intent to distribute the product through various distribution methods.

The market for contraband detection systems has become intensely competitive and many of our competitors are better capitalized and have greater marketing and other resources than Applied Visual Sciences, Inc. PinPoint™ continues to be developed to address the market for contraband detection. The extended alpha version of PinPoint™ has been tested successfully at live carry-on baggage checkpoints in three international airports. Integration within currently deployed manufacturers’ scanning equipment is a requisite to anticipated sales, and is considered a significant development risk. PinPoint™ is available for sale to customers; however no sales are anticipated until we are able to seamlessly integrate with the manufacturers’ scanning equipment.

We have been involved in a number of wide ranging U.S. Government proposals since 2011. We have teamed on a few of the proposals with large, well-known defense contractors, a federally funded research laboratory and directly. The proposals were submitted to various U.S. Government agencies. Unfortunately, most of the projects were deferred due to the ongoing federal budget discussions in Congress and operational uncertainties within the funding agencies. At this point in time, we have no indication that any of these projects will be funded. We will continue to pursue opportunities for the deployment of our PinPoint™ product as opportunities develop. With these uncertainties and our limited cash resources during 2014, we have focused on the marketing and sale of our healthcare products, as better discussed below.

Healthcare Technology Solutions - Signature Mapping™

In an effort to expand upon the use of our core technology 3i™ “intelligent imaging informatics,” we have modified our threat detection algorithms and quantitative imaging capabilities for use in the imaging field of diagnostic radiology and pathology. The technology is called Signature Mapping™. Our Signature Mapping™ platform technology represents the technological basis upon which our computer vision diagnostic radiology and pathology applications are being developed. Any Signature Mapping™ product introduced in the United States may be subject to Food and Drug Administration (“FDA”) review and approval, including with regard to its safety and effectiveness before we may begin marketing and selling any such product in the U.S. Such approval may require us to obtain extensive data from clinical studies to demonstrate such safety or effectiveness. Within the international markets the regulatory requirements differ, specifically in South Africa, where we have been testing our TBDx™ application for the detection of tuberculosis by analyzing digital images of auramine stained sputum slides captured through a photo microscopy system. There may be similar regulatory requirements in foreign countries in which we seek to market and sell our healthcare CAD products. As of the date of this report, we have developed and continue to develop two TB diagnostic products, TBDx™ and TBDxV™ and our SMDS™ product, an automated hardware-software laboratory solution.

Laboratory Pathology: SMDS™

Signature Mapping Detection System (“SMDS™”) is an automated hardware-software laboratory solution designed to operate one or multiple infectious disease applications via multi-threaded detection algorithms. SMDS™ automation software controls every movement of the integrated hardware components from slide management to image capture. Where SMDS™ is integrated with a specific infectious disease detection application; the solution is capable of automatically analyzing each field-of-view for the presence of specific characteristics of the targeted disease. The detection algorithms will perform with high sensitivity without sacrificing specificity. The end product is a flexible; user defined diagnostic patient report that can be integrated to a laboratory information system. Standard information includes patient information, processing date, field-of-view diagnostic findings and overall case severity or diagnostic finding.

In laboratory environments that use the image capture and visualization capabilities of Signature Mapping™ without specific infectious disease algorithms or in situations where the interface of the laboratory technician with the computer-aided identification software is a desired procedure, the SMDS™ laboratory platform includes the Decision Support Quick View (“DSQV”) module. DSQV has been designed for rapid review of captured images and increased speed in diagnostic decision-making. DSQV includes post-processing image tools to magnify, zoom or review images in alternative formats. Using a high-resolution touch-screen monitor and an icon-driven menu system facilitates ease of use for even the most computer challenged individuals. Signature Mapping SMDS™ includes built-in networking support to allow DICOM images to be transmitted for remote diagnosis or to be interfaced with an enterprise network.

When SMDS™ is integrated with a disease specific automated detection algorithm, such as Signature Mapping Tuberculosis Detection (“TBDx™”), the solution expands to a fully automated diagnostic system. For high volume diagnostic laboratories, automation begins with a slide loader capable of processing up to 200 slides without human intervention. At system initialization the slide loader automatically inventories every patient slide to be processed. One-by-one the slides are moved from the holding cassettes onto the automated stage of the microscope. A barcode reader collects information about the patient just prior to the slide being placed on the stage. Information captured by the barcode reader can be automatically transferred to a laboratory information system along with the captured digital images and diagnostic case findings.

TBDx™ - TBDxV™

The Company has developed two fully-automated, computer-vision diagnostic products for the detection of tuberculosis (“TB”). Both Signature Mapping TBDx™ for use in laboratory environments using Auramine-O staining protocols and Signature Mapping TBDxV™, a decision support visualization technology, for use in laboratory environments using Ziehl-Neelsen staining protocols can address the approximately 80 million diagnostic slides analyzed by clinical lab technicians each year. Both products are targeted to government and private institutions that diagnose tuberculosis patients.

TBDx™ is a fully-automated hardware and software technology platform that is capable of: (i) automatically managing 1-200 slides without human intervention, (ii) digitally capturing patient information (eliminates human recordation errors), (iii) adjusting focus for variances in sputum location, quality and topology, (iv) capturing high-quality digital images (standard 100 images per slide or user-defined), (v) automated identification of M Tuberculosis bacilli if present, and (vi) robust user-defined reporting and communication of diagnostic results. Phase II clinical trials were undertaken and completed in South Africa during 2011. Slides used in the clinical trial were provided from the international Thibela TB Study trial conducted by The Aurum Institute for Health Research.

TBDxV™, the precursor to TBDx™, is a fully-automated visualization technology that maintains the same slide capacity range and digital image quality as TBDx™. TBDxV™, using high-resolution touch-screen monitors, provides the microscopist with a fast, easy-to-use system for the analysis of high-quality images, thereby alleviating the tedious and error prone diagnosis using a microscope. TBDxV™ assists microscopists in decision-making, specifically on the most difficult scanty cases, through access to advanced visualization tools. The visualization tools are applicable to both Auramine-O and Ziehl-Neelsen staining processes.

The Company believes that the performance of both products could be further enhanced through the exploration of new staining techniques. Further, design initiatives have been discussed that would allow the products to be deployed at the point-of-care, a major strategic initiative of The World Health Organization. To advance these design ideas from concepts - to proof of concept - to working models ready for clinical evaluation, the company will need to develop strategic partnerships with academic institutions capable of providing targeted technological input and research capabilities. The company has begun the process of reaching out to academic institutions. One such potential institution is the Clinical Microbiology Laboratory at the Stanford University Medical Center. The Medical Center has extensive expertise in infectious diseases and has expressed a willingness to assist the Company in planning and executing technology research and development. A formal business relationship is under development.

Development continues in the refinement of TBDx™ and its detection algorithms. Additional classifiers have been created to improve sensitivity, which is the measurement of correctly identifying positive cases, and specificity, which is the measurement of correctly identifying negative cases. The underlying scripting language has been re-written to enable laboratories to either use TBDx™ as a diagnostic tool or as a pre-screening technology that identifies probable candidate TB cases that are confirmed by a secondary technology. The ability to communicate to and from the camera and TBDx™ technology will permit the system to acquire a pre-set number of images, then move to another location on the slide and capture additional images. Also, the system can monitor the acquisition of the images and stop the acquisition process once the algorithms have determined that a case is severely infected. Internal testing continues to validate the progress of algorithm improvements.

There is no current computer-aided-detection for TB sputum microscopy analysis that can be identified as competition to Signature Mapping™. Although, there are substitute technologies that compete for sputum specimen analysis, such as the Cepheid Systems GeneXpert^® System, a dip-stick or biomarker approach that is considered a competitor to Signature Mapping™. Ultimately, competition to our approach will be driven by its cost per procedure, ease-of-use, sensitivity and specificity, and ability to be used by non-trained or lightly trained personnel in the point of care environment. These emerging tests are Polymerase Chain Reaction, TB Breathalyzer, Q-Beta Replicase Assay, Transcription-Medicated Amplification, Ligase Chain Reaction, Strand Displacement Amplification, Nucleic Acid Sequence-Based Amplification and Branched DNA.

Radiology: BCDx™

The Company is adding vision to breast cancer diagnosis by developing a radiological suite of products, a breast cancer detection solution to be known as Signature Mapping™ Breast Cancer Detection (“BCDx™”). Annual estimates of breast cancer diagnostic activity within the U.S are: 35 million mammograms performed; 1.5 million biopsies performed; 87% of biopsies return a negative finding (mammogram ‘false positive’); 200,000 confirmed cancer cases; and immeasurable emotional, mental, and physical pain for the individuals and families of biopsy patients. The 1.3 million biopsies undertaken that resulted in negative findings can be directly attributed to an inability to resolve areas of concern due to the limited information provided in the mammography images. In addition, approximately 10% of cancerous lesions are missed – partly due to dense tissue obscuring the cancer or the appearance of cancer having common characteristics with the appearance of normal tissue. The goal of BCDx™ is to deliver sophisticated image analysis processes that provide enhanced visualization capabilities and automated detection algorithms to help prevent unnecessary biopsies, while flagging previously unseen lesions for additional review.

Similar to a person’s fingerprint, each tissue has a unique structure. Each structure creates a unique pattern or “signature” that can be extracted from an image to differentiate, locate, identify, and classify by using our Signature Mapping™ technology. Management anticipates BCDx™ to further help radiologists by visualizing the various structures within a particular tissue so they can be examined and quantified. This capability is expected to provide a next-generation image analysis, clarification, visualization and Signature Mapped™ “tissue characterization” and detection. Management believes that it will add significant clinical value to a wide range of difficult to detect diseases in diagnostic radiology by distinguishing and characterizing different tissue types in images regardless of the modality that generated the image.

Based on its unique properties, Signature Mapping™ is expected to be capable of being used to analyze images generated across all imaging modalities without the need for new image capture hardware costs. It will serve as a software-based, multi-modality approach to image analysis when combined with Signature Mapping’s™ unique” tissue characterization” and detection. As a result, Signature Mapping™ is expected to differentiate the contrast resolution between different tissue types, even when the material or tissue in the image is very diffuse or obscured by other objects, such as is the case where diseased lung tissue is located behind a rib in an x-ray chest examination. It is capable of displaying these ‘signatures’ in a way that empowers radiologists to make a more informed and confident diagnosis, even for hard to distinguish structures such as masses in dense breast tissue.

Signature Mapping™ appears to provide advantages for providing the knowledge for automatic detection. The development of a “tissue characterization” and detection model employs the use of supervised machine learning and contextual image analysis to analyze and classify the features associated with the newly created “signatures.” The fusion of these three technologies is known as Applied Visual Sciences, Inc.’s Intelligent Imaging Informatics 3i™. Unlike other pattern recognition methodologies, the 3i™ solution can reveal and differentiate inherent structures for all materials in an image regardless of: the imaging modality used to create the image, location within the image, shape or texture, and object orientation even if obscured by its relationship to other materials.

The Company has been engaged in discussions, negotiations, and due diligence on the formation of a strategic partnership focused exclusively on breast cancer computer vision detection technology. Our subsidiary, Instasis Imaging, would license Applied Visual’s core analysis technology platform for research and development, as well as for inclusion in the diagnostic products to be commercialized. Applied Visual would contribute its intellectual property, including patents, which are specific to the area of breast cancer detection. In support of such negotiations, the Company paid a $400,000 non-refundable formation fee, of which $300,000 was paid in October 2011, and $100,000 in January 2012. The formation fee was funded by promissory notes with interest at a rate of twelve percent (12%) per annum, which have been extended as indicated above. There can be no assurances that we will be successful in our efforts to establish a strategic partnership.

Clinical Experience and Medical Accomplishments

While Signature Mapping™ is expected to be capable of use in a wide range of medical image analysis applications, our initial application product development efforts are focused in four areas:

detection of tuberculosis by analyzing digital images of stained sputum slides captured through a photo microscopy system;

breast cancer detection using x-ray mammography, MRI and ultrasound;

neurological imaging analysis through the detection and quantification of acute intracranial hemorrhage using non-contrast CT, normal pressure hydrocephalus,

Laboratory Pathology: TBDx™

The Joint Clinical Research Center in Kampala, Uganda has approved a research protocol for the evaluation of the TBDx™ technology. It is likely that this evaluation will occur in the 4th quarter of 2014.

On November 14, 2013, the Company shipped a TBDx™ system to Abuja, Nigeria in support of Dr. Luis Cuevas of the Liverpool School of Tropical Medicine who received funding from the European and Developing Countries Clinical Trials Partnership (EDCTP) to conduct a tuberculosis research project. A portion of this project funding is to be used to evaluate the TBDx™ technology. Similar to the protocol in South Africa, the clinical evaluation is a triple blind study with TBDx™ compared against routine microscopy, using MGIT culture as the reference standard, and the use of a new molecular diagnostic test provided by Epistem. It is expected that the evaluation of TBDx™ will run through the 3rd Quarter of 2014.

On November 3, 2013, Dr. Nazir Ismail, from the National Institute for Communicable Diseases, made a presentation at the 44^th World Conference on Lung Health the International Union Against Tuberculosis and Lung Disease (The Union) and the Center for Disease Control and Prevention (CDC) Late-Breaker session, which was held in Paris, France. The Late-Breaker session is intended to present the latest findings from new, innovative, and substantial research initiatives. Dr. Ismail presented “A novel TB diagnostic algorithm using automated microscopy achieves high sensitivity while reducing the volume of Xpert MTB/RIF testing”. The basis of

the presentation was the results of a TBDx™ triple blind study (organism culture, molecular testing, and independent microscopist) that was completed on May 3, 2013 in Johannesburg, South Africa of patients suspected of having tuberculosis.

During the 44^th Union World Conference on Lung Health held in November 2013, the company demonstrated the TBDx™ technology over a 4-day period. More than 50 demonstrations were held in the hall to more than 100 TB experts. Attending these demonstrations included The World Health Organization (WHO), the Global Fund, the International Union Against Tuberculosis and Lung Disease (the UNION), the Foundation for Innovation in New Diagnostics (FIND), the Stop TB Partnership, PATH, the Research Institute of Japan, the KNTV Tuberculosis Foundation, and National TB Program Managers from Pakistan, India, Bangladesh, Brazil, Peru, Ukraine, Russia, Uganda, Zimbabwe, Nigeria, Malawi, South Africa, Turkey, Saudi Arabia, China, and Japan. Also attending presentations included representatives from Johns Hopkins University, the London School of Hygiene and Tropical Medicine, the Liverpool School of Tropical Medicine, The University of Illinois at Chicago, the University of Maryland - School of Medicine, the AGA KHAN University of Pakistan, the University of China, and the Chinese University of Hong Kong.

On May 3, 2013, the Company completed a triple blind study (organism culture, molecular testing, and independent microscopist) of TBDx™ in Johannesburg, South Africa of patients suspected of having tuberculosis. The evaluation took place at the National Health Laboratory Services (“NHLS”) / Center for Tuberculosis. In its most thorough external evaluation of TBDx™ to-date, the Company was assisted by the National Institute for Communicable Diseases (“NICD”), who dedicated considerable staff and material resources to execute a test protocol that was approved by the London School of Tropical Medicine. During the technology evaluation, TBDx™ processed 1,249 patient slide specimens and acquired approximately 375,000 digital images. The total number of patient slide specimens available for analysis was 1,006, after consideration of specimens excluded from analysis due to contamination, missing culture, missing PCR tests, missing smear, and specimens mislabeled.

The results of the study, and the presentation by Dr. Ismail during the conference, provided significant diagnostic evidence that TBDx™ not only can be used by itself to outperform routine microscopists in detecting tuberculosis, but also it can be used as a “screening” or triage technology.

Reporting the results of the evaluation on behalf of a study team of renowned infectious disease professionals, Dr. Ismail concluded:

As a stand-alone test TBDx™ provides a level of sensitivity and specificity that would be equivalent to microscopists with 80 years of experience, or more. Dr. Ismail noted that having microscopists with this level of experience is both extraordinary and almost impossible to replace.

TBDx™ performance occurred among a low prevalence cohort (10%). It is very possible TBDx™ performance will be greater in a higher prevalence setting.

One limitation of the study was the high performing standard of the microscopists participating in the study, which is well above the accepted norm. For example, comparing TBDx™ to a standard microscopist performance (60%), TBDx™ would show sensitivity improvements of 25%-30%, with equivalent specificity.

Sensitivity = measures the proportion of actual positive cases, which are correctly identified as having tuberculosis.

Specificity = measures the proportion of negatives cases, which are correctly identified as not having tuberculosis.

TBDx™ performance shows it can be a triage tool for molecular testing, and can achieve high sensitivity:

Sensitivity of 78%; Specificity of 98.8%, with 75% fewer polymerase chain reaction (“PCR”) tests.

Sensitivity of 73%; Specificity of 99.3%, with 90% fewer PCR tests.

These conclusions led the study team to recommend demonstrations studies, similar to evaluations on molecular tests in recent years, should be conducted broadly on TBDx™ to test and confirm these findings. The evaluators can see several potential applications:

If a laboratory can test ALL TB suspects utilizing PCR, use TBDx™ automated microscopy to monitor treatment.

If a laboratory has a limited budget for PCR testing, and drug resistance is not a concern, use TBDx™ automated microscopy on ALL TB suspects and use PCR to confirm scanty cases. If drug resistance is a concern use PCR tests on all positive cases identified by TBDx™ automated microscopy.

If there is no budget for PCR testing, use TBDx™ automated microscopy throughout, or use it in central locations.

On March 15, 2013, the Company completed an evaluation of TBDx™, which was in cooperation with The TB Clinical Diagnostic Research Consortium (“CDRC”), an organization funded by the National Institute for Allergy and Infectious Diseases of the National Institutes of Health and managed by Johns Hopkins University. The evaluation consisted of the company correctly identifying 60 patient slides prepared from cases gathered from the CDRC’s work in Uganda. The diagnosis, unknown to the company, was independently verified by two sets of 3 microscopists in two laboratories in Uganda. The CDRC conducts feasibility studies of new diagnostic technologies. Members include the Johns Hopkins University; Imperial College of London in the United Kingdom; Infectious Diseases Institute in Kampala, Uganda; Boston Medical Center, University of Cape Town, South Africa; Universidade Federal do Espirito Santo in Vitoria, Brazil; University of Medicine and Dentistry of New Jersey – New Jersey Medical School; National Masan Tuberculosis Hospital-Yonsei University College of Medicine in the Republic of Korea; Foundation for Innovative New Diagnostics (FIND), and Westat Inc.

Other Developments - TBDx™

On November 29, 2012, the Public Library of Science One (“PloS One”) published the initial evaluation of TBDx™ entitled “Proof-of-Concept” Evaluation of an Automated Sputum Smear Microscopy System for Tuberculosis Diagnosis, which was undertaken by The Aurum Institute. PLoS One is a highly regarded and open source of scientific research in the TB community. This peer-reviewed evaluation represents the state of the TBDx^TM technology development as it existed in May, 2011.

On November 14, 2012, Dr. David Clark, Deputy CEO of The Aurum Institute, presented an update on the latest TBDx™ performance metrics and algorithm improvements during the 43^rd Union World Conference on Lung Health in Kuala Lumpur, Malaysia. Dr. Clark made the poster presentation entitled Automated TB Microscopy – Recent results and a model to increase pre-test probability to gene-based diagnostics. Dr. Clark presented the results of recent performance testing using multiple TBDx™ detection algorithms, and described the potential of TBDx™ to reduce laboratory costs by directing the most highly probable TB positive cases to more expensive molecular tests.

On April 26, 2012, the Company held a meeting in New Delhi, India, at the LRS Institute of Tuberculosis and Respiratory Disease to finalize the technical components and operating budget of a multi-site, nine-month project. The proposed project contains three phases: (i) clinical evaluation of TBDxV™ (tuberculosis visualization software), (ii) development of automated detection algorithms for use in Ziehl-Neelsen (ZN) laboratory settings; and, (iii) clinical evaluation of TBDx™ for the automated detection of TB in ZN stained sputum slides. The grant funding proposal was submitted to the Department of Biotechnology (“DBT”) on April 30, 2012. The Company received notification that DBT and its affiliates would participate in a clinical study upon the Company funding the program. The company is working towards an equitable solution.

On March 28, 2012, the Company held a demonstration of TBDx™ at the National Health Laboratory Services (“NHLS”) in Johannesburg, South Africa. The attendees included Dr. Michael Kimerling, Senior Program Officer in Tuberculosis for the Bill & Melinda Gates Foundation, Dr. Ishmail, Director of the Center for Tuberculosis (National Institute for Infectious Diseases), and Dr. David Clark, Deputy CEO of The Aurum Institute. The demonstration was at the request of Dr. Kimerling following a presentation he attended at the 2012 Conference on Retrovirals and other Opportunistic Infections (“CROI”) where results of our TBDx™ clinical trial were presented. Dr. Kimerling was especially interested in the results of our recent internal testing and a presentation illustrating the per-positive case cost advantages of using TBDx™.

On March 8, 2012, Dr. Gavin Churchyard, CEO of The Aurum Institute presented the first summary analysis of our initial clinical evaluation of TBDx™ conducted in South Africa, at the 2012 Conference on Retrovirals and other Opportunistic Infections held in Seattle, Washington. The presentation entitled “Automated AFB Microscopy Substantially Reduces Microscopists Work Load” was followed by a panel discussion on our technology and infectious diseases. The TBDx™ presentation was focused on the productivity gains to be realized as a result of automating smear microscopy and using detection algorithms to diagnose patient sputum specimens. TBDx™ automated detection increases the sensitivity of smear microscopy while reducing the reliance on human visual inspection. In a single laboratory shift, TBDx™ can handle the diagnostic workload of four microscopists while reducing errors that normally occur due to human factors. In a global environment of increasing growth in TB diagnostic needs to maintain status quo, resource challenged countries will need less capital investment to build new laboratories, with less stress on the human resource requirements for hiring, training and retaining laboratory technicians.

On February 4, 2012, Dr. Fleming Lure, VP for Signature Mapping, presented an abstract at the SPIE Medical Imaging Conference in San Diego, CA. SPIE is an international society for optics and photonics. The abstract presented by Dr. Lure is entitled “Automated Detection Of Tuberculosis On Sputum Smeared Slides Using Stepwise Classification.”

Breast Cancer Detection: BCDx™

Our research to-date includes five programs and studies conducted under the direction of the Image Processing and Informatics Laboratory at the University of Southern California (“USC”) using clinical data and images provided by: the Image Processing and Informatics Laboratory at USC, Howard University, and the South Florida Clinical Mammography Data Base. Competition is expected with existing computer-aided-detection (“CAD”) manufactures such as iCAD, Hologic, Medipatten, Confirma, Siemens, or Carestream Health. We may partner with one or more of these existing CAD manufacturers, or with an emerging company with new technology for the CAD arena. Once our products are commercially viable, we anticipate marketing and selling our products through original equipment manufacturers (“OEM”), or system integrators.

Early detection is a critical factor for controlling survival. Early detection provides increased therapeutic options and improved probability of survival. Mammography is a reliable and cost-effective screening technology. When properly conducted, mammography has been estimated to reduce breast cancer mortality by 20-30%. Currently, ductal carcinoma-in-situ (DCIS) represents 25%-30% of all reported breast cancers. Approximately 95% of all DCIS are diagnosed because radiologists identify them in mammograms. However, reading mammograms is difficult and prone to misinterpretation, subjectivity, and misreads. Studies have found that screening x-ray exams are about 80% accurate at best and that lesions are simply not detected 10% to 15% of the time. The

National Cancer Institute reported that 25% of breast tumors are missed in women in their forties. (See Liu B, Z. M., Document J (2005, "Utilizing data grid architecture for the backup and recovery of clinical image data." Comput Med Imaging Graph. 29(2-3): 95-102, and National Cancer Institute, "Cancer in African American Women."). Dense breasts pose a greater challenge to cancer detection using mammograms, especially early-stage breast cancers. Approximately 25% of women have dense breasts; thus a large number of mammograms, especially in AAW, are more difficult to clinically interpret. The risk of breast cancer associated with the highest category of density is estimated to be two to six times greater than for women with the lowest category of breast density.

On the basis of our initial studies, the signatures of malignant tumors in mammograms exhibit significant differences when compared with cysts, benign lesions, or dense breast tissue after being processed with Signature Mapping™. Measurable differences exist among different breast structures in both the spatial and frequency domains. Signatures of different tissues vary in their entropy, linearity, boundary gradients, and homogeneity. As a result, the internal structure of masses in dense breast tissue can be characterized and identified and displayed radiographically to the clinician. Signature Mapping™ is expected to visually display levels within the tumor and distortions in the breast geometry outside the tumor.

The effectiveness of these algorithms was evaluated through a pilot study conducted with the Norris Cancer Center at the University of Southern California. The study consisted of two sets of mammographic cases, a training set and a testing set. Both sets contained 40 normal and 40 confirmed solid cancer masses and were matched for levels of interpretation difficulty and patient age, variations in breast density, and types of tumors. Applied Visual used the training set for the development of its algorithms and for training the participating radiologists in the study. The test set was used in the pilot study to gain clinical feedback and determine the effectiveness of the radiologist’s interpretations using Signature Mapping™. Preliminary clinical results based on the visual performance of five highly-skilled and experienced mammographers using the mammography-specific Signature Mapping™ process demonstrated improved accuracy and ease of use in the study.

Clustered micro-calcifications may be the only visually detectable manifestation of early breast cancer. Mammography is very responsive to the presence of micro-calcifications, however, the specificity of mammography remains low. Benign calcifications cannot always be distinguished from those indicating malignancy resulting in a large population of women who do not have cancer, but are subjected to biopsy. Using Signature Mapping™ we expect that the miniscule structures within micro-calcifications can be characterized and their potential for pathology identified by the radiologists.

While carcinomas are rarely found in cysts, they are difficult to accurately diagnose through the use of mammography because they cannot be distinguished from other well circumscribed solid masses unless they display several characteristic patterns of calcification. Applied Visual is optimizing Signature Mapping™ for the accurate characterization of cysts as part of ongoing development that includes an early-onset cancer detection model.

Markets and Competition

Aviation/Homeland Security Technology Solution - PinPoint™

Market

Initially, management has focused its principal development and marketing efforts for its PinPoint™ product on the market for airport baggage screening technology solutions. However, as discussed further below, and although there can be no assurance, management believes that its PinPoint™ solution is also capable of being adapted for use in the people portal and cargo screening markets. The following discussion focuses on the market for baggage screening solutions; however, we have also provided an overview of the potential market for baggage screening, whole body imagery, and cargo screening technology solutions, potential future markets for our PinPoint™ product.

Baggage Screening

Security oversight of airports in the United States is overseen by the Transportation Safety Administration (“TSA”) with an annual operating budget in excess of $5 billion. TSA has the responsibility for over 480 U.S. airports with a combined inventory of baggage scanning equipment (checked baggage area and the carry-on baggage area) in excess of 6,000 scanners. While exact statistics on the number of scanners deployed in the rest of the world are not readily available, management estimates that the market is four times greater than the U.S. In addition to baggage scanners, airports worldwide are faced with replacing or supplementing existing metal detectors for passenger processing. Currently, there are limited standards within the aviation security marketplace for the testing and validation of software technology solutions. To date the marketplace has placed a premium on the newest innovations in hardware technology and has failed to grasp how a threat detection software solution can succeed.

To date the marketplace has placed a premium on the newest innovations in hardware technology and has failed to grasp how a threat detection software solution can succeed. It was expected that a major joint initiative between the Department of Homeland Security (DHS) and the National Electrical Manufacturers Association (NEMA) would open a path to both increase the interoperability of security equipment as well as provide a mechanism to use third party threat detection software as part of the screening solution. This

enabling initiative is the Digital Imaging and Communications in Security (DICOS) standard, similar to the Digital Imaging and Communications in Medicine (DICOM) standard. With a defined standard for the output of each screening device, complimentary automated threat detection software can be appended to any x-ray equipment. Applied Visual Sciences, Inc co-chaired one of the three NEMA working groups drafting the DICOS standard, and the DICOS standard was published in October 2010. To date DHS has not made this standard a mandatory requirement for proposals or procurements which, as a result, has not enabled third party detection software providers the ability to enter the marketplace which has given an undue advantage to the existing security equipment providers.

Management believes that international market acceptance of PinPoint™ as a viable threat detection solution will not only enhance our ability to sell worldwide, but it will open additional opportunities for the development of PinPoint™ as the “intelligent image” analysis solution for areas such as military target acquisition, satellite remote sensing, and additional opportunities within aviation security such as people portals and cargo scanning. Additionally, we will seek support of the U.S. Congress and the equipment manufacturers through lobbying and other efforts. We continue the ongoing development of PinPoint™. This focus must be even sharper when we enter the pilot test arena where the duration of the pilot test, the conditions under which the pilot test is conducted, and the definition of success and failure will vary country-by-country.

Whole Body Imagers

Almost every threat that requires people screening is currently monitored by a different system (explosives, weapons, biological, chemical, and nuclear/radiological). Management believes that today's people screening systems deliver unacceptable performance (high ‘false alarm’ rates, slow processing throughput, continued dependence on human detection, and high transaction costs. Management believes that the market for people portals that utilize imaging as its detection methodology is a sub-set, to which we believe PinPoint™ can address. It is management’s belief that the current people portal technology fails to meet the post-9/11 requirements. It is management’s belief that the technology will undergo dramatic technological changes when the multiple-threats "checkpoint of the future" is introduced.

Competition

The competition between the manufacturers of baggage (hand-held and small parcel) screening, luggage and large parcel screening, people screening for weapons and explosives detection, container and vehicle screening, and cargo screening is intense. These same equipment manufacturers represent Applied Visual Sciences, Inc.’s major competition, and include: AS&E, Smiths-Detection, OSI Rapiscan and L3, each of which is better capitalized and has greater marketing and other resources than Applied Visual Sciences, Inc. The competition between manufacturers is intense in view of amounts appropriated by the U.S. Government for threat detection technologies. What is not so obvious is that the manufacturers that once held the largest share of installed base are at risk due to aging and inadequate technology. Due to the agnostic nature of PinPoint™, we believe we can integrate PinPoint™ with any manufacturer’s scanning equipment. We believe our technology improves the efficiency of the underperforming hardware and extends the obsolescence of the existing scanning equipment. Funds previously appropriated for the upgrade or replacement of the in-place scanners could then be redeployed for the acquisition of required technologies such as body scanners or cargo scanners.

The equipment manufacturers in conjunction with software companies and academic institutions are attempting to develop sophisticated solutions to aid in the detection of contraband substances. To date there has been no known solution developed. We believe that Applied Visual Sciences, Inc.’s approach is unique in that it is a non-intrusive adjunct to the current manufacturers’ products. The enhancement identifies contraband at an accuracy level that is higher than the methodology used today by TSA.

The market for contraband detection systems software is anticipated to become intensely competitive and is characterized by continuously developing technology and frequent introductions of new products and features. We expect competition to increase as other companies introduce additional and more competitive products in the aviation security market and as we develop additional capabilities and enhancements for PinPoint™ and new applications for our technology. Historically, the principal competitors in the market for explosive detection systems have been GE-InVision, Vivid Technologies, Inc., EG&G Astrophysics, Smiths-Detection, Thermedics Detection Inc., and Barringer Technologies Inc. Each of these competitors provides aviation security solutions and products for use in the inspection of checked and carry-on luggage. We expect certain major corporations competing in other markets to enter the aviation security market.

Applied Visual Sciences, Inc. believes that its ability to compete in the aviation security market is based upon such factors as: product performance, functionality, quality and features; quality of customer support services, documentation and training; and the capability of the technology to appeal to broader applications beyond the inspection of checked and carry-on baggage. Although we believe that PinPoint™ is superior to our competitors’ products in its detection capability and accuracy, PinPoint™ must also compete on the basis of price, throughput, and the ease of integration into existing baggage handling systems. Certain of our competitors may have an advantage over our existing technology with respect to these factors.

Healthcare Technology Solutions - Signature Mapping™

Market

CAD vendors today have developed and sold clinical products in three major applications segments; mammography as a second look for the screening and early detection of breast cancer; chest CT for the early detection of nodules and CT of the colon for the non-endoscope screening of polyps.

Integrated CAD solutions is critical for gaining market share and may lead to higher profits…These new systems will enable workflow improvements while providing a smooth migration to the digital solution. This will increase the viability and broaden the appeal of these systems, and is likely to result in increased sales and revenues." These are new markets with new applications. The market is shifting towards CAD as physicians’ confidence levels continue to grow. For example, the radiologist who uses CAD for Mammography (one of the most prevalent today) would most likely be very willing to trying new clinical applications. This is true for general radiologists and specialty radiologists. Frost and Sullivan studies published in 2006 estimated world wide radiology imaging procedures for all modalities at slightly a billion procedures per year and estimated that approximately 300 million to 350 million procedures were attributed to the USA.

Replacement is expected in the two segments with the most demand expected to be the breast MRI CAD segment and the mammography CAD segment. With each new CAD technology introduced to the market, the potential size of this new market grows exponentially “Given the myriad of body parts and systems that CAD technology could be applied to in the future, as well as the different imaging modalities associated with each, growth in this market could be virtually unstoppable.” Such as, new technology introduced for CT would be applicable to the brain, chest, neck, abdominal and other areas of the body; and new technology for Ultrasound would be applicable for the breast, liver, prostate and abdominal.

Shalom S. Buchbinder, M.D., FACR, Chairman, Department of Radiology, Staten Island University Hospital, and Clinical Associate Professor of Radiology, Obstetrics, Gynecology and Women’s Health, Albert-Einstein College of Medicine of Yeshiva University, New York, U.S.A. (Changing the Way Healthcare is Delivered, RSNA 2004, p89) states “This relatively new technology improves the decision making compatibilities of clinicians…In my opinion mammography CAD has proven its clinical value and the future is about more robust and sophisticated tools that can, in addition to detection, help in the analysis of lesions. Innovative technologies can provide valuable information to support lesion classification.”

Financial support to fight TB comes from multiple sources world leaders, public health officials and international donors have taken action against TB and financial resources for control and research have increased dramatically in recent years. Public-private partnerships like the Foundation for Innovative New Diagnostics (“FIND”) have emerged to bring together key players in these sectors to move research and development forward for the needs of patients. Primarily, the government of each country is financially responsible for fighting TB with outside support of international organizations.

Market Conditions

Management’s review of current market conditions has identified the following trends:

TB is becoming a worldwide epidemic

Automatic differentiation of TB bacilli is a very challenging issue

Currently no such CAD product exists

Steady adoption of digital microscopy

Need for higher throughput and continued cost reduction without sacrificing quality

CAD is evolving as a clinical tool and physicians are adopting it

Current graphics cards and computational processing power are sufficient

Retiring workforce and the current prediction that there will be a shortage of pathologists

Economic pressures and increasing clinical demands

Facilitates productivity gains with inclusion of CAD

Pathologist can performs diagnosis on digital images and monitor

PMA FDA approvals of digital pathology tests is increasing

Facilitates improved workflow efficiency and enhances patient management practices

Pathology lab is poised for digital revolution

Pressures on the anatomical pathology sciences will drive change

STOP TB has stated they want “effective, efficient and validated clinical algorithms”

Potential Market For New TB Diagnostics

The persistent TB epidemic and expanding global population ensure that the total market for a range of TB diagnostic products is likely to increase yearly over the next decade by approximately 16%. The current international policy on TB case detection recommends the examination of three sputum smears for the diagnosis of pulmonary tuberculosis (PTB). The present definition of a

smear-positive case states "Tuberculosis in a patient with at least two initial sputum smear examinations (direct smear microscopy) positive for acid fast bacilli (AFB+)".

Worldwide, the WHO estimates that the largest potential available market for a new TB diagnostic would be for a test that both detects latent infection and predicts progression to active disease. Such a test, if widely implemented and accompanied by successful treatment, has the potential to revolutionize TB control. The infrastructure to achieve this globally is not available at this moment.

The next largest total available market is for a point-of-care screening test, which is estimated to be 193 million patient’s evaluations/year, of which approximately 70%, or 137 million patient’s evaluations/year is concentrated in the 22 high-burden countries. Substantial markets also exist for less revolutionary replacement technologies. Specifically, the total available markets for smear, culture, and monitoring and DST replacement tests are 83 million, 57 million, 40 million, and 6 million patient evaluations, respectively in 2005. We estimate that replacement technologies could capture a greater proportion of the market by 2020: smear 59% (49 million), culture 35% (20 million), monitoring 58% (23 million) and DST 45% (3 million). Without exception, between 70%–90% of the potential available markets for these replacement technologies are in the 22 high-burden countries. The continued emphasis on improving market conditions will encourage market growth in the high-burden countries and increase the accessibility to new products. (See “Global Tuberculosis Control - surveillance, planning and financing,” WHO Report 2008.)

Competition

We expect to compete with existing CAD manufactures such as iCAD, Hologic, Medipatten, Confirma, Siemens, or Carestream Health and manufacturers of dipstick or biomarker manufacturers, including SPAN Diagnostics Ltd., India, Yayasan Hati Sehat (YHS), Indonesia and Wiener Laboratorios, Argentina. We may also partner with one or more of these existing CAD manufacturers, or an emerging company with new technology for the CAD arena. Once our products are commercially viable, we anticipate marketing and selling our products through original equipment manufacturers (“OEM”), or system integrators.

While we are unaware of any computer-aided-detection for TB sputum microscopy analysis that can be identified that competes with our Signature Mapping™ products, there are substitute technologies that compete with sputum specimen analysis, such as the Cepheid Systems GeneXpert^® System, a dip-stick or biomarker approach. Management believes that competition will be driven by cost per procedure, ease-of-use, sensitivity and specificity, and the ability to be used by non-trained or lightly trained personnel in the point of care environment. These emerging tests include: Polymerase Chain Reaction, TB Breathalyzer, Q-Beta Replicase Assay, Transcription-Medicated Amplification, Ligase Chain Reaction, Strand Displacement Amplification, Nucleic Acid Sequence-Based Amplification and Branched DNA.

Sales, Marketing, and Distribution

Sales

Sales for products within our specific markets are conducted through both direct sales and indirect distribution channels worldwide.

Product Distribution and Marketing

We have entered into the following distributor, strategic partnership, development, and consulting agreements with regard to our products, although they have not produced revenue for the Company:

Preferred International Distributor Agreement with Rodash 136 (Pty) Ltd, of South Africa

On May 25, 2010, the Company and Rodash 136 (Pty) Ltd, of South Africa, entered into a Preferred International Distributor Agreement. Under the agreement, Rodash has agreed to promote the licensing and distribution of Applied Visual Sciences’ PinPoint™ suite of software. Rodash will also provide support to licensees of the products. The three year agreement provides for automatic successive one year renewal periods, unless either party provides written notice to the other of its intention to terminate or to re-negotiate the agreement no less then one hundred and twenty days prior to the end of the then-current period. The Company appointed Rodash as the exclusive distributor for such products in Africa, Brazil, Argentina, Indonesia and Australia, although the agreement permits Applied Visual Sciences to enter into business relationships with original equipment manufactures for the licensing, distribution, or resale of PinPoint™ products.

Preferred International Distributor Agreement Romador 168 (Pty) Ltd, of South Africa

On May 25, 2010, the Company and Romador 168 (Pty) Ltd, of South Africa, entered into a Preferred International Distributor Agreement. Under the agreement, Romador has agreed to promote the licensing and distribution of Applied Visual Sciences’ Signature Mapping™ suite of software. Romador will also provide support to licensees of the products. The three year agreement provides for automatic successive one year renewal periods, unless either party provides written notice to the other of its intention to terminate or to re-negotiate the agreement no less then one hundred and twenty days prior to the then-current period. The Company

appointed Romador as the exclusive distributor for such products in Africa, Brazil, Argentina, Indonesia and Australia, although the agreement permits Applied Visual Sciences to enter into business relationships with original equipment manufactures for the licensing, distribution, or resale of Signature Mapping™ products.

Memorandum of Understanding with Aurum Innova (Pty) Limited and the National Health Laboratory Services of South Africa

On March 24, 2009, Applied Visual Sciences, Inc. signed a Memorandum of Understanding (“MOU”) with Aurum Innova (Pty) Limited (“Innova”) and the National Health Laboratory Services of South Africa (“NHLS”). The purpose of the agreement is for the parties to jointly undertake activities for the completion of our Signature Mapping™ Tuberculosis (“TBDx™”) product for deployment in the NHLS laboratories. The parties will collaborate to enhance TBDx™’s overall performance, customize its use for application in the National Health Laboratory Services tuberculosis diagnosis and quality management program, and clinically evaluate, measure, and test TBDx™ performance. The collaboration includes conducting the clinical evaluation at selected NHLS laboratories that conduct sputum slide tuberculosis analysis and diagnosis.

Master Development Agreement with Aurum Innova (Pty), Ltd.

On February 4, 2009, Applied Visual Sciences, Inc. signed a Master Development Agreement Aurum Innova (Pty), Ltd., a company related to the Aurum Institute for Health Research, and installed in February 2009 an alpha product of Signature Mapping™ tuberculosis (“TBDx™”) software in a “retrofit configuration” for an evaluation by the National Health Laboratory Services (“NHLS”) in South Africa. This agreement extends the Company’s contractual relationship with Aurum that was first established with the signing of a Memorandum of Understanding on July 25, 2008. The new agreement provides for the joint development of products and services aimed at the screening, early detection and staging of diseases including TB, silicosis, and malaria. Each product will be the subject of a separate project specifications and the MDA included project specifications for our joint development of an automated TB sputum detection product. Aurum has agreed to clinically evaluate the products, and the parties agreed to jointly market and sell, initially in South Africa but eventually in sub-Saharan Africa, the jointly developed products, including our Signature Mapping™ TBDx™ product, through third parties and/or through Aurum. The Company agreed to pay Aurum a royalty on a product by products basis, based on the net revenue received by us through our distributors, and to be delineated by the parties. Also, the Company agreed to pay Aurum a commission with regard to sales of the products by Aurum. Further, Aurum has agreed to use every reasonable effort to raise funding to complete the development of a product following completion of the initial proof of concept. Any intellectual property jointly developed by us and Aurum will be jointly owned. The agreement may be terminated on one year’s prior written notice by either party, automatically terminates upon completion of project specifications and if no products are being marketed under the agreement, or for cause. The agreement also contains certain confidentiality and indemnification provisions.

Patents and Proprietary Rights

We rely on a combination of common law trademark, service mark, copyright and trade secret law and contractual restrictions to establish and protect our proprietary rights and promote our reputation and the growth of our business. We do not own any patents that would prevent or inhibit our competitors from using our technology or entering our market, although we intend to seek such protection as appropriate. It is our practice to require all of our employees, consultants and independent contractors to enter into agreements containing non-disclosure, non-competition and non-solicitation restrictions and covenants, and while our agreements with some of our customers and suppliers include provisions prohibiting or restricting the disclosure of proprietary information, we can not assure you that these contractual arrangements or the other steps taken by us to protect our proprietary rights will prove sufficient protection to prevent misappropriation of our proprietary rights or to deter independent, third-party development of similar proprietary assets.

The United States Patent & Trademark Office (“USPTO”) has granted the Company six patents, and we were granted one foreign patent, all of which are related to our underlying 3i™ technology. We also have three pending patents applications (U.S. and foreign) that further cover the implementation of our core 3i™ technology. We cannot provide assurance that any or all of the remaining patent applications or provisional applications will be issued patents, or that they will not be challenged, or that rights granted to us would actually provide us with an advantage over our competitors. Prior art searches have been conducted and, based on the results of these searches; we believe that we do not infringe any third party patents identified in the searches.


Date Granted	Patent No.	Patent Description
February 17, 2009	7,492,937	System and Method for Identifying Objects of Interest in Image Data
February 24, 2009	7,496,218	System and Method for Identifying Objects of Interest in Image Data
December 31, 2009	MY-140267-A7,907,762	System and Method for Identifying Objects of Interest in Image Data (Malaysian)
October 19, 2010	7,817,833	System and Method for Identifying Feature of Interest in Hyperspectral Data
November 23, 2010	7,840,048	System and Method for Determining Whether There is an Anomaly in Data
March 15, 2011	7,907,762	Method of Creating a Divergence Transform for Identifying a Feature of Interest in Hyperspectral Data


October 25, 2011	8,045,805	Method for Determining Whether a Feature of Interest Anomaly is Present in an Image

Due to the rapid pace of technological change in the software industry, we believe patent, trade secret and copyright protection are less significant to our competitive edge than factors such as the knowledge, ability and experience of our personnel, new product development, frequent product enhancements, name recognition and the ongoing reliability of our products.

Principal Offices

We maintain our principal office at 525K East Market Street, # 116, Leesburg, Virginia, 20176. Our telephone number in the U.S. is (703) 539-6190. Our Internet address is www.appliedvs.com, and the Company also disseminates information on Facebook at https://www.facebook.com/appliedvs and Twitter at https://mobile.twitter.com/appliedvs. Such information on our website, Facebook and Twitter is not deemed to be part of this Quarterly Report on Form 10-Q.

CONSOLIDATED RESULTS OF OPERATIONS

Results of Operations

Three months ended June 30, 2014 Compared to the three months ended June 30, 2013

The following analysis reflects the condensed consolidated results of operations of the Company and its subsidiaries.

Net Revenues. There were no revenues for three months ended June 30, 2014, or for the same period in 2013.

Cost of Sales. There was no cost of sales for three months ended June 30, 2014, or for the same period in 2013.

Selling, General and Administrative Expenses. Selling, general and administrative expenses for the three months ended June 30, 2014 of $232,234, decreased by $399,579 (63.2%), as compared to $631,813 for the same period in 2013. The table below details the components of selling, general and administrative expense, as well as the dollar and percentage changes for the three month period.


	Three Months Ended June 30
	2014	2013	$ Change	% Change
Payroll and related costs	$ 158,069	$ 216,445	$ (58,376)	(27.0)
Professional fees	33,871	58,966	(25,095)	(42.6)
Research and development costs	17,087	33,128	(16,041)	(48.4)
Other operating expenses	11,325	16,815	(5,490)	(32.6)
Depreciation and amortization	11,858	18,684	(6,826)	(36.5)
Stock-based compensation	24	287,775	(287,751)	(100.0)
Total	$ 232,234	$ 631,813	$ (399,579)	(63.2)

Payroll and related costs, which includes salaries, commissions, taxes and benefits, decreased $58,376 (27.0%) due to a reduction in staff. The Company currently employs three full-time, two part-time employees, and one employee on a temporary leave of absence who assists the Company upon request, and during 2013 we employed five full-time, one part-time employee, and one employee on a temporary leave of absence who assists the Company upon request.

Professional fees include legal, accounting, stock transfer agent, SEC filing, and general consulting fees. Professional fees decreased for the three months ended June 30, 2014 versus the same period last year by $25,095 (42.6%) due to: (i) an increase in general consultants, and miscellaneous services and fees of $2,629, (ii) a decrease in immigration, patent, and other legal fees of $4,392, (iii), an increase in audit fees of $10,000 due to timing of completing the December 31, 2013 audit, and (iv) a decrease in information technology consulting fees of $33,332.

Research and development (“R&D”) costs decreased for the three months ended June 30, 2014, compared to the same period last year by $16,041 (48.4%), due to Signature Mapping TBDx™ decreased development activities on performance metrics and algorithm improvements and an increased certification and business development activities.

Other operating expenses decreased by $5,490 (32.6%) to $11,325 for the three months ended June 30, 2014, compared to $16,815 for the same period in 2013. The decrease is attributed to: (i) increased other administrative expenses of $2,873, (ii) decreased travel costs of $8,363, due to timing of business development and certification activities scheduled in July and August 2014.

Depreciation and amortization expense in selling, general, and administrative for the three months ended June 30, 2014 is $11,858, compared to the same period in 2013 of $18,684, or a decrease of $6,826 (36.5%). The decrease is due to the impact of fully depreciated assets in prior periods.

Stock-based compensation, which represents a noncash expense category, is the amortization of the estimated fair value of stock-based compensation to employees, non-employee members of our Board of Directors, and consultants in lieu of cash compensation. The Company granted stock options to employees in January and August of 2013, and no stock options were issued to employees during 2014. During the three months ended June 30, 2014, the Company recognized stock-based compensation expense associated with employees, including its named executives, of $24, and for consultants of $0. During the same period of 2013, the Company recognized stock-based compensation expense for employees and directors of $287,775, and an expense of $0 for consulting services. Stock-based compensation expense for the current period decreased $287,751 for employees and $0 for consultants.

Employee stock option expense in 2014 and 2013 represents the amortization of the Black-Scholes fair value as outlined above in accordance with ASC 718-10. ASC 718-10 requires the recognition of all share-based payments to employees or to non-employee directors, as compensation for service on the Board of Directors, as compensation expense in the consolidated financial statements. The amount of compensation is measured based on the estimated fair values of such stock-based payments on their grant dates, and is amortized over the estimated service period to vesting. Consulting expense for stock-based payments to consultants is based on the fair value of the stock-based compensation at inception and amortized over the estimated service period but, in accordance with ASC 505-50, is remeasured on each reporting date until the performance commitment is complete.

Other Income (Expense). Other income (expense) includes interest income, interest expense and other non-operating income and expense. Net other income for the three months ended June 30, 2014 was $104,606, compared to net other expense of $287,988 for the same period last year, for a decrease in other expense of $183,382 (63.7%).

There was no interest income from interest bearing accounts for the three months ended June 30, 2014, or for the same period in 2013, due to low average daily cash balances in interest bearing accounts during the periods.

For the three months ended June 30, 2014, the Company had other non-operating income of $104,606, compared to an expense of $287,988 for the same period in 2013, or a decrease in non-operating expense of $183,382 (63.7%). The components of non-operating income (expense) for the second quarter of 2014 and 2013, and the variances include: (i) debt discount amortization costs in 2014 of $5,537 and $61 in 2013, or an increase in expense of $5,476, (ii) interest expense in 2014 for short-term notes of $24,913, whereby $17,814 for the same period in 2013, or an increase in expense of $7,099 (39.9%), (iii) income of $135,056 in 2014 for the revaluation of derivative liability related to the outstanding debentures, compared to an expense of $270,113 in 2013, or a decrease in expense of $405,169 (150.0%). Non-cash other income included above for the three months ended June 30, 2014 was $129,519, compared to other expense of $270,174 for the same period in 2013, or a decrease in non-cash other expense of $399,693.

Net Loss and Net Loss per Common Share. Net loss for the three months ended June 30, 2014 was $127,628, compared to $919,801 for the same period in 2013, for a decrease in net loss of $792,173 (86.1%). Net loss for the Company per common share (“basic EPS”) is computed by dividing net income (loss) by the weighted average number of shares outstanding. Net loss per common share assuming dilution (“diluted EPS”) is computed by reflecting potential dilution from contingently issuable shares (i.e. common stock purchase warrants and stock options issued and outstanding).

Reconciliation between the numerators and denominators of the basic EPS computations is as follows:


	Three Months Ended June 30
	2014	2013
Numerator:
Net loss	$ (127,628)	$ (919,801)

Denominator:
Weighted average common shares outstanding - basic	103,138,601	101,026,612

Net loss per common share - basic	$0.00	($0.01)

Six months ended June 30, 2014 Compared to the six months ended June 30, 2013

The following analysis reflects the condensed consolidated results of operations of the Company and its subsidiaries.

Net Revenues. There were no revenues for six months ended June 30, 2014, or for the same period in 2013.

Cost of Sales. There was no cost of sales for six months ended June 30, 2014, or for the same period in 2013.

Selling, General and Administrative Expenses. Selling, general and administrative expenses for the six months ended June 30, 2014 of $515,738, decreased by $721,388 (58.3%), as compared to $1,237,126 for the same period in 2013. The table below details the components of selling, general and administrative expense, as well as the dollar and percentage changes for the three month period.


	Six Months Ended June 30
	2014	2013	$ Change	% Change
Payroll and related costs	$ 389,489	$ 477,240	$ (87,751)	(18.4)
Professional fees	43,228	125,165	(81,937)	(65.5)
Research and development costs	27,324	38,513	(11,189)	(29.1)
Other operating expenses	16,023	44,503	(28,480)	(64.0)
Depreciation and amortization	29,395	37,368	(7,973)	(21.3)
Stock-based compensation	10,279	514,337	(504,058)	(98.0)
Total	$ 515,738	$ 1,237,126	$ (721,388)	(58.3)

Payroll and related costs, which includes salaries, commissions, taxes and benefits, decreased $87,751 (18.4%). The Company currently employs three full-time, two part-time employees, and one employee on a temporary leave of absence who assists the Company upon request, and during 2013 we employed five full-time, one part-time employee, and one employee on a temporary leave of absence who assists the Company upon request.

Professional fees include legal, accounting, stock transfer agent, SEC filing, and general consulting fees. Professional fees decreased for the six months ended June 30, 2014 versus the same period last year by $81,937 (65.5%) due to: (i) a decrease in legal fees of $1,088, (ii) an increase in general consultants, miscellaneous services and fees of $2,481, and (iii) a decrease in information technology consulting fees of $83,330.

Research and development (“R&D”) costs decreased for the six months ended June 30, 2014, compared to the same period last year by $11,189 (29.1%), due to Signature Mapping TBDx™ decreased development activities on performance metrics and algorithm improvements and an increased certification and business development activities

Other operating expenses decreased by $28,480 (64.0%) to $16,023 for the six months ended June 30, 2014, compared to $44,503 for the same period in 2013. The decrease is attributed to: (i) decreased utilities and phone costs of $5,660, (ii) decreased travel costs of $7,590, due to timing of business development and certification activities scheduled in July and August 2014, and (iii) a decrease in rent expense of $15,230.

Depreciation and amortization expense in selling, general, and administrative for the six months ended June 30, 2014 is $29,395, compared to the same period in 2013 of $37,368, or a decrease of $7,973 (21.3%). The decrease is due to the sale of furniture in March 2013, which reduced the depreciable base amount and the impact of fully depreciated assets in prior periods.

Stock-based compensation, which represents a noncash expense category, is the amortization of the estimated fair value of stock-based compensation to employees, non-employee members of our Board of Directors, and consultants in lieu of cash compensation. The Company granted stock options to employees in January and August of 2013, and no stock options were issued to employees during 2014. During the six months ended June 30, 2014, the Company recognized stock-based compensation expense associated with employees, including its named executives, of $10,279, and for consultants of $0. During the same period of 2013, the Company recognized stock-based compensation expense for employees and directors of $508,837, and an expense of $5,500 for consulting services. Stock-based compensation expense for the current period decreased $498,558 for employees and $5,500 for consultants.

Other Income (Expense). Other income (expense) includes interest income, interest expense and other non-operating income and expense. Net other income for the six months ended June 30, 2014 was $211,214, compared to net other expense of $367,834 for the same period last year, for a decrease in other expense of $579,048 (157.4%).

There was no interest income from interest bearing accounts for the six months ended June 30, 2014, or for the same period in 2013, due to low average daily cash balances in interest bearing accounts during the periods.

For the six months ended June 30, 2014, the Company had other non-operating income of $211,214, compared to an expense of $367,834 for the same period in 2013, or a decrease in non-operating expense of $579,048 (157.4%). The components of non-operating income (expense) for the first six months of 2014 and 2013, and the variances include: (i) financing costs for commissions on short-term notes of $0 in 2014 versus $225 for the same period in 2013, or a decrease of $225 (100.0%), (ii) a gain from the sale of furniture of $0 in 2014, and a gain in 2013 of $8,338, (iii) debt discount amortization costs in 2014 of $15,541 and $3,063 in 2013, or an increase in expense of $12,478 (407.4%), (iv) interest expense in 2014 for short-term notes of $43,358, whereby $35,243 for the

same period in 2013, or an increase in expense of $8,115 (23.0%), (v) income of $270,113 in 2014 for the revaluation of derivative liability related to the outstanding debentures, compared to an expense of $337,641 in 2013, or a decrease in expense of $607,754 (180.0%). Non-cash other income included above for the six months ended June 30, 2014 was $254,572, compared to other expense of $340,704 for the same period in 2013, or a decrease in non-cash other expense of $595,276 (174.7%).

Net Loss and Net Loss per Common Share. Net loss for the six months ended June 30, 2014 was $304,524, compared to $1,604,960 for the same period in 2013, for a decrease in net loss of $1,300,436 (81.0%). Net loss for the Company per common share (“basic EPS”) is computed by dividing net income (loss) by the weighted average number of shares outstanding. Net loss per common share assuming dilution (“diluted EPS”) is computed by reflecting potential dilution from contingently issuable shares (i.e. common stock purchase warrants and stock options issued and outstanding).

Reconciliation between the numerators and denominators of the basic EPS computations is as follows:


	Six Months Ended June 30
	2014	2013
Numerator:
Net loss	$ (304,524)	$ (1,604,960)

Denominator:
Weighted average common shares outstanding - basic	102,948,463	100,322,940

Net loss per common share - basic	$0.00	($0.02)

LIQUIDITY AND CAPITAL RESOURCES

The following table presents a summary of our net cash provided by (used in) operating, investing and financing activities:


	Six Months Ended June 30
Category	2014	2013
Net cash (used) in operating activities	$ (23,355)	$ (149,519)
Net cash provided by investing activities	-	28,934
Net cash provided by financing activities	33,000	126,500
Effect of exchange rates on cash and cash equivalents	-	-
Net increase in cash	$ 9,645	$ 5,915

Net Cash Used in Operating Activities

Net cash used in operating activities for the six months ended June 30, 2014, was $23,355, compared with net cash used in operating activities of $149,519 during the same period for 2013, or a decrease in the use of cash for operating activities of $126,164 (84.4%). The decrease in the use of cash is due to: (i) lower operating costs including, but not limited to a decrease in selling, general and administrative costs (other than depreciation and amortization, and stock based compensation) of $209,357 (30.5%), and an increase in non-operating expense (other than noncash items) of $7,890 (22.2%); and (ii) offset by a net decrease in components of operating assets and liabilities of $75,303 (13.2%).

Net Cash Provided by Investing Activities

Net cash provided by investing activities of $0 for the six months ended June 30, 2014, and for the same period in 2013 of $28,934 for the sale of furniture, or a net decrease in cash provided by investing activities of $28,934 (100.0%). The Company anticipates it will incur equipment costs during the current fiscal year ending December 31, 2014, as we design add-on features that extend our current products into other areas, and ongoing patent costs related to further protection of our PinPoint™ and Signature Mapping™ products.

Net Cash Provided by Financing Activities

Net proceeds from financing activities were $33,000 the six months ended June 30, 2014, compared with $126,500 for the same period in 2013, or a decrease of $101,500 (80.2%). The decrease in the net cash provided by financing activities of $101,500 is due to a decrease from the issuance of short-term notes of $93,000, and reduction of $8,500 in notes payable from a related party. Management is seeking, and expects to continue to seek to raise additional capital through equity or debt financings or bank borrowings, including through one or more equity or debt financings or bank borrowings to fund its operations, repay or repurchase its debentures, and pay amounts due to its creditors and employees. However, there can be no assurance that the Company will be able to raise such additional equity or debt financing or obtain such bank borrowings on terms satisfactory to the Company or at all.

Cash

Our cash increased during the six months ended June 30, 2014 by $9,645, compared to an increase in cash during the same period in 2013 of $5,915. As outlined above, the decrease in cash for the current period in 2014 was the result of; (i) cash used in operating activities of $23,355, (ii) cash provided by investing activities of $0, and (iii) cash from financing activities of $33,000. The net change in cash for the six months ended June 30, 2014, as compared to the same period in 2013, was $3,730, and is the result of (i) a decrease in cash used in operating activities of $126,164 (84.4%), (ii) a decrease from investing activities $28,934 (100.0%), and (iii) a decrease in financing activities of $93,500 (80.2%).

Working Capital Information - The following table presents a summary of our working capital at the end of each period:


	(unaudited)
Category	June 30, 2014	December 31, 2013
Cash	$ 10,753	$ 1,108

Current assets	18,851	2,223
Current liabilities	13,556,769	13,299,173
Working capital (deficit)	$ (13,537,918)	$ (13,296,950)

Cash is stated at cost, which approximates fair value, and consists of interest and noninterest bearing accounts at a bank. Balances may periodically exceed federal insurance limits. The Company does not consider this to be a significant risk. The Company considers all highly liquid debt instruments with initial maturities of 90 days or less to be cash equivalents. There were no cash equivalents as of June 30, 2014 and December 31, 2013, respectively.

As of June 30, 2014, the Company had a working capital deficit of $13,537,918, compared to $13,296,950 at December 31, 2013, or an increase in working capital deficit of $240,968 (1.8%). As of June 30, 2014, the Company had cash of $10,753 as compared to $1,108 on December 31, 2013. The increase in cash of 9,645 is the net result of our operating, investing and financing activities outlined above. For the six months ended June 30, 2014, current liabilities increased $257,596 (1.9%), with specific decreases in current liabilities of $303,993 including: (i) $33,880 for conversion of accrued wages for stock, (ii) $270,113 for the revaluation of derivative liabilities related to the outstanding debentures, and specific increases in current liabilities of $561,589, including: (i) $15,541 short-term note payable due to reduction of debt discount, (ii) $33,000 in promissory notes, (iii) $42,877 in trade and accrued payables, (iv) $43,358 in accrued interest, and (v) $426,813 for the continued accrual of unpaid wages and related expenses for all employees.

Our revenue generating activities during the period, as in previous years, have not produced sufficient funds for profitable operations, and we have incurred operating losses since inception. Accordingly, we have continued to utilize the cash raised in our financing activities to fund our operations. In addition to raising cash through additional financing activities, we may supplement our future working capital needs through the extension of trade payables and increases in accrued expenses. In view of these matters, realization of certain of the assets in the accompanying balance sheet is dependent upon our continued operations, which in turn is dependent upon our ability to meet our financial requirements, raise additional financing, and the success of our future operations.

Other Liabilities

2014 Short-Term Promissory Notes

During the first six months of 2014, the Company issued promissory notes to four accredited investors in the aggregate principal amount of $33,000. The notes are non-interest bearing, and as consideration to the note holders, the Company shall pay a total premium of 50% (total payment due of 1.5 times principal) of such notes, and the entire unpaid principal and premium amounts shall become immediately due on or before September 30, 2014. If such notes are not paid by September 30, 2014, then the Company shall pay a total premium of 100% (total payment due of 2 times principal), and such payments of total principal and premium amounts shall be from net revenue of future TBDx™ sales.

2013 Short-Term Promissory Notes

During 2013, the Company issued nine promissory notes to eight accredited investors in the aggregate principal amount of $179,500 ($179,275, net of commissions and expenses in the amount of $225), of which five notes for an aggregate of $48,500 originally matured during 2013 and were amended to mature on June 30, 2014, $14,000 matures on June 30, 2014, $100,000 matures on September 21, 2014, and $17,000 matures on October 25, 2014. The notes that matured on June 30, 2014, were amended to mature on December 31, 2014. The terms of the notes are essentially the same as the 2011 and 2012 short-term promissory notes, except that $40,000 of the notes accrue interest at a rate of 12% per annum, one note for $8,500 was noninterest bearing during 2013 and accrues interest at a rate of 10% effective January 1, 2014, one note for $14,000 accrues interest at a rate of 10% per annum, one note for $8,500 accrues interest at a rate of 5.9%, with two notes for $108,500 being noninterest bearing. Consideration for one $8,500 noninterest bearing note during 2013 received a modification to 540,000 warrants to include a cashless provision, one note of $8,500

received an extension of 4,632,725 warrants to December 31, 2018, and one note for $100,000 received a 2% royalty payment of future TBDx™ net revenue in South Africa up to $300,000. The Company issued to six of the note holders an aggregate of 450,000 shares of common stock, and the relative fair value of the common stock of $31,100 will be amortized over the term of the notes.

2012 Short-Term Promissory Notes

During 2012, the Company issued six promissory notes to accredited investors in the aggregate principal amount of $160,000. The twelve-month notes accrue interest at a rate of 12% per annum. The Company also issued to the note holders an aggregate of 285,000 shares of common stock. The relative fair value of the common stock of $11,715 will be amortized over the term of the notes. The Company also issued 10,800 shares of common stock as compensation in connection with the financing for a fair value of $2,700. The notes were subsequently amended to mature on December 31, 2014.

2011 Short-Term Promissory Notes

During October and November 2011, the Company issued twelve-month promissory notes to accredited investors in the aggregate principal amount of $400,000. The twelve-month notes accrue interest at a rate of 12% per annum. The Company also issued to the two note holders an aggregate of 400,000 shares of common stock. The relative fair value of the common stock of $34,700 will be amortized over the term of the notes. The Company also issued 250,000 shares of common stock as compensation in connection with the financing for a fair value of $25,000. The notes were subsequently amended to mature on December 31, 2014.

2006 through 2013 Short-Term Promissory Notes, Related Party

On October 18, 2006, the Company entered into a Loan Agreement with Mr. Michael W. Trudnak, our Chairman and Chief Executive Officer pursuant to which Mr. Trudnak loaned the Company $100,000. The Company issued a non-negotiable promissory note, dated effective October 18, 2006, to Mr. Trudnak in the principal amount of $100,000. The note is unsecured, non-negotiable and non-interest bearing. The note is repayable on the earlier of (i) six months after the date of issuance, (ii) the date the Company receives aggregate proceeds from the sale of its securities after the date of the issuance of the Note in an amount exceeding $2,000,000, or (iii) the occurrence of an event of default. The following constitute an event of default under the note: (a) the failure to pay when due any principal or interest or other liability under the loan agreement or under the note; (b) the material violation by us of any representation, warranty, covenant or agreement contained in the loan agreement, the note or any other loan document or any other document or agreement to which the Company is a party to or by which the Company or any of our properties, assets or outstanding securities are bound; (c) any event or circumstance shall occur that, in the reasonable opinion of the lender, has had or could reasonably be expected to have a material adverse effect; (d) an assignment for the benefit of our creditors; (e) the application for the appointment of a receiver or liquidator for us or our property; (f) the issuance of an attachment or the entry of a judgment against us in excess of $100,000; (g) a default with respect to any other obligation due to the lender; or (h) any voluntary or involuntary petition in bankruptcy or any petition for relief under the federal bankruptcy code or any other state or federal law for the relief of debtors by or with respect to us, provided however with respect to an involuntary petition in bankruptcy, such petition has not been dismissed within 30 days of the date of such petition. In the event of the occurrence of an event of default, the loan agreement and note shall be in default immediately and without notice, and the unpaid principal amount of the loan shall, at the option of the lender, become immediately due and payable in full. The Company agreed to pay the reasonable costs of collection and enforcement, including reasonable attorneys’ fees and interest from the date of default at the rate of 18% per annum. The note is not assignable by Mr. Trudnak without our prior consent. The Company may prepay the note in whole or in part upon ten days notice. On November 10, 2006, Mr. Trudnak extended the due date of the note to May 31, 2007. Mr. Trudnak made an additional $24,000 loan to the company on June 25, 2008, and $5,000 on September 14, 2011, for cumulative outstanding loans of $129,000. The maturity date of the outstanding loans was extended multiple times during 2009 through 2013. On December 31, 2013, the outstanding loans were extended to June 30, 2014, and subsequently to December 31, 2014. The Company repaid an aggregate of $6,900 of the notes during 2010, an aggregate $33,100 during 2011, an aggregate of $8,500 during 2013, resulting in an outstanding balance at June 30, 2014 of $80,500. The terms of the above transaction were reviewed and approved by the Company’s audit committee and by the independent members of our Board of Directors. Upon the death of Mr. Trudnak on April 18, 2014, the notes became part of his estate and will be assigned to his spouse, Jean M. Trudnak.

2006 and 2007 Series A Debentures (as Amended on October 15, 2010)

Under a securities purchase agreement, dated November 3, 2006, between the Company and certain institutional accredited investors, the Company sold an aggregate of $5,150,000 in principal amount of our Series A Debentures and Series D Common Stock Purchase Warrants to purchase an aggregate of 4,453,709 shares of our common stock. On November 8, 2006, the Company issued to the institutional investors an aggregate of $2,575,000 in principal amount of Series A Debentures and 4,453,709 Series D Warrants. On April 12, 2007, the Company issued an additional $2,575,000 in principal amount of the Series A Debentures, which followed the effectiveness of a registration statement registering the shares of our common stock underlying the Series A Debentures and Series D Warrants. Proceeds of the two offerings were used for the purpose of new personnel, research and development, registration expenses, for general working capital purposes, and repaying $200,000 in loans made to us by Mr. Michael W. Trudnak, our Chairman and CEO. The Company allocated proceeds from each closing to the derivative liability features of the Series A Debentures and Series D

Warrants that were recognizable as a liability under generally accepted accounting principles. We also issued at the first closing an aggregate of 623,520 common stock purchase warrants to the placement agent as compensation in the offering, which were upon terms substantially similar to the Series D Warrants. One-half of the Series D Warrants (2,226,854 warrants) and the placement agent warrants (311,760 warrants) became exercisable on November 8, 2006. The remaining one-half of the Series D Warrants (2,226,855 warrants) and the placement agent warrants (311,760 warrants) became exercisable on April 12, 2007. The Series D Warrants and the placement agent’s warrants may be exercised via a cashless exercise if certain conditions are met. Due to the potential of the milestone-related adjustments, the initial exercise price of $1.15634 may be reset and the maximum number of shares to be issued under the debentures was at that time indeterminable, and the Company considered the guidance of ASC 815-40, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”, whereby public companies that are or could be required to deliver shares of common stock as part of a physical settlement or a net-share settlement, under a freestanding financial instrument, are required to initially measure the contract at fair value, and concluded that the potential of the milestone-related adjustments at that time may cause insufficient shares to share settle the contracts. On April 1, 2007, due to the various milestone-related provisions, the conversion price of the Series A Debentures and the exercise price of the Series D Warrants and Placement Agent’s Warrants were reset to a price of $0.7453 per share, then to $0.6948 effective October 1, 2007, and the final milestone reset of $0.4089 effective April 1, 2008. The Series A Debentures and Series D Warrants also have a fully ratchet anti-dilution provision, whereby any subsequent equity transaction entitling a person to acquire shares of common stock at an effective price per share that is lower then the then conversion price, then the conversion price of the Debentures and Warrants shall be reduced to equal the lower subsequent equity transaction price. Subsequently, as a result of a June 2009 financing in which the Company elected to issue shares of common stock and warrants at $0.25 per share, the conversion price of our debentures and the exercise price of the Series D Warrants was adjusted under the anti-dilution provisions of such instruments to a price of $0.25 per share, and the number of shares underlying the Series D Warrants (including the warrants the Company issued to the placement agent in the financing) were increased by an aggregate of 2,677,417 Series D warrants. On July 10, 2007, a debenture holder exercised 864,798 Series D Warrants for 864,798 shares of common stock, and 914,798 warrants were exercised during 2010 under the cashless provision for 420,166 shares of common stock. Of the remaining Series D Warrants and Placement Agent Warrants, 3,062,527 warrants expired on November 11, 2011, and 3,012,523 warrants expired on April 12, 2012.

As of June 30, 2014, an aggregate of $3,461,795 in principal amount of the Series A Debentures have been converted into 8,730,037 shares of common stock, an aggregate of $663,043 in interest amount have been converted into 2,675,576 shares of common stock, and an aggregate of 1,779,596 Series D Warrants have been exercised resulting in the issuance of 1,284,964 shares of common stock. Accordingly, as of June 30, 2014, an aggregate of $1,688,205 of principal amount of the debentures remain unconverted.

Our outstanding Series A 10% Convertible Debentures originally became due on November 7, 2008. On October 15, 2010, we entered into an agreement with our two remaining Series A Debenture holders to amend and effect a restructuring of the debentures that originally became due on November 7, 2008. Under the amendment agreement, the Company and two debenture holders agreed: (i) to an extension of the maturity date of the debentures to June 30, 2011, (ii) that the $1,688,205 of outstanding principal amount will not bear interest from July 1, 2010 through the new maturity date, (iii) that, in exchange for the payment in cash of amounts of accrued but unpaid regular interest of approximately $638,163, and waived all additional interest and late fees, liquidated damages and certain other amounts due under the debentures (“Interest and Default Amounts”) the Company issued an aggregate of 2,552,653 shares of common stock, (iv) that all claims with regard to the payment of the Interest and Default Amounts and all prior events of default under the Debentures and breaches of any covenant, agreement, term or condition (“Defaults”) under our debentures and debenture transaction documents would be waived and the Company was released from any claims with respect to the Additional Interest and Late Fees of approximately $773,314, and Default Amounts of approximately $2,541,739, and prior Defaults Events, (v) to terminate the registration rights agreements between the Company and each debenture holder, and (vi) that the Company may force a conversion of the debentures if our common stock equals or exceeds certain price and volume conditions. There were no conversions of our debentures during 2013 or 2014.

Under the Debenture amendment agreement, the Debenture holders agreed, commencing March 3, 2011, that the Company may force a conversion of the Debentures. Such a forced conversion may only be effected once every 90 days and the ability of the Company to force any such conversion is subject to certain equity conditions, which conditions were amended under the terms of the Debenture Amendment Agreement in accordance with the following:

if the variable weighted average price for the Company’s common stock (“VWAP”) for any five consecutive trading days exceeds $0.50 and the average daily dollar trading volume for the Company’s common stock during such period equals or exceeds $50,000, the Company may require a Holder to convert up to 25% of the outstanding principal amount of its Debenture on September 3, 2010, plus any liquidated damages or other amounts owing under the Debenture;

if the VWAP for any five consecutive trading days exceeds $0.75 and the average daily dollar trading volume for the common stock during such period equals or exceeds $75,000, the Company may require a Holder to convert up to an additional 25% of the outstanding principal amount of its Debenture on September 3, 2010, plus any liquidated damages or other amounts owing under the Debenture;

if the VWAP for any five consecutive trading days exceeds $1.00 and the average daily dollar trading volume for the common stock during such period equals or exceeds $100,000, the Company may require a Holder to convert up to

100% of the outstanding principal amount of its Debenture on September 3, 2010, plus any liquidated damages or other amounts owing under the Debenture.

The principal amount of our outstanding Series A Debentures of $1,688,205 became due on July 1, 2011, and such amount was not paid. Therefore, the Company could be considered in default and may result in enforcement of the debenture holders’ rights and remedies under the debentures and applicable law. We are in discussions with the debenture holders to re-negotiate the terms of the debentures, including the repayment or repurchase of the debentures and/or seek to extend their maturity date, although we have not reached any agreement with the debenture holders with regard to any such repayment, repurchase or extension. Our ability to repay or repurchase the debentures is contingent upon our ability to raise additional financing, of which there can be no assurance. Also, as a condition to any such extension, debenture holders may seek to amend or modify certain other terms of the debentures. When an event of default occurs under the debentures, the debenture holders may elect to require us to make immediate repayment of the mandatory default amount, which equals the sum of (i) the greater of either (a) 120% of the outstanding principal amount of the debentures, or (b) the outstanding principal amount unpaid divided by the conversion price on the date the mandatory default amount is either (1) demanded or otherwise due or (2) paid in full, whichever has the lower conversion price, multiplied by the variable weighted average price of the common stock on the date the mandatory default amount is either demanded or otherwise due, whichever has the higher variable weighted average price, and (ii) all other amounts, costs, expenses, and liquidated damages due under the debentures. In anticipation of such election by the debenture holders, due to the nonpayment of principal amount on the due date of July 1, 2011, we measured the mandatory default at approximately $337,641 and subsequently on each balance sheet date, which is reflected in the carrying value of the debentures and also recognized as interest expense. We remeasured the mandatory default amount as of June 30, 2014 at approximately $337,641. As of the date of this report, the debenture holders have not made an election requiring immediate repayment of the mandatory amount, although there can be no assurance they will not do so. The Company currently has insufficient funds to repay the outstanding amount in the event the debenture holders make a demand for payment.

Prior to the Debenture amendment agreement and absent a default, the Debentures bore interest at the rate of 10% per annum. The Debenture agreement, as amended on October 15, 2010, states no interest and that from July 1, 2010 through the maturity date of June 30, 2011, the principal amount of this Debenture shall bear no interest.” Any reference to the accrual of interest or late fees, beyond the maturity date, was specifically deleted from the Debenture agreement. If an Event of Default occurs, the outstanding principal amount of the Debenture, plus accrued but unpaid interest, liquidated damages and other amounts owing in respect thereof through the date of acceleration, shall become, at the holder’s election, immediately due and payable in cash at the mandatory default amount. Commencing 5 days after the occurrence of any Event of Default that results in the eventual acceleration of the Debenture, the interest rate on the Debenture shall accrue at an interest rate equal to the lessor of 18% per annum or the maximum rate permitted under applicable law. In accordance with the terms of the amendment agreement, management believes there is no legal requirement to continue the accrual of interest or late fees. Management also determined that there are two (2) events that must take place before the default interest rate of 18% takes effect. One is an event of default, which occurred when the Company did not make payment of the outstanding principle amount on the amended due date of July 1, 2011. The other event is an “eventual acceleration” of the mandatory default amount, which did not take place since the default did not occur before the maturity date of June 30, 2011, and the event of default occurred on the due date of July 1, 2011 when payment was not made by the Company. Since the default did not take place before the maturity or due date, no acceleration of the payment for the outstanding principal amount of the Debentures took place, and the 18% default interest provision does not apply.

The Debenture agreement, as amended on October 15, 2010, continues to permit the payment of interest, if due, in cash or registered shares of our common stock. If we elected to pay the interest due in shares of our common stock, the number of shares to be issued in payment of interest is determined on the basis of 85% of the lesser of the daily volume weighted average price of our common stock as reported by Bloomberg LP (“VWAP”) for the five trading days ending on the date that is immediately prior to (a) date the interest is due or (b) the date such shares are issued and delivered to the holder. We could pay interest in shares of our common stock only if the equity conditions, described below, have been met during the 20 consecutive trading days prior to the date the interest is due and through the date the shares are issued. The payment of interest in shares of our stock, the redemption of the Debentures and the occurrence of certain other events, was subject to a requirement that certain equity conditions (“equity conditions”) were met, as follows: (i) we have honored all conversions and redemptions of a Debenture by the holder, (ii) we have paid all liquidated damages and other amounts due to the holder, (iii) the registration statement covering the resale of the shares underlying the Debentures and Series D Warrants is effective permitting a holder to utilize the registration statement to resell its shares, (iv) our stock is traded on the OTC Markets, OTCQB or other securities exchange and all of the shares upon conversion or exercise of the Debentures and Series D Warrants are listed for trading, (v) we have sufficient authorized but unreserved shares of our common stock to cover the issuance of the shares upon conversion or exercise of the Debentures and Series D Warrants, (vi) there is no event of default under the Debentures, (vii) the issuance of the shares would not violate a holder’s 4.99% or 9.99% ownership restriction cap, (viii) we have not made a public announcement of a pending merger, sale of all of our assets or similar transaction or a transaction in which a greater than 50% change in control of the Company may occur and the transaction has not been consummated, (ix) the holder is not in possession of material public information regarding us, and (x) the daily trading volume of our shares for 20 consecutive trading days prior to the applicable date exceeds 100,000 shares. Under the terms of the Debenture Amendment Agreement, (A) the equity condition in (iii) above was amended to provide that such condition is met if, in the alternative, the shares issuable upon conversion of the Debentures may then be resold pursuant to Rule 144 without restriction or limitation and the Company has delivered to a holder an opinion of the Company’s counsel that such resale may legally be made and provided the holder has furnished a representation letter

reasonable acceptable to the Company’s counsel that the holder is not an “affiliate” for purposes of Rule 144; (B) the equity condition in (vi) above was amended to except an event of default that has previously been waived; and (C) the equity condition in (x) above was amended to except circumstances where another volume condition is applicable.

The Debentures contain a limitation on the amount of Debenture that may be converted at any one time in the event the holder owns beneficially more than 4.99% of our common stock without regard to the number of shares underlying the unconverted portion of the Debenture. This limitation may be waived upon 61 days’ notice to us by the holder of the Debenture permitting the holder to change such limitation to 9.99%.

An event of default may occur under the Debentures if (a) the Company defaults in the payment of principal or, liquidated damages , (b) the Company fails to materially observe or perform a covenant or agreement in the Debentures, (c) a default or event of default occurs under any other transaction document related to the financing or in any other material agreement to which the Company is a party that results in a material adverse effect on the Company, (d) any representation or warranty the Company made to investors in the transaction documents related to the financing is materially untrue or incorrect, (e) a bankruptcy event occurs with regard to the Company, (f) the Company defaults on any other loan, mortgage, or credit arrangement that involves an amount greater than $150,000 and results in the obligation becoming declared due prior to the due date, (g) the Company’s common stock is not eligible for quotation on the OTC Markets or other exchange on which the Company’s shares are traded, (h) a transaction occurs in which the control of the Company changes, the Company effects a merger or consolidation, the Company sells substantially all of the assets, a tender offer is made for the Company’s shares, the Company reclassify their shares or a compulsory share exchange, or the Company agrees to sell more than 33% of the assets, unless the Company receives the consent of holders of 67% of then outstanding principal of the Company’s Debentures, (i) the Company fails to deliver certificates for shares to be issued on conversion within seven trading days, (j) the Company has a judgment against it for more than $150,000. We have agreed to compensate a holder of a Debenture in the event our transfer agent fails to deliver shares upon conversion of the Debentures within three trading days of the date of conversion, and the holder’s broker is required to purchase shares of our common stock in satisfaction of a sale by a holder.

The conversion price of the Debentures or the number of shares to be issued upon conversion or exercise of the Debentures are subject to adjustment in the event of a stock dividend, stock split, subdivision or combination of our shares of common stock, reclassification, sales of our securities below their then conversion or exercise price (“subsequent equity sales anti-dilution adjustment provisions”), a subsequent rights offering, or a reclassification of our shares. Also, if we effect a merger or consolidation with another company, we sell all or substantially all of our assets, a tender offer or exchange offer is made for our shares, or we effect a reclassification of our shares or a compulsory share exchange, a holder that subsequently converts its Debenture will be entitled to receive the same kind and amount of securities, cash or property as if the shares it is entitled to receive on the conversion had been issued and outstanding on the date immediately prior to the date any such transaction occurred. Except as discussed above, no such events have occurred through the date of this report.

We were not required to make an adjustment to the conversion or exercise price or the number of shares to be issued upon conversion or exercise of the Debentures pursuant to the subsequent equity sales anti-dilution adjustment provisions related to an “exempt issuance,” which is defined as: (A) any stock or options that are issued under our stock option plans or are approved by a majority of non-employee directors and issued (i) to employees, officers or directors or (ii) to consultants, but only if the amount issued to consultants does not exceed 400,000 shares in a 12 month period, (B) securities issued under the Debentures, (C) shares of common stock issued upon conversion or exercise of, or in exchange for, securities outstanding on the date we entered into the securities purchase agreement, or (D) the issuance of securities in an acquisition or strategic transaction approved by our disinterested directors. Under the Debenture Amendment Agreement, commencing October 15, 2010, Debenture holders agreed that an “exempt issuance” shall also include the issuance of stock or common stock equivalents authorized and approved in advance by the Company’s disinterested directors at a price per share or at a conversion or exercise price per share equal to or greater than $0.25.

In connection with our Series A Debenture financing, we entered into a registration rights agreement with purchaser of our debentures pursuant to which we agreed we would use our best efforts to file a registration statement under the Securities Act within 45 days of the first closing to permit the public resale by debenture holders of the shares that may be issued upon conversion of the Debentures and upon exercise of the Series D Warrants, including the shares of our common stock underlying the Debentures to be issued at the second closing. Pursuant to the amendments we entered into with the current debenture holders on October 15, 2010, the debenture holders agreed to terminate their registration rights agreements with us. Accordingly, we are not required to register or maintain the registration of the shares underlying the Series A Debentures, however, the Company was obligated under the terms of the Registration Rights Agreement that the Company entered into with each purchaser that has fully converted its Debenture.

We also granted to each purchaser of the Debentures the right to participate in any offering by us of common stock or common stock equivalents until the later of (i) 12 months after the effective date of the registration statement and (ii) the date a purchaser holds less than 20% of the principal amount of the Debenture the purchaser originally agreed to purchase, except for an exempt issuance or an underwritten public offering of our common stock. Purchasers may participate in such an offering up to the lesser of 100% of the future offering or the aggregate amount subscribed for under the securities purchase agreement by all purchasers. Although such common stock offerings have occurred, the Debenture holders have notified the Company that they do not want to participate in any future financings.

The securities purchase agreement also contained representations and warranties of both us and purchasers, conditions to closing, certain indemnification provisions, and other customary provisions. Also the Debenture Amendment Agreement amended certain provisions covering events of default under the Debentures, contained certain representations and warranties of the Company, a reaffirmation of certain of the representations and warranties in the securities purchase agreement, contained certain conditions to closing, and certain other customary provisions.

We were prohibited from effecting a reverse or forward stock split or reclassification of our common stock except as may be required to comply with the listing standards of any national securities exchange.

The Company had interest expense of $43,358, and $35,243, for the six months ended June 30, 2014, and the same period in 2013, respectively. Debt discount amortization costs of $15,541, and $3,063, for the six months ended June 30, 2014, and the same period in 2013, respectively

Additional Capital

To the extent that additional capital is raised through the sale of our equity or equity-related securities of our subsidiaries, the issuance of our securities could result in dilution to our stockholders. No assurance can be given that we will have access to the capital markets in the future, or that financing will be available on terms acceptable to satisfy our cash requirements, implement our business strategies, and meet the restrictive requirements of the debenture financing described above. If we are unable to access the capital markets or obtain acceptable financing, our results of operations and financial condition could be materially and adversely affected. We may be required to raise substantial additional funds through other means. We have not begun to receive material revenues from our commercial operations associated with the software products. Management may seek to raise additional capital through one or more equity or debt financings or have discussions with certain investors with regard thereto. We cannot assure our stockholders that our technology and products will be commercially accepted or that revenues will be sufficient to fund our operations. If adequate funds are not available to us, we may be required to curtail operations significantly or to obtain funds through entering into arrangements with collaborative partners or others that may require us to relinquish rights to certain of our technologies or products.

Off-Balance Sheet Arrangements

We do not maintain any off-balance sheet arrangements, transactions, obligations or other relationships with unconsolidated entities that would be expected to have a material current or future effect upon our financial condition, or results of operations as of June 30, 2014 and December 31, 2013.

Financial Condition, Going Concern Uncertainties and Events of Default

default amount, which equals the sum of (i) the greater of either (a) 120% of the outstanding principal amount of the debentures, or (b) the outstanding principal amount unpaid divided by the conversion price on the date the mandatory default amount is either (1) demanded or otherwise due or (2) paid in full, whichever has the lower conversion price, multiplied by the variable weighted average price of the common stock on the date the mandatory default amount is either demanded or otherwise due, whichever has the higher variable weighted average price, and (ii) all other amounts, costs, expenses, and liquidated damages due under the debentures. In anticipation of such election by the debenture holders, due to the nonpayment of principal amount on the due date of July 1, 2011, we measured the mandatory default at approximately $337,641 and subsequently on each balance sheet date, which is reflected in the carrying value of the debentures and also recognized as interest expense. We remeasured the mandatory default amount as of June 30, 2014 at approximately $337,641. As of the date of this report, the debenture holders have not made an election requiring immediate repayment of the mandatory amount, although there can be no assurance they will not do so. The Company currently has insufficient funds to repay the outstanding amount in the event the debenture holders make a demand for payment.

During the six months ended June 30, 2014, our total stockholders’ deficit increased by $270,363 to $13,196,440, and our consolidated net loss for the period was $304,524, or a decrease of $1,300,436 (81.0%) in net loss from the same period in 2013Notwithstanding the foregoing discussion of management’s expectations regarding future cash flows, Applied Visual Sciences’ insolvency continues to increase the uncertainties related to its continued existence. Both management and the Board of Directors are carefully monitoring the Company’s cash flows and financial position in consideration of these increasing uncertainties and the needs of both creditors and stockholders.

Significant Accounting Policies

The preparation of the Company’s financial statements requires management to make estimates, judgments, and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses during the periods presented. The Company, previously an operating stage company, became a development stage company on April 1, 2012. A development stage company, as defined by ASC-915-10 “Accounting and Reporting by Development Stage Enterprise”, is an entity that devotes substantially all of its efforts to establish a business and either of the following conditions exists: 1) the principal operations have not commenced, or 2) the principal operations have commenced, but there has been no significant revenue therefrom. For a discussion of the Company’s critical accounting policies and estimates, refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013. Except as disclosed in Part I, Item 4, Controls and Procedures of this report, and in Note 2 of our 2013 Form 10-K, there have been no material changes to these critical accounting policies that impacted the Company’s reported amounts of assets, liabilities, revenues or expenses during the six-month period ended June 30, 2014.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

Our market risk is confined to changes in foreign currency exchange rates and potentially adverse effects of differing tax structures. There were no international revenues subject to such market risks during the six-month period ended June 30, 2014, although,, we may be exposed to foreign exchange rate fluctuations as the Company pursues revenue opportunities outside the United States. As exchange rates vary, results when translated may vary from expectations and adversely impact overall expected profitability. As of June 30, 2014, the Company’s foreign currency exposure is related to accounts payable trade in the amount of $30,371.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this Report, the Chief Executive Officer and Chief Financial Officer of the Company (the “Certifying Officers”) conducted evaluations of the Company’s disclosure controls and procedures. As defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), the term “disclosure controls and procedures” means controls and other procedures of an issuer that are designed to ensure the information required to be disclosed by the issuer 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 Securities and Exchange Commission’s (“SEC”) rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer’s management, including the Certifying Officers, to allow timely decisions regarding required disclosure.

Based on this evaluation, and for reasons discussed below, the Certifying Officers determined that, as of the end of the period covered by this Report, the Company’s disclosure controls and procedures were not effective to ensure that the 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 SEC’s rules and forms and to ensure that information required to be disclosed by the Company in the Reports that it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including the Company’s principal executive and principal financial officers, or persons performing similar functions, as appropriate, to allow timely decisions regarding disclosure. On November 6, 2013, the Company filed its June 30, 2013 Form 10-Q, which was due on August 14, 2013.

Although the Certifying Officers have determined that our disclosure controls and procedures were not effective, management continues to believe that a refinement to our disclosure controls is an ongoing process. The Audit Committee believes the Company should continue the following activities: (a) additional education and professional development for the Company’s accounting and other staff on new and existing applicable SEC filing requirements, certain applicable SEC disclosure requirements, and the timing of the filing thereof, and (b) reviewing disclosure requirements, including Form 10-K and Regulation S-K disclosure requirements, SEC staff guidance and interpretations related thereof, as well as Accounting Standards Codification (“ASCs”) and updates.

Changes in Internal Controls

There were no changes in the Company’s internal controls over financial reporting during the period covered by the Report that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

None

ITEM 1A. RISK FACTORS

An investment in our common stock involves a high degree of risk. You should carefully consider the risks described below (which reflect changes to certain of the risk factors we disclosed in our 2013 Form 10-K) and other information contained in this Report in deciding whether to invest in our common stock, as well as certain risk factors set forth under Part I, Item 1A of our 2013 Form 10-K. Additional risks not presently known to us or which we currently consider immaterial may also adversely affect our company. If any of the following risks actually occur, our business, financial condition and operating results could be materially adversely affected. In such case, the trading price of our common stock could decline, and you could lose a part of your investment.

Risks Related to Our Company and Our Operations

We have incurred substantial debt which could affect our ability to obtain additional financing and may increase our vulnerability to business downturns. We may be unable to repay our Series A Debentures that matured on June 30, 2011.

As of June 30, 2014, the aggregate principal under our outstanding Series A Debentures was $1,688,205, which matured on June 30, 2011. Also, we have outstanding trade and accrued payables of $1,732,024, other accrued liabilities of $187,937, and accrued salaries due to our employees and management of $7,871,710, as well as accrued related payroll liabilities of $621,168. Also, the Company has an outstanding noninterest-bearing loan from its past Chief Executive Officer of $80,500, and $772,500 short-term notes from thirteen (13) investors. We are subject to the risks associated with substantial indebtedness, including insufficient funds to repay the outstanding principal in the event the debenture holders make a demand for payment; it may be more expensive and difficult to obtain additional financing; and we are more vulnerable to economic downturns.

We did not make timely payment of outstanding principal when due under our Series A Debentures, and failure to make such payment is an event of default under the debentures. We have insufficient cash resources to repay the amounts due to our debenture holders.

We have a severe working capital deficit and, in addition to proceeds from financings, we continue to have outstanding loans from our previous chief executive officer and deferrals of salaries by our executive officer, employees and a consultant/director. In the event we are unable to pay our employees salaries, we may experience employee attrition which could materially and adversely affect our business and operations.

During the six months ended June 30, 2014, our total stockholders’ deficit increased by $270,363 to $13,196,440, and our consolidated net loss for the period was $304,524 or a decrease of $1,300,436 (81.0%) in net loss from the same period in 2013. Our revenue generating activities had not produced sufficient funds for profitable operations and we have incurred operating losses since inception. Although we have obtained limited cash from certain financings, we continue to have outstanding loans from our previous chief executive officer of approximately $80,500, accrued and unpaid salaries of our two named executive officers and previous chief executive officer in the amount of $4,508,661, and to other employees of $3,363,049, and outstanding accounts payable to a previous consultant/director of the Company in the amount of $804,250. The Company currently employs three full-time, two part-time employees, and one employee on a temporary leave of absence who assists the Company upon request, and during 2013 employed five full-time, one part-time employee, and one employee on a temporary leave of absence who assists the Company upon request. The Company’s insolvency continues to increase the uncertainties related to its continued existence. Also, in the event we are unable to pay our employees, we may continue to experience further employee attrition which could materially adversely affect our business and operations, including our ongoing research and development activities. Both management and the Board of Directors are carefully monitoring the Company’s cash flows and financial position in consideration of these increasing uncertainties and the needs of both creditors and stockholders.

Our certifying officers evaluated the effectiveness of our disclosure controls and procedures, and concluded that our disclosure controls were not effective for the period ending June 30, 2013, and that we had certain weaknesses during the period in our internal controls over timely reporting. Therefore, internal controls over timely reporting were ineffective as of the period covered by this Report.

Our Chief Executive Officer and Chief Financial Officer (the “Certifying Officers”) are responsible for establishing and maintaining our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e) and 15d-15(e)). The Certifying Officers designed

such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under their supervision, to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified by the SEC’s rules and forms, and is made known to management (including the Certifying Officers) by others within the Company, including its subsidiaries. We regularly evaluate the effectiveness of our disclosure controls and procedures and report our conclusions about the effectiveness of the disclosure controls quarterly in our Forms 10-Q and annually in our Forms 10-K. In completing such reporting, we disclose, as appropriate, any significant change in our internal control over financial reporting that occurred during our most recent fiscal period that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. As we disclosed above, on November 6, 2013, the Company filed its June 30, 2013 Form 10-Q, which was due on August 14, 2013. Our Certifying Officers concluded that our disclosure controls and procedures were not effective as of the end of the period covered by such reports. Although the Certifying Officers have determined that our disclosure controls and procedures were not effective, management continues to believe that refinement to our disclosure controls and procedures is an ongoing progress. The Audit Committee believes the Company should continue the following activities: (a) additional education and professional development for the Company’s accounting and other staff on new and existing applicable SEC filing requirements, certain applicable SEC disclosure requirements, and the timing of the filing thereof, and (b) reviewing disclosure requirements, including Form 10-K and Regulation S-K disclosure requirements, SEC staff guidance and interpretations related thereto. While management is responsible for establishing and maintaining our disclosure controls and procedures and has taken steps to ensure that the disclosure controls are effective and free of “significant deficiencies” and/or “material weaknesses,” the ability of management to implement the remediation of such weaknesses and deficiencies and the inherent nature of our business and rapidly changing environment may affect management’s ability to be successful with this initiative.

Dilutive effect of conversion of Series A Senior Convertible Debentures, and the exercise of outstanding common stock purchase warrants, of which some carry a cashless exercise provision.

At June 30, 2014, an aggregate of 6,752,820 of our shares of our common stock issuable upon full conversion of our outstanding Series A Debentures. The Company also has an aggregate of 21,638,835 of our shares issuable upon exercise of outstanding common stock purchase warrants that have an average exercise price of $0.26, of which approximately 4,843,973 warrants may be exercised pursuant to the cashless exercise provisions of such warrants and may be subsequently resold as “restricted securities” under the provisions of Rule 144 under the Securities Act. Increased sales volume of the Company’s common stock could cause the market price of the Company’s common stock to drop. Sales of a substantial number of shares of our common stock in the public market, or the perception that these sales might occur, could depress the market price of our common stock and could impair our ability to raise capital through the sale of additional equity securities.

Our lease expired in January 2013 and was not be able to extend our existing lease, and elected not to obtain a lease for new office space because of our financial condition and limited cash resources.

The Company’s office lease for our principal executive offices expired on January 31, 2013. The lease did include a renewal provision, and due to our financial condition and limited cash, the Company was not able to renew the lease, and elected to not obtain a lease for office space due to terms that are unacceptable to us.

Our directors and named executive officers own a substantial percentage of our common stock.

As of August 19, 2014, our directors, executive officers and the estate of our previous chief executive officer beneficially owned approximately 28.5% of our shares of common stock. Accordingly, our directors, executive officers, the estate of our previous chief executive officer, and most highly compensated employee are entitled to cast an aggregate of 12,803,534 votes on matters submitted to our stockholders for a vote or approximately 12.3% of the total number of votes entitled to be cast at a meeting of our stockholders. These stockholders, if they acted together, could exert substantial control over matters requiring approval by our stockholders. These matters would include the election of directors and the approval of mergers or other business combination transactions. This concentration of ownership may discourage or prevent someone from acquiring our business.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

On July 1, 2014, the Company issued 200,000 shares of common stock to a consultant as compensation for business advisory services. The common stock was issued in reliance upon the exemption from the registration requirements set forth in Section 4(2) of the Securities Act and/or Rule 506 of Regulation D promulgated thereunder.

On July 18, 2014, the Company received $50,000 from an accredited investor and issued an aggregate of 200,000 shares of common stock, of which 185,000 shares were issued under the 2009 Stock Compensation Plan. The remaining 15,000 shares of common stock was issued in reliance upon the exemption from the registration requirements set forth in Section 4(2) of the Securities Act and/or Rule 506 of Regulation D promulgated thereunder.

ITEM 3. DEFAULT UNDER OUR SERIES A DEBENTURES

ITEM 5. OTHER INFORMATION

Not Applicable

ITEM 6. INDEX TO EXHIBITS

Copies of the following documents are included as exhibits to this report pursuant to Item 601 of Regulation S-K.


APPLIED VISUAL SCIENCES, INC.

INDEX TO EXHIBITS
Exhibit		Incorporated by Reference		Filed
Number	Description	Form	Filing Date	Herewith
31.1	Certification Pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, As Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (CEO)			X
31.2	Certification Pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, As Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (CFO)			X
32.1	Certification Pursuant Rule 13a-14(b) or Rule 15d-14(b) and 18 U.S.C. Section 906 of the Sarbanes-Oxley Act of 2002, As Amended (CEO)			X
32.2	Certification Pursuant Rule 13a-14(b) or Rule 15d-14(b) and 18 U.S.C. Section 906 of the Sarbanes-Oxley Act of 2002, As Amended (CFO)			X
101.INS	XBRL Instance Document *			X
101.SCH	XBRL Taxonomy Extension Schema Document *			X
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document *			X
101.LAB	XBRL Taxonomy Extension Definition Linkbase Document *			X
101.PRE	XBRL Taxonomy Extension Label Linkbase Document *			X
101.DEF	XBRL Taxonomy Extension Presentation Linkbase Document *			X

* Users of this data are advised pursuant to Rule 406T of Regulation S-X that this interactive data file is deemed not filed or part of a registration statement or prospectus for the purpose of section 11 or 12 of the Securities Act of 1933, as amended, is deemed not filed for purposes of section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise is not subject to liability under these sections.

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.

APPLIED VISUAL SCIENCES, INC.

By: /s/ William J. Donovan

William J. Donovan

Chief Executive Officer

(Principal Executive Officer)

By: /s/ Gregory E. Hare

Gregory E. Hare

Chief Financial Officer

(Principal Financial and Accounting Officer)

Date: August 19, 2014

Exhibit 31.1

CERTIFICATION PURSUANT TO RULE 13a-14(a) OR 15d-14(a) UNDER THE SECURITIES
EXCHANGE ACT OF 1934, AS ADOPTED PURSUANT TO SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002, AS AMENDED

I, William J. Donovan, certify that:

I have reviewed this Quarterly Report on Form 10-Q of Applied Visual Sciences, Inc.;

Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal controls over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a)

Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)

Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c)

Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d)

Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

(a)

All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b)

Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: August 19, 2014

Signed:

/s/ William J. Donovan

Name:

William J. Donovan

Title:

Chairman and Chief Executive Officer

Exhibit 31.2

CERTIFICATION PURSUANT TO RULE 13a-14(a) OR 15d-14(a) UNDER THE SECURITIES
EXCHANGE ACT OF 1934, AS ADOPTED PURSUANT TO SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002, AS AMENDED

I, Gregory E. Hare, certify that:

I have reviewed this Quarterly Report on Form 10-Q of Applied Visual Sciences, Inc.;

(a)

(b)

(c)

(d)

(a)

(b)

Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: August 19, 2014

Signed:

/s/ Gregory E. Hare

Name:

Gregory E. Hare

Title:

Chief Financial Officer

Exhibit 32.1

CERTIFICATION

PURSUANT TO RULE 13a-14(b) or

RULE 15d-14(b) AND 18 U.S.C. SECTION 1350
(AS ADOPTED PURSUANT TO SECTION 906 OF THE

SARBANES-OXLEY ACT OF 2002, AS AMENDED)

Pursuant to 18 U.S.C. Section 1350 (as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, as amended), the undersigned officer of Applied Visual Sciences, Inc., a Delaware corporation (the “Company”), does hereby certify, to such officer’s knowledge, that:

The Quarterly Report on Form 10-Q for the quarter ended June 30, 2014 (the “Report”) of the Company fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (15 U.S.C. 78m or 78o(d), and the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: August 19, 2014

Signed:

/s/ William J. Donovan

Name:

William J. Donovan

Title:

Chairman and Chief Executive Officer

Exhibit 32.2

CERTIFICATION

PURSUANT TO RULE 13a-14(b) or

RULE 15d-14(b) AND 18 U.S.C. SECTION 1350
(AS ADOPTED PURSUANT TO SECTION 906 OF THE

SARBANES-OXLEY ACT OF 2002, AS AMENDED)

Date: August 19, 2014

Signed:

/s/ Gregory E. Hare

Name:

Gregory E. Hare

Title:

Chief Financial Officer

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