Stock Purchase Warrants

The following table summarizes information about warrant activity during the six months ended March 31, 2006:

At March 31, 2006, the following stock purchase warrants were outstanding arising from offerings and other transactions:

The $3.01 warrants, the $3.25 warrants, the $6.36 warrants and the $6.55 warrants contain certain antidilution rights if the Company sells securities for less than the exercise price.

11. NET LOSS PER SHARE

Basic net loss per share includes no dilution and is computed by dividing net loss available to common stockholders, after deduction for cumulative imputed and accreted dividends, by the weighted average number of common shares outstanding for the period. Diluted net loss per share reflects the potential dilution of securities that could share in the earnings of an entity. The Company’s losses for the periods presented cause the inclusion of potential common stock instruments outstanding to be antidilutive. Stock options and warrants exercisable into 4,384,789 and 4,437,545 shares of common stock were outstanding at March 31, 2006 and 2005, respectively. These securities are not included in the computation of diluted net loss per share because of the losses, but could potentially dilute earnings per share in future periods.

Net loss available to common stockholders decreased to ($0.11) in the three months ended March 31, 2006 from ($0.15) in the three months ended March 31, 2005, and decreased to ($0.14) in the six months ended

16

Table of Contents

AMERICAN TECHNOLOGY CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

March 31, 2006 from ($0.24) in the six months ended March 31, 2005. In computing net loss per share, the net loss for the three and six months ended March 31, 2005 was increased by $1,518,651 and $1,796,426, respectively, by imputed deemed dividends based on the value of warrants issued and the computed beneficial conversion amount of convertible preferred stock. Such non-cash imputed deemed dividends were not included in the Company’s stockholders’ equity as the Company has an accumulated deficit and therefore were reflected as an increase and a related decrease to additional paid in capital. Amounts are included in net loss available to common stockholders. The imputed deemed dividends were not contractual obligations of the Company to pay such imputed dividends.

The provisions of each of the Company’s series of preferred stock also provided for a 6% per annum accretion in the conversion value (similar to a dividend). Such accretions were not included in the Company’s stockholders’ equity as the Company has an accumulated deficit and therefore they were reflected as an increase and a related decrease to additional paid in capital. These non-cash amounts also increased the net loss available to common stockholders. Net loss available to common stockholders is computed as follows:

12. MAJOR CUSTOMERS

For the three months ended March 31, 2006, revenues from four customers accounted for 39%, 17%, 14% and 14% of total revenues, respectively; and for the six months ended March 31, 2006, revenues from two customers accounted for 20% and 36% of total revenues, respectively. At March 31, 2006, trade accounts receivable from five customers accounted for 23%, 11%, 11%, 10% and 10%, respectively, of total trade accounts receivable.

No other customers accounted for more than 10% of total revenues for the three and six months ended March 31, 2006, or more than 10% of total trade accounts receivable at March 31, 2006. At September 30, 2005, trade accounts receivable from two customers accounted for 18% and 14%, respectively, of total trade accounts receivable, and no other customers accounted for more than 10% of total trade accounts receivable.

The Company’s major customers consist of resellers that sell to various end customers in the commercial retail, cruise lines as well as various government and military divisions.

13. LEASE FOR PRINCIPAL FACILITIES

In December 2005, the Company entered into a sublease agreement with Anacomp, Inc., as sublandlord, to sublease approximately 23,698 square feet of office, warehousing, product assembly, and research space located

17

Table of Contents

AMERICAN TECHNOLOGY CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

at 15378 Avenue of Science, San Diego, California 92118. The sublease is for a term commencing January 1, 2006 and expiring May 31, 2011. The agreement provides for a monthly expense of $29,622.50 (representing $1.25 per rentable square foot) during the term. In addition to the monthly base rental expense, the Company is responsible for certain costs and charges specified in the sublease, including the Company’s proportionate share of the building operating expenses and real estate taxes. Costs associated with this move were approximately $280,000, which amount included approximately $248,000 of leasehold improvements.

In addition, the sublease provides that the Company has a right of first refusal on additional space in the building, which contains a total of 68,910 square feet including the Company’s premises. Anacomp will also provide a $10,000 tenant improvement allowance towards the completion of lobby improvements and a $50,000 letter of credit in the Company’s favor which the Company may draw upon to the extent necessary to offset any increase in our rent or relocation costs that is incurred due to Anacomp’s failure to maintain the lease with the master landlord for the building.

In January 2006, the Company entered into a lease agreement with Priority Properties LLC, to lease approximately 1,700 square feet of office space located in Topsham, Maine, used as a sales office for the Government and Military Group. The lease is for 12 months and can be renewed for up to five years.

14. LITIGATION

The Company may at times be involved in litigation in the ordinary course of business. The Company will also, from time to time, when appropriate in management’s estimation, record adequate reserves in the Company’s financial statements for pending litigation. Currently, there are no pending material legal proceedings to which the Company is a party or to which any of its property is subject.

15. INCOME TAXES

At March 31, 2006, a valuation allowance has been provided to offset the net deferred tax asset as management has determined that it is more likely than not that the deferred tax asset will not be realized. At September 30, 2005, the Company had for federal income tax purposes net operating loss carryforwards of approximately $46,972,000, which expire through 2026 of which certain amounts are subject to significant limitations under the Internal Revenue Code of 1986, as amended.

16. BUSINESS SEGMENT DATA

The Company is engaged in design, development and commercialization of sound, acoustic and other technologies. The Company’s operations are organized into two segments by the end-user markets they serve. The Company’s reportable segments are strategic business units that sell the Company’s products into distinct markets. The Commercial Products Group (Commercial Group) markets and licenses LRAD, HSS, NeoPlanar and other sound products incorporating the Company’s technologies to customers and end-users that employ audio in consumer, commercial and professional applications. The Government and Force Protection Systems Group (Government and Military Group) markets LRAD, MRAD and NeoPlanar products to government and military customers and to the expanding force protection and commercial security markets. The segments are managed separately because each segment requires different selling and marketing strategies as the class of customers within each segment is different.

The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company does not allocate operating expenses or assets between its two reportable segments. Accordingly the measure of profit for each reportable segment is gross profit.

18

Table of Contents

AMERICAN TECHNOLOGY CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Summarized below are the revenues and gross profit (loss) for our business units:

17. SUBSEQUENT EVENTS

Mr. Richard Wagner, a director of the Company, declined to stand for re-election on March 21, 2006 and completed his term of service on May 4, 2006.

19

Table of Contents

The following discussion should be read in conjunction with the accompanying unaudited interim financial statements and the related notes included under Item 1 of this Quarterly Report on Form 10-Q, together with Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2005.

The following discussion provides an overview of our results of operations for the three and six months ended March 31, 2006 and 2005. Significant period-to-period variances in the statements of operations are discussed under the caption “Results of Operations.” Our financial condition and cash flows are discussed under the caption “Liquidity and Capital Resources.”

Forward Looking Statements

This report contains certain statements of a forward-looking nature relating to future events or future performance. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the only means of identifying forward-looking statements. Prospective investors are cautioned that such statements are only predictions and that actual events or results may differ materially. In evaluating such statements, prospective investors should specifically consider various factors identified in this report, including any matters set forth under Part II, Item 1A (Risk Factors) of this report and under the caption “Risk Factors” in our Annual Report on Form 10-K, which could cause actual results to differ materially from those indicated by such forward-looking statements.

Overview

We are continuing to make a major transition from focusing on research and development of new directed sound technologies to sales, marketing and licensing of our products and technologies. While this transition has been challenging, we are working successfully with U.S. and international companies and organizations to create new markets and integrate our directed sound products and technologies into digital signage networks and other commercial and military/government applications.

In fiscal year 2005, we completed the commercialization of four proprietary directed sound technologies, recording revenues from each. During the first half of fiscal year 2006, our HSS ^® H-450 has gained acceptance from digital signage and networked narrowcasting display providers as in-store networks proliferate in retail chains throughout the U.S. and abroad We have experienced increased revenues from the commercial marine and yachting industries as we have added new LRAD ^™ products and accessories for our customers. With key additions to our executive management team over the last two months, including Mr. Steven D. Stringer, Chief Financial Officer, Mr. James T. Taylor III, Vice President, General Counsel and Secretary, and two new members of our Board of Directors, Mr. Tom Brown and Admiral Raymond Smith, we believe we are refining our approach to the sales, marketing and licensing of directed sound to expand our leadership position in this developing market.

In February 2006, we incorporated a wholly owned subsidiary of the company, “American Technology Holdings, Inc”. We plan for this entity to conduct international sales and marketing of our products and services. To date there have been no transactions made by American Technology Holdings, Inc. other than company setup fees.

Accelerating our product sales and revenue growth will require organizational discipline, effective processes and controls, improved customer focus, and a new, targeted marketing strategy for our company and products. We are focused on these areas of our business while also containing costs.

20

Table of Contents

Overall Performance for the Second Quarter of Fiscal 2006

For the second fiscal quarter ended March 31, 2006:

We have substantial research and development and selling, marketing and general administrative expenses, and our margins from the sale of our products have not yet been sufficient to offset these costs. We expect to incur additional operating losses during fiscal 2006. Cash and cash equivalents on hand at March 31, 2006 was $5,448,894. Based on our current cash position and order backlog, and assuming currently planned expenditures and current level of operations, we believe we have sufficient capital to fund operations for approximately the next six months. We anticipate improved cash flow from projected increased revenues, however, we believe that approximately $5 million to $10 million of additional capital will be required to sustain operations through May 2007. We are currently reviewing borrowing and equity financing opportunities to meet its future cash requirements. See “Liquidity and Capital Resources” and “Risk Factors” below.

Our various technologies are high risk in nature. However, we believe we have a solid technology and product foundation for business growth over the next several years. We have significant new technologies and products in various stages of development. We also believe we have strong market opportunities, particularly given the dramatic growth and acceptance of digital signage requiring the use of our directed sound products, and the continuing global threats to both governments and commerce where our LRAD products have proven to be effective at hailing and notification for force protection.

Critical Accounting Policies

We have identified a number of accounting policies as critical to our business operations and the understandings of our results of operations. These are described in our financial statements located in Item 1 of Part I, “Financial Statements,” and in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report of Form 10-K for the year ended September 30, 2005. The impact and any associated risks related to these policies on our business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations when such policies affect our reported and expected financial results.

21

Table of Contents

Effective October 1, 2005, we adopted the provisions of Statement of Financial Accounting Standards Statement No. 123 (revised 2004), Share-Based Payment (SFAS 123(R)). SFAS 123(R) was issued by the Financial Accounting Standards Board (FASB) on December 16, 2004. In March 2005, the U.S. Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 which the Company has applied in the adoption of SFAS 123(R). On April 14, 2005, the U.S. Securities and Exchange Commission adopted a new rule amending the effective dates for SFAS 123(R). In accordance with the new rule, the accounting provisions of SFAS 123(R) are effective for our company beginning in the quarter ended December 31, 2005. We grant options to purchase our common stock to our employees, directors and consultants under our stock option plans. The benefits provided under these plans are share-based payments subject to SFAS 123(R) and use the fair value method to account for share-based payments with a modified prospective application which provides for certain changes to the method for valuing share-based compensation.

SFAS 123(R) is based on the underlying accounting principle that compensation cost resulting from share-based payment transactions be recognized in financial statements at fair value. SFAS 123(R) replaces FASB No. 123, “Accounting for Stock-Based Compensation” (SFAS 123) and supersedes Accounting Principles Board Opinion 25. SFAS 123, as originally issued in 1995, established as preferable, but did not require, a fair-value-based method of accounting for share-based payment transactions with employees. SAB 107 expresses views of the SEC staff regarding the interaction between SFAS 123(R) and certain SEC rules and regulations and provides the staff’s views regarding the valuation of share-based payment arrangements for public companies.

In summary SFAS 123(R) requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That cost is recognized over the period during which an employee is required to provide requisite service in exchange for the award (usually over the vesting period). No compensation cost is recognized for equity instruments for which employees do not render the requisite service, i.e. forfeitures are adjusted to actual.

The grant-date fair value of employee share options and similar instruments is to be estimated using option-pricing models adjusted for the unique characteristics of those instruments. If an equity award is modified after the grant date, incremental compensation cost will be recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately before the modification.

Excess tax benefits, as defined by SFAS 123(R), are to be recognized as an addition to paid-in capital. Cash retained as a result of any excess tax benefits is to be presented in the statement of cash flows as financing cash inflows. The write-off of deferred tax assets relating to unrealized tax benefits associated with recognized compensation cost is to be recognized as income tax expense unless there are excess tax benefits from previous awards remaining in paid-in capital to which it can be offset.

As of the required effective date, all public entities that used the fair-value-based method for disclosure under SFAS 123 are to apply SFAS 123(R) using a modified version of prospective application. Under that transition method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards, for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS 123 for pro forma disclosures. Total compensation cost for our share-based payments recognized in the first three and six months of 2006 was $189,812 and $378,188, respectively. As of March 31, 2006, $2.3 million of total unrecognized compensation costs related to nonvested awards is expected to be recognized over a weighted average period of 3.5 years.

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

22

Table of Contents

Results of Operations for the Three Months Ended March 31, 2006 and 2005

Revenues

Total revenues for the three months ended March 31, 2006 were $1,465,628, representing a 48% decrease from $2,817,393 in revenues for the three months ended March 31, 2005. Total revenues for the three months ended March 31, 2006 included $1,361,244 of product sales and $104,384 of contract and license revenues. Total revenues for the three months ended March 31, 2005 consisted of $2,814,293 of product sales and $3,100 of contract and license revenues. The decrease in revenues was due to $1.7 million of shipments on one large military order shipped in the three months ended March 31, 2005. This was partially offset by an increase in our commercial sales due to the launch of our HSS 450 into the digital signage and in-store broadcasting markets. Our revenues are highly dependent on the timing of large orders from a small number of customers. We expect continued uneven quarterly revenues in future periods due to the lack of established markets for our proprietary products.

Revenues by Business Segment

Our operations are organized into two segments by the end-user markets they serve. Our reportable segments are strategic business units that sell our products into distinct markets. The Commercial Products Group (Commercial Group) markets and licenses LRAD, HSS, NeoPlanar and other sound products incorporating our technologies to customers and end-users that employ audio in consumer, commercial and professional applications. The Government and Force Protection Systems Group (Government and Military Group) markets LRAD, NeoPlanar and SoundVector products to government and military customers and to the expanding force protection and commercial security markets. The segments are managed separately because each segment requires different selling and marketing strategies as the class of customers within each segment is different.

Commercial Group Revenues —The Commercial Group reported revenues of $833,915 for the three months ended March 31, 2006, representing a 661% increase from revenues of $109,523 for the three months ended March 31, 2005. Sound product revenues were $779,748 and $109,523, and contract and license revenues were $54,167 and $0 for the three months ended March 31, 2006 and 2005, respectively. The increase in sound product revenues resulted primarily from increased LRAD sales to commercial cruise lines.

In fiscal 2005, we entered into a license agreement which contained multiple elements. Based on our evaluation of the agreement under the guidance of EITF Issue No. 00-21 we determined this arrangement does not qualify for multiple element accounting and revenue will be recognized ratably over the three year term of the agreement. For the three months ended March 31, 2006, we recognized $54,167 in contract revenue representing the ratable earned revenue under the three year agreement. At March 31, 2006, $137,500 remained unearned under this agreement and has been recorded as deferred revenue. At March 31, 2006, we had aggregate deferred license revenue of $434,616 representing amounts collected from Commercial Group license agreements in advance of recognized earnings. Although we anticipate additional license revenues in fiscal year 2006 from existing and new arrangements, this revenue component is subject to significant variability based on the timing, amount and recognition of new arrangements, if any.

Government and Military Group —Government and Military Group revenues for the three months ended March 31, 2006, were $631,713 compared to $2,707,870 for the three months ended March 31, 2005, representing a 77% decrease. Sound product revenues were $581,496 and $2,704,771 and contract and license revenues were $50,218 and $3,100 for the three months ended March 31, 2006 and 2005, respectively. The decrease in revenues resulted from lower sales of our LRAD product line for the three months ended March 31, 2006. Included in product revenues for the three months ended March 31, 2005 is $1.7 million of a $4.9 million order received in December 2004 for delivery of LRAD units to the US Army.

Our order backlog was approximately $7,542,929 at March 31, 2006 which includes $1,849,840 of orders with scheduled delivery dates after September 30, 2006. Our order backlog was approximately $128,017 at

23

Table of Contents

March 31, 2005. Backlog orders are subject to modification, cancellation or rescheduling by our customers. Future shipments may also be delayed due to production delays, component shortages and other production and delivery related issues.

Gross Profit

Gross profit for the three months ended March 31, 2006 was $188,213, or 13% of total revenues, compared to $1,326,545, or 47% of total revenues, for the three months ended March 31, 2005. The decrease in gross profit, both absolute and as a percentage of total revenues, was principally the result of the decreased sales of our higher margin LRAD products.

Gross loss for our Commercial Group was $63,767 and $426,578 for the three months ended March 31, 2006 and 2005, respectively. Increased sales of our higher margin LRAD products in the three months ended March 31, 2006 were the primary contributor to the decrease in gross loss for our Commercial Group. The gross loss for the three months ended March 31, 2005 was primarily as a result of increased costs associated with various manufacturing and supply chain problems and insufficient margins earned on HSS product sales to offset the allocation of manufacturing overhead to this segment of our business. Gross profit for our Government and Military Group was $251,980 for the three months ended March 31, 2006, or 40% of total revenues, compared to $1,753,123 for the three months ended March 31, 2005 or 65% of total revenues. The decrease in gross profit, both absolute and as a percentage of total revenues, was due to lower sales of our higher-margin in LRAD product line. Gross profit percentage is highly dependent on sales prices, volumes, purchasing costs and overhead allocations.

Our products have varying gross margins, so product sales mix will materially affect gross profits. In addition, we continue to make product updates and changes, including raw material and component changes that may impact product costs. We do not believe that historical gross profit margins should be relied upon as an indicator of future gross profit margins.

Selling, General and Administrative Expenses

Selling, general and administrative expenses for the three months ended March 31, 2006 increased $3,147 to $2,047,085, or 140% of total revenues, compared to $2,043,938, or 73% of total revenues, for the three months ended March 31, 2005. The major component changes in selling general and administrative expenses were: $189,644 for increased personnel and related expenses; $157,608 for increased consulting, accounting, and auditing expenses primarily as a result of Section 404 of the Sarbanes-Oxley Act of 2002 and the internal control deficiencies as discussed in Part I, Item 4 of this report; $58,556 for increased utilities and outside storage costs and $12,026 for increased travel and commissions, offset in part by decreased legal and related fees of $381,469 and $51,183 in reduced demonstration equipment and trade show activity.

We may expend additional resources on marketing our products in future periods which may increase selling, general and administrative expenses. During fiscal year 2005, we incurred a significant amount of outside consultant costs and audit fees to comply with the Sarbanes-Oxley Act (particularly Section 404), relating to management assessment of internal control over financial reporting. We expect to incur significant additional audit fees and other costs in fiscal year 2006 to comply with the Sarbanes-Oxley Act and to improve our internal control over financial reporting and procedures in our accounting organization. We do not currently have an estimate of these future costs, but we anticipate we will increase spending for increased staffing, outside consultants and legal and audit costs.

Research and Development Expenses

Research and development expenses decreased $963,392 to $502,217, or 34% of total revenues, for the three months ended March 31, 2006, compared to $1,465,609, or 52% of total revenues, for the three months ended March 31, 2005. This decrease in research and development expenses was primarily due to $524,990 decrease in personnel and related expenses; $324,938 decrease in prototype component acquisition, fabrication

24

Table of Contents

and testing for new products developed during fiscal year 2005; $50,152 decrease in outside consulting fees associated with product design; $27,286 decrease in small tools, equipment and supplies; and $8,661 in reduced travel expenses.

Research and development costs vary period to period due to the timing of projects, the availability of funds for research and development and the timing and extent of use of outside consulting, design and development firms. We completed and introduced significant new products in fiscal year 2005, including our HSS H450 product and our portable LRAD500. With the completion of these major projects, and based on current plans and reduced engineering staffing, we expect fiscal year 2006 research and development costs to be lower than fiscal year 2005.

Share-Based Compensation

Effective at the beginning of fiscal year 2006, we adopted SFAS 123(R) ,and elected to adopt the modified prospective application method. SFAS 123(R) requires us to use a fair-valued based method to account for share-based compensation. Accordingly, share-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as expense over the employees’ requisite service period. Total compensation cost for our share-based payments for the three months ended March 31, 2006 was $189,812. Cost of revenues, selling, general and administrative expense, and research and development expense for the three months ended March 31, 2006 include share-based compensation of $28,817, $136,104 and $11,566, respectively. As of March 31, 2006, $2.3 million of total unrecognized compensation costs related to nonvested awards is expected to be recognized over a weighted average period of 3.5 years. See Note 4, “Stock-Based Compensation,” in the Notes to Interim Financial Statements (unaudited) for further discussion.

Loss from Operations

Loss from operations was $2,361,089 for the three months ended March 31, 2006, compared to a loss from operations of $2,183,002 for the three months ended March 31, 2005. The increase in loss from operations resulted primarily from the decrease in revenues and gross margin as a result of reduced LRAD sales to government and military customers.

Other Income (Expense)

During the three months ended March 31, 2006, we earned $70,480 of interest income on our cash balances and incurred $183 of interest expense. Other expense for the three months ended March 31, 2006 included $339,500 related to the change in the fair value of warrants issued in connection with our July 2005 sale of common stock and warrants.

At March 31, 2006, our short term and long term derivative warrant instrument was $1,153,300. We must make certain assumptions and estimates to value our derivative warrant instrument periodically. Factors affecting the amount of this liability include changes in our stock price and other assumptions. The change in value is non-cash income or expense and the changes in the carrying value of derivatives can have a material impact on our financial statements each period. The derivative liability associated with our July 2005 sale of common stock and warrants may be reclassified into stockholders’ equity upon warrant exercise, expiration or other events, and the timing of such events may be outside our control.

During the three months ended March 31, 2005, we earned $18,407 of interest on our cash balances and incurred $130,631 of interest expense and $682,210 of unrealized gain on derivative revaluation associated with a derivative instrument issued in December 2004 and cancelled in July 2005.

Net Loss

The net loss for the three months ended March 31, 2006 was $2,630,292 compared to a net loss of $1,613,016 for the three months ended March 31, 2005. We had no income tax expense for either of these periods presented.

25

Table of Contents

Net Loss Available to Common Stockholders

Net loss available to common stockholders was $2,630,292 or $0.11 per share for the three months ended March 31, 2006, compared to a net loss available to common stockholders of $3,131,667 or $0.15 for the three months ended March 31, 2005 respectively. In computing net loss per share for fiscal 2005, imputed deemed dividends were based on the value of warrants issued in connection with convertible preferred stock. The net loss available to common stockholders was also increased by an additional deemed dividend computed from a discount provision in our convertible preferred stock. The imputed deemed dividends were not contractual obligations to pay such imputed dividends. Net loss available to common stockholders was further increased by a 6% accretion (similar to a dividend) on outstanding preferred stock. These amounts aggregated $1,518,651 for the three months ended March 31, 2005. No preferred stock was outstanding during the three months ended March 31, 2006.

Results of Operations for the Six Months Ended March 31, 2006 and 2005

Revenues

Total revenues for the six months ended March 31, 2006 were $3,365,006, representing a 53% decrease from $7,226,306 in revenues for the six months ended March 31, 2005. Total revenues for the six months ended March 31, 2006 included $3,201,213 of product sales and $163,793 of contract and license revenues. Revenues for the six months ended March 31, 2005 consisted of $7,161,206 of product sales and $65,100 of contract and license revenues. The decrease in revenues was due to reduced sales of LRAD products by our Government and Military Group. The prior year period revenues included $4.9 million on one large military order. This was partially offset by an increase in our Commercial sales due to the launch of our HSS 450 into the digital signage and in-store broadcasting segments. Our revenues are highly dependent on the timing of large orders from a small number of customers. We expect continued uneven quarterly revenues in future periods due to the lack of established markets for our proprietary products.

Revenues by Business Segment

Commercial Group Revenues —The Commercial Group reported revenues of $2,138,388 for the six months ended March 31, 2006, representing a 620% increase from revenues of $296,872 for the six months ended March 31, 2005. Sound product revenues were $2,027,313 and $296,872, and contract and license revenues were $111,076 and $0 for the six months ended March 31, 2006 and 2005, respectively. The increase in sound product revenues resulted primarily from increased LRAD sales to commercial cruise lines.

In fiscal 2005, we entered into a license agreement which contained multiple elements. Based on our evaluation of the agreement under the guidance of EITF Issue No. 00-21 we determined this arrangement does not qualify for multiple element accounting and revenue will be recognized ratably over the three year term of the agreement. For the six months ended March 31, 2006, we recognized $108,333 in contract revenue representing the ratable earned revenue under the three year agreement. At March 31, 2006, $137,500 remained unearned under this agreement and has been recorded as deferred revenue. At March 31, 2006, we had aggregate deferred license revenue of $434,616 representing amounts collected from Commercial Group license agreements in advance of recognized earnings. Although we anticipate additional license revenues in fiscal year 2006 from existing and new arrangements, this revenue component is subject to significant variability based on the timing, amount and recognition of new arrangements, if any.

Government and Military Group —Government and Military Group revenues for the six months ended March 31, 2006, were $1,226,618 compared to $6,929,434 for the six months ended March 31, 2005, representing an 82% decrease. Sound product revenues were $1,173,900 and $6,864,334 and contract and license revenues were $52,718 and $65,100 for the six months ended March 31, 2006 and 2005, respectively. The decrease in revenues resulted from reduced orders for the six months ended March 31, 2006. Included in product revenues for the six months ended March 31, 2005 is a $4.9 million order received in December 2004 from ADS, Inc. for delivery of LRAD units to the US Army.

26

Table of Contents

Gross Profit

Gross profit for the six months ended March 31, 2006 was $1,252,350, or 37% of total revenues, compared to $4,169,053, or 59% of total revenues, for the six months ended March 31, 2005. The decrease in gross profit, both absolute and as a percentage of revenues, was principally the result of the decreased sales of our higher margin LRAD products.

Gross profit (loss) for our Commercial Group was $741,449 and $(650,224) for the six months ended March 31, 2006 and 2005, respectively. Increased sales of our higher margin LRAD products in the six months ended March 31, 2006 were the primary contributor to the increase in gross profit for our Commercial Group. The gross loss for the six months ended March 31, 2005 was primarily a result of insufficient margins earned on HSS product sales to offset the allocation of manufacturing overhead to this segment of our business. Gross profit for our Government and Military Group was $510,901 for the six months ended March 31, 2006 or 42% of revenues, compared to $4,819,278 for the six months ended March 31, 2005 or 70% of revenue. The decrease in gross profit, both absolute and as a percentage of total revenues, was due to lower sales of our higher-margin in LRAD product line. Gross profit percentage is highly dependent on sales prices, volumes, purchasing costs and overhead allocations.

Our products have varying gross margins, so product sales mix will materially affect gross profits. In addition, we continue to make product updates and changes, including raw material and component changes that may impact product costs. We do not believe that historical gross profit margins should be relied upon as an indicator of future gross profit margins.

Selling, General and Administrative Expenses

Selling, general and administrative expenses for the six months ended March 31, 2006 increased $435,419 to $4,422,207 or 131% of total revenues, compared to $3,986,788, or 55% of total revenues, for the six months ended March 31, 2005. The increase in selling general and administrative expenses was primarily attributable to: $422,545 for increased personnel and related expenses; $383,512 for increased consulting, accounting, and auditing expenses primarily as a result of Section 404 of the Sarbanes-Oxley Act of 2002 and the internal control deficiencies as discussed in Part I, Item 4 of this report; $47,555 for increased SEC reporting costs; and $56,790 for increased travel and commissions, partially offset by decreased legal and related fees of $395,264 and $54,226 in reduced demonstration equipment and trade show activity.

We may expend additional resources on marketing our products in future periods which may increase selling, general and administrative expenses. During fiscal year 2005, we incurred a significant amount of outside consultant costs and audit fees to comply with the Sarbanes-Oxley Act (particularly Section 404), relating to management assessment of internal control over financial reporting. We expect to incur significant additional audit fees and other costs in fiscal year 2006 to comply with the Sarbanes-Oxley Act and to improve our internal control over financial reporting and procedures in our accounting organization. We do not currently have an estimate of these future costs, but we anticipate we will increase spending for increased staffing, outside consultants and legal and audit costs.

Research and Development Expenses

Research and development expenses decreased $1,872,377 to $1,068,210, or 32% of total revenues, for the six months ended March 31, 2006, compared to $2,940,587, or 41% of total revenues, for the six months ended March 31, 2005. This decrease in research and development expenses was primarily due to $1,215,043 decrease in personnel and related expenses, of which $245,183 was non-cash compensation associated with an extension of time to exercise stock options; $449,350 decrease in prototype component acquisition, fabrication and testing for new products developed during fiscal year 2005; $50,257 decrease in outside consulting fees associated with product design; $59,535 decrease in small tools, equipment and supplies; and $23,416 in reduced travel expenses.

Research and development costs vary period to period due to the timing of projects, the availability of funds for research and development and the timing and extent of use of outside consulting, design and development

27

Table of Contents

firms. We completed and introduced significant new products in fiscal year 2005, including our HSS H450 product and our portable LRAD500. With the completion of these major projects, and based on current plans and reduced engineering staffing, we expect fiscal year 2006 research and development costs to be lower than fiscal year 2005.

Share-Based Compensation

Effective at the beginning of fiscal year 2006, we adopted Statement of Financial Accounting Standards No. 123(R) (“SFAS 123(R)”), “Share-Based Payment,” and elected to adopt the modified prospective application method. SFAS No. 123(R) requires us to use a fair-valued based method to account for share-based compensation. Accordingly, share-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as expense over the employees’ requisite service period. Total compensation cost for our share-based payments for the six months ended March 31, 2006 was $378,188. Cost of revenues, selling, general and administrative expense, and research and development expense for six months ended March 31, 2006 include share-based compensation of $102,847, $206,258 and $32,315, respectively. As of March 31, 2006, $2.3 million of total unrecognized compensation costs related to nonvested awards is expected to be recognized over a weighted average period of 3.5 years. See Note 4, “Stock-Based Compensation” in the Notes to Condensed Consolidated Financial Statements (unaudited) for further discussion.

Loss from Operations

Loss from operations was $4,238,067 for the six months ended March 31, 2006, respectively, compared to a loss from operations of $2,758,322 for the six months ended March 31, 2005. The increase in loss from operations resulted primarily from the decrease in revenues and gross margin as a result of reduced LRAD product sales to government and military customers. We also incurred significant expense in evaluating our system of internal control over financial reporting for compliance with the Sarbanes-Oxley Act.

Other Income (Expense)

During the six months ended March 31, 2006, we earned $145,103 of interest income on our cash balances and incurred $543 of interest expense. Other income for the six months ended March 31, 2006 included $692,700 related to the increase in the fair value of warrants issued in connection with our July 2005 sale of common stock and warrants.

At March 31, 2006 our long term derivative warrant instrument was $1,153,300. We must make certain assumptions and estimates to value our derivative warrant instrument periodically. Factors affecting the amount of this liability include changes in our stock price and other assumptions. The change in value is non-cash income or expense and the changes in the carrying value of derivatives can have a material impact on our financial statements each period. The derivative liability associated with our July 2005 sale of common stock and warrants may be reclassified into stockholders’ equity upon warrant exercise, expiration or other events, and the timing of such events may be outside our control.

During the six months ended March 31, 2005, we earned $29,348 of interest on our cash balances and incurred $142,961 of interest expense and $267,931 of unrealized loss on derivative revaluation.

Net Loss

The net loss for the six months ended March 31, 2006 was $3,400,807 compared to a net loss of $3,139,866 for the six months ended March 31, 2005. We had no income tax expense for either of these periods.

28

Table of Contents

Net Loss Available to Common Stockholders

Net loss available to common stockholders increased to $3,400,807 or $0.14 per share for the six months ended March 31, 2006, compared to a net loss available to common stockholders of $4,936,292 or $0.24 for the six months ended March 31, 2005. Imputed deemed dividends and accretion on outstanding preferred stock aggregated $1,796,426 for the six months ended March 31, 2005. No preferred stock was outstanding during the three and six months ended March 31, 2006.

Liquidity and Capital Resources

We continue to experience significant negative cash flow from operating activities including developing, introducing and marketing our proprietary sound technologies. We have financed our working capital requirements through cash generated from products sales and from financing activities. Cash at March 31, 2006 was $5,448,894 compared to $10,347,779 at September 30, 2005. The decrease in cash was primarily the result of the operating loss and cash used to support other activities.

Other than cash and our balance of accounts receivable, we have no other unused sources of liquidity at this time. We expect to incur additional operating losses as a result of expenditures for research and development, marketing and sales costs and general and administrative costs for our sound products and technologies. The timing and amounts of these expenditures and the extent of our operating losses will depend on many factors, some of which are beyond our control.

Principal factors that could affect the availability of our internally generated funds include:

Principal factors that could affect our availability to obtain cash from external sources include:

Based on our current cash position and order backlog, and assuming currently planned expenditures and level of operations, we believe we have sufficient capital to fund operations for approximately the next six months. We anticipate improved cash flow from operations; however, we believe that approximately $5 million to $10 million of additional capital will be required to sustain operations through May 2007. We believe that the investment capital we require to meet future capital resource requirements will be available to us, but there can be no guarantee that we will be able to raise funds on terms acceptable to us, or at all.

Cash Flows

Operating Activities

Our net cash used in operating activities was $5,047,160 for the six months ended March 31, 2006 compared to $1,712,084 for the six months ended March 31, 2005. Cash used in operating activities for the six months ended March 31, 2006 included the $3,400,807 net loss, reduced by expenses not requiring the use of cash of $726,261 and a $151,017 reduction in inventories (net of obsolescence reserve); and increased by a net

29

Table of Contents

unrealized gain of $692,700 on derivative revaluation, an $937,140 increase in trade accounts receivable and prepaid expenses, and a $914,175 decrease in accounts payable and accrued liabilities. Cash used in operating activities for the six months ended March 31, 2005 included the net loss of $3,139,866, reduced by expenses not requiring the use of cash of $504,163, unrealized gain of $267,931 on derivative revaluation, and a $506,832 decrease in accounts payable and accrued liabilities; and increased by a $432,244 decrease in trade accounts receivable and a $253,615 increase in inventories.

At March 31, 2006, we had working capital of $6,745,876 compared to working capital of $9,726,309 at September 30, 2005. This decrease was primarily a result of cash used for operations.

At March 31, 2006, we had trade accounts receivable of $1,942,527. This compares to $880,276 in trade accounts receivable at September 30, 2005. The level of trade accounts receivable at March 31, 2006 represented approximately 112 days of revenues compared to 32 days of revenues at September 30, 2005. The increase in days was due to increased shipments of products in the last 10 days of the quarter. Terms with individual customers vary greatly. We typically require thirty-day terms from our customers. Our receivables can vary dramatically due to overall sales volumes and due to quarterly variations in sales and timing of shipments to and receipts from large customers and the timing of contract payments.

Investing Activities

We use cash in investing activities primarily for the purchase of laboratory and computer equipment and software and investment in patents. Cash used in investing activities for equipment was $279,397 for the six months ended March 31, 2006. Cash used in investing activities for equipment was $355,995 for the six months ended March 31, 2005. Cash used for investment in patents was $118,076 and $144,420, for the six months ended March 31, 2006 and March 31, 2005, respectively. We anticipate continued capital expenditures for patents in fiscal year 2006. Cash used in investing activities of $58,266 for the six months ended March 31, 2006, consisted of a security deposit for our current facilities.

Financing Activities

Cash provided by financing activities for the six months ended March 31, 2006 was $604,012, which included $610,940 of net cash proceeds from the exercise of stock options. Cash provided by financing activities for the six months ended March 31, 2005 was $4,195,940 and consisted primarily of $2,000,000 in proceeds from the sale of unsecured promissory notes, $1,661,277 from exercise of common stock warrants and $643,802 of net cash proceeds from the exercise of stock options

Recent Accounting Pronouncements

A number of new pronouncements have been issued for future implementation as discussed in the Notes to our Interim Financial Statements (see Note 3).