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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K/A
(Amendment No. 1)
 
S ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED      DECEMBER 31, 2007   .

£ 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: 
0-23336
AROTECH CORPORATION

(Exact name of registrant as specified in its charter)
 
Delaware
 
95-4302784
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
     
1229 Oak Valley Drive, Ann Arbor, Michigan
 
48108
(Address of principal executive offices)
 
(Zip Code)

(800) 281-0356
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class
 
Name of each exchange on which registered
Common Stock, $0.01 par value
 
The Nasdaq Stock Market LLC
 
Securities registered pursuant to Section 12(g) of the Act: 
 Common Stock, $0.01 par value
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes £    No S

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes £    No S

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 S    No £

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  £

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

Large accelerated filer: £
Accelerated filer: £
Non-accelerated filer: £
Smaller reporting company: S

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

The aggregate market value of the registrant’s voting stock held by non-affiliates of the registrant as of June 30, 2007 was approximately $40,382,408 (based on the last sale price of such stock on such date as reported by The Nasdaq Global Market and assuming, for the purpose of this calculation only, that all of the registrant’s directors and executive officers are affiliates).

 (Applicable only to corporate registrants)  Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date:
13,599,197 as of 3/31/08

Documents incorporated by reference:
 
None
 


 
 

 

PRELIMINARY NOTE
 
This annual report contains historical information and forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 with respect to our business, financial condition and results of operations. The words “estimate,” “project,” “intend,” “expect” and similar expressions are intended to identify forward-looking statements. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those contemplated in such forward-looking statements. Further, we operate in an industry sector where securities values may be volatile and may be influenced by economic and other factors beyond our control. In the context of the forward-looking information provided in this annual report and in other reports, please refer to the discussions of risk factors detailed in, as well as the other information contained in, our other filings with the Securities and Exchange Commission.
 
Electric Fuel® is a registered trademark and Arotech™ is a trademark of Arotech Corporation, formerly known as Electric Fuel Corporation. All company and product names mentioned may be trademarks or registered trademarks of their respective holders. Unless otherwise indicated, “we,” “us,” “our” and similar terms refer to Arotech and its subsidiaries.
 
EXPLANATORY NOTE
 
Arotech Corporation is filing this Amendment No. 1 to its Annual Report on Form 10-K for the year ended December 31, 2007, as filed with the Securities and Exchange Commission on April 14, 2008, in order to correct certain typographical errors in the report. Additionally, as required by SEC regulations, we are replacing the Section 302 and Section 906 certifications from Arotech’s Chairman and Chief Executive Officer and Arotech’s Vice President – Finance and Chief Financial Officer.
 
 
 
 

 

PART I
 
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDI­TION AND RESULTS OF OPERATION
 
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve inherent risks and uncertainties. When used in this discussion, the words “believes,” “anticipated,” “expects,” “estimates” and similar expressions are intended to identify such forward-looking statements. Such statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to publicly release the result of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors including, but not limited to, those set forth elsewhere in this report. Please see “Risk Factors,” above, and in our other filings with the Securities and Exchange Commission.
 
The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements contained in Item 8 of this report, and the notes thereto. We have rounded amounts reported here to the nearest thousand, unless such amounts are more than 1.0 million, in which event we have rounded such amounts to the nearest hundred thousand.
 
General
 
We are a defense and security products and services company, engaged in three business areas: interactive simulation for military, law enforcement and commercial markets; batteries and charging systems for the military; and high-level armoring for military, paramilitary and commercial vehicles. We operate in three business units:
 
 
Ø
we develop, manufacture and market advanced high-tech multimedia and interactive digital solutions for use-of-force and driving training of military, law enforcement, security and other personnel (our Training and Simulation Division);
 
 
Ø
we provide aviation armor kits and we utilize sophisticated lightweight materials and advanced engineering processes to armor vehicles (our Armoring Division); and
 
 
Ø
we develop, manufacture and market primary Zinc-Air batteries, rechargeable batteries and battery chargers for defense and security products and other military applications (our Battery and Power Systems Division).
 
Critical Accounting Policies
 
The preparation of financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue recognition, allowance for bad debts, inventory, contingencies and warranty reserves, impairment of intangible assets and goodwill. We base our estimates and judgments on historical experience and on various other factors 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. Under different assumptions or conditions, actual results may differ from these estimates.
 
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

 

 

Revenue Recognition
 
Significant management judgments and estimates must be made and used in connection with the recognition of revenue in any accounting period. Material differences in the amount of revenue in any given period may result if these judgments or estimates prove to be incorrect or if management’s estimates change on the basis of development of the business or market conditions. Management judgments and estimates have been applied consistently and have been reliable historically.
 
A portion of our revenue is derived from license agreements that entail the customization of FAAC’s simulators to the customer’s specific requirements. Revenues from initial license fees for such arrangements are recognized in accordance with Statement of Position 81-1 “Accounting for Performance of Construction – Type and Certain Production – Type Contracts” based on the percentage of completion method over the period from signing of the license through to customer acceptance, as such simulators require significant modification or customization that takes time to complete. The percentage of completion is measured by monitoring progress using records of actual time incurred to date in the project compared with the total estimated project requirement, which corresponds to the costs related to earned revenues. Estimates of total project requirements are based on prior experience of customization, delivery and acceptance of the same or similar technology and are reviewed and updated regularly by management.
 
We believe that the use of the percentage of completion method is appropriate as we have the ability to make reasonably dependable estimates of the extent of progress towards completion, contract revenues and contract costs. In addition, contracts executed include provisions that clearly specify the enforceable rights regarding services to be provided and received by the parties to the contracts, the consideration to be exchanged and the manner and terms of settlement. In all cases we expect to perform our contractual obligations and our licensees are expected to satisfy their obligations under the contract. The complexity of the estimation process and the issues related to the assumptions, risks and uncertainties inherent with the application of the percentage of completion method of accounting affect the amounts of revenue and related expenses reported in our consolidated financial statements. A number of internal and external factors can affect our estimates, including labor rates, utilization and specification and testing requirement changes.
 
We account for our other revenues from IES simulators in accordance with the provisions of SOP 97-2, “Software Revenue Recognition,” issued by the American Institute of Certified Public Accountants and as amended by SOP 98-4 and SOP 98-9 and related interpretations. We exercise judgment and use estimates in connection with the determination of the amount of software license and services revenues to be recognized in each accounting period.
 
We assess whether collection is probable at the time of the transaction based on a number of factors, including the customer’s past transaction history and credit worthiness. If we determine that the collection of the fee is not probable, we defer the fee and recognize revenue at the time collection becomes probable, which is generally upon the receipt of cash.

 
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Stock Based Compensation
 
We account for stock options and awards issued to employees in accordance with the fair value recognition provisions of Financial Accounting Standards Board (“FASB”) Statement No. 123(R) (“SFAS No. 123(R)”), “Share-Based Payment,” using the modified prospective transition method. Under SFAS No. 123(R), stock-based awards to employees are required to be recognized as compensation expense, based on the calculated fair value on the date of grant. We determine the fair value using the Black Scholes option pricing model. This model requires subjective assumptions, including future stock price volatility and expected term, which affect the calculated values.
 
Allowance for Doubtful Accounts
 
We make judgments as to our ability to collect outstanding receivables and provide allowances for the portion of receivables when collection becomes doubtful. Provisions are made based upon a specific review of all significant outstanding receivables. In determining the provision, we analyze our historical collection experience and current economic trends. We reassess these allowances each accounting period. Historically, our actual losses and credits have been consistent with these provisions. If actual payment experience with our customers is different than our estimates, adjustments to these allowances may be necessary resulting in additional charges to our statement of operations.
 
Accounting for Income Taxes
 
Significant judgment is required in determining our worldwide income tax expense provision. In the ordinary course of a global business, there are many transactions and calculations where the ultimate tax outcome is uncertain. Some of these uncertainties arise as a consequence of cost reimbursement arrangements among related entities, the process of identifying items of revenue and expense that qualify for preferential tax treatment and segregation of foreign and domestic income and expense to avoid double taxation. Although we believe that our estimates are reasonable, the final tax outcome of these matters may be different than that which is reflected in our historical income tax provisions and accruals. Such differences could have a material effect on our income tax provision and net income (loss) in the period in which such determination is made.
 
We have provided a valuation allowance on the majority of our net deferred tax assets, which includes federal and foreign net operating loss carryforwards, because of the uncertainty regarding their realization. Our accounting for deferred taxes under Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“Statement 109”), involves the evaluation of a number of factors concerning the realizability of our deferred tax assets. In concluding that a valuation allowance was required, we primarily considered such factors as our history of operating losses and expected future losses in certain jurisdictions and the nature of our deferred tax assets. We provide valuation allowances in respect of deferred tax assets resulting principally from the carryforward of tax losses. Management currently believes that it is more likely than not that the deferred tax regarding the carryforward of losses and certain accrued expenses will not be realized in the foreseeable future. We do not provide for U.S. federal income taxes on the undistributed earnings of our foreign subsidiaries because such earnings are re-invested and, in the opinion of management, will continue to be re-invested indefinitely.

 
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On January 1, 2007, we adopted the provisions of the Financial Accounting Standards Board Interpretation No.48, Accounting for Uncertainty in Income Taxes (“FIN 48”), an interpretation of Statement 109. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken in a tax return. We must determine whether it is “more-likely-than-not” that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. Once it is determined that a position meets the more-likely-than-not recognition threshold, the position is measured to determine the amount of benefit to recognize in the financial statements. FIN 48 applies to all tax positions related to income taxes subject to Statement 109. Uncertain tax positions require determinations and estimated liabilities to be made based on provisions of the tax law which may be subject to change or varying interpretation.  If our determinations and estimates prove to be inaccurate, the resulting adjustments could be material to its future financial results.  Based on the analysis performed, we did not record any unrecognized tax positions as of December 31, 2007.
 
In addition, we operate within multiple taxing jurisdictions and may be subject to audits in these jurisdictions. These audits can involve complex issues that may require an extended period of time for resolution. In management’s opinion, adequate provisions for income taxes have been made.
 
Inventories
 
Our policy for valuation of inventory and commitments to purchase inventory, including the determination of obsolete or excess inventory, requires us to perform a detailed assessment of inventory at each balance sheet date, which includes a review of, among other factors, an estimate of future demand for products within specific time horizons, valuation of existing inventory, as well as product lifecycle and product development plans. The estimates of future demand that we use in the valuation of inventory are the basis for our revenue forecast, which is also used for our short-term manufacturing plans. Inventory reserves are also provided to cover risks arising from slow-moving items. We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based on assumptions about future demand and market conditions. We may be required to record additional inventory write-down if actual market conditions are less favorable than those projected by our management. For fiscal 2007, no significant changes were made to the underlying assumptions related to estimates of inventory valuation or the methodology applied.
 
Goodwill
 
Under Financial Accounting Standards Board Statement No. 142, “Goodwill and Other Intangible Assets” (SFAS 142), goodwill and intangible assets deemed to have indefinite lives are no longer amortized but are subject to annual impairment tests based on estimated fair value in accordance with SFAS 142.
 
We determine fair value using a discounted cash flow analysis. This type of analysis requires us to make assumptions and estimates regarding industry economic factors and the profitability of future business strategies. It is our policy to conduct impairment testing based on our current business strategy in light of present industry and economic conditions, as well as future

 
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expectations. In assessing the recoverability of our goodwill, we may be required to make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. This process is subjective and requires judgment at many points throughout the analysis. If our estimates or their related assumptions change in subsequent periods or if actual cash flows are below our estimates, we may be required to record impairment charges for these assets not previously recorded.
 
Other Intangible Assets
 
Other intangible assets are amortized to the Statement of Operations over the period during which benefits are expected to accrue, currently estimated at two to ten years.
 
The determination of the value of such intangible assets requires us to make assumptions regarding future business conditions and operating results in order to estimate future cash flows and other factors to determine the fair value of the respective assets. If these estimates or the related assumptions change in the future, we could be required to record additional impairment charges.
 
Contingencies
 
We are from time to time involved in legal proceedings and other claims. We are required to assess the likelihood of any adverse judgments or outcomes to these matters, as well as potential ranges of probable losses. We have not made any material changes in the accounting methodology used to establish our self-insured liabilities during the past three fiscal years.
 
A determination of the amount of reserves required, if any, for any contingencies are made after careful analysis of each individual issue. The required reserves may change due to future developments in each matter or changes in approach, such as a change in the settlement strategy in dealing with any contingencies, which may result in higher net loss.
 
If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material.
 
Warranty Reserves
 
Upon shipment of products to our customers, we provide for the estimated cost to repair or replace products that may be returned under warranty. Our warranty period is typically twelve months from the date of shipment to the end user customer. For existing products, the reserve is estimated based on actual historical experience. For new products, the warranty reserve is based on historical experience of similar products until such time as sufficient historical data has been collected on the new product. Factors that may impact our warranty costs in the future include our reliance on our contract manufacturer to provide quality products and the fact that our products are complex and may contain undetected defects, errors or failures in either the hardware or the software.
 
Functional Currency
 
We consider the United States dollar to be the currency of the primary economic environment in which we and our Israeli subsidiary EFL operate and, therefore, both we and EFL have adopted and are using the United States dollar as our functional currency. Transactions and

 
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balances originally denominated in U.S. dollars are presented at the original amounts. Gains and losses arising from non-dollar transactions and balances are included in net income.
 
The majority of financial transactions of our Israeli subsidiaries MDT and Epsilor is in New Israel Shekels (“NIS”) and a substantial portion of MDT’s and Epsilor’s costs is incurred in NIS. Management believes that the NIS is the functional currency of MDT and Epsilor. Accordingly, the financial statements of MDT and Epsilor have been translated into U.S. dollars. All balance sheet accounts have been translated using the exchange rates in effect at the balance sheet date. Statement of operations amounts have been translated using the average exchange rate for the period. The resulting translation adjustments are reported as a component of accumulated other comprehensive loss in stockholders’ equity.
 
Recent Developments
 
Purchase of the Minority Interest in MDT Israel and MDT Armor
 
In January 2008, we purchased the minority shareholder’s 24.5% interest in MDT Israel and the 12.0% interest in MDT Armor, as well as settling all outstanding disputes regarding severance payments, in exchange for a total of $1.0 million. We are currently evaluating the impact of this transaction on our first quarter 2008 financial statements.
 
Purchase of Realtime Technologies, Inc.
 
In February 2008 our FAAC subsidiary acquired Realtime Technologies, Inc. (RTI), a privately-owned corporation headquartered in Royal Oak, Michigan, close to the headquarters of the rest of our Training and Simulation Division, for a total of $1,350,000 ($1,250,000 in cash and $100,000 in stock) with a 2008 earn-out (maximum of $250,000) based on 2008 net profit. Since its founding in 1998, RTI has specialized in multi-body vehicle dynamics modeling and graphical simulation solutions. RTI offers simulation software applications, consulting services, custom engineering solutions, and software and hardware development.
 
AoA Arbitration
 
In connection with our acquisition of AoA, we had a contingent earnout obligation in an amount equal to the revenues AoA realized from certain specific programs that were identified by us and the seller of AoA (“Seller”) as appropriate targets for revenue increases. As of December 31, 2006, we had reduced the $3.0 million escrow held by the Seller by $1,520,174 for a putative claim against such escrow in respect of such earn-out obligation.
 
On March 20, 2007, we filed a Demand for Arbitration with the American Arbitration Association against the Seller. In our demand, we sought the return of $3.0 million, plus interest, held in escrow by the Seller in connection with his sale of AoA to us in 2004. The Seller asserted counterclaims against us in the arbitration, alleging (i) that he is entitled to keep the $3.0 million, (ii) that he is entitled to an additional $3.0 million in post-sale earnouts, and (iii) that he is entitled to $70,000 in compensation (plus interest and statutory penalties) wrongfully withheld by us when we constructively terminated his employment.
 
In February 2008, the arbitration panel issued a decision denying the Seller’s counterclaims (i) and (ii) above, granting the Seller’s counterclaim for $70,000 in compensation, awarding us the entire $3.0 million escrow (less the $70,000 in compensation (with simple interest but

 
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without statutory penalties)), and awarding us $135,000 in attorneys’ fees. The time for the Seller to move to vacate or modify this award has not yet expired.
 
Executive Summary
 
Overview of Results of Operations
 
We incurred significant operating losses for the years ended December 31, 2007 and 2006. While we expect to continue to derive revenues from the sale of products that we manufacture and the services that we provide, there can be no assurance that we will be able to achieve or maintain profitability on a consistent basis.
 
A portion of our operating loss during 2007 and 2006 arose as a result of non-cash charges. These charges were primarily related to our acquisitions, financings and issuances of restricted shares and options to employees. To the extent that we continue certain of these activities during 2008, we would expect to continue to incur such non-cash charges in the future.
 
Acquisitions
 
In acquisition of subsidiaries, part of the purchase price is allocated to intangible assets and goodwill. Amortization of intangible assets related to acquisition of subsidiaries is recorded based on the estimated expected life of the assets. Accordingly, for a period of time following an acquisition, we incur a non-cash charge related to amortization of intangible assets in the amount of a fraction (based on the useful life of the intangible assets) of the amount recorded as intangible assets. Such amortization charges continued during 2007. We are required to review intangible assets for impairment whenever events or changes in circumstances indicate that carrying amount of the assets may not be recoverable. If we determine, through the impairment review process, that intangible asset has been impaired, we must record the impairment charge in our statement of operations.
 
In the case of goodwill, the assets recorded as goodwill are not amortized; instead, we are required to perform an annual impairment review. If we determine, through the impairment review process, that goodwill has been impaired, we must record the impairment charge in our statement of operations.
 
As a result of the application of the above accounting rule, we incurred non-cash charges for amortization of intangible assets in 2007 and 2006 in the amount of $1.4 million and $1.9 million, respectively.
 
Financings and Issuances of Restricted Shares, Options and Warrants
 
The non-cash charges that relate to our financings occurred in connection with our issuance of convertible securities with warrants, and in connection with our repricing of certain warrants and grants of new warrants. When we issue convertible securities, we record a discount for a beneficial conversion feature that is amortized ratably over the life of the debenture. When a debenture is converted, however, the entire remaining unamortized beneficial conversion feature expense is immediately recognized in the quarter in which the debenture is converted. Similarly, when we issue warrants in connection with convertible securities, we record debt discount for financial expenses that is amortized ratably over the term of the convertible securities; when the

 
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convertible securities are converted, the entire remaining unamortized debt discount is immediately recognized in the quarter in which the convertible securities are converted.
 
During 2007 and 2006, we issued restricted shares to certain of our employees. These shares were issued as stock bonuses, and are restricted for a period of up to three years from the date of issuance. Relevant accounting rules provide that the aggregate amount of the difference between the purchase price of the restricted shares (in this case, generally zero) and the market price of the shares on the date of grant is taken as a general and administrative expense, amortized over the life of the period of the restriction.
 
As a result of the application of the above accounting rules, we incurred non-cash charges related to stock-based compensation in 2007 and 2006 in the amount of $1,332,000 and $360,000, respectively.
 
As a result of options granted to employees and the adoption of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payments,” we incurred non-cash charges related to stock-based compensation in 2007 and 2006 in the amount of $86,000 and $141,000, respectively.
 
As part of the repricings and exercises of warrants described in Note 13 of the Notes to Consolidated Financial Statements, we issued warrants to purchase up to 298,221 shares of common stock. Since the terms of these warrants provided that the warrants were exercisable subject to our obtaining stockholder approval, in accordance with Emerging Issues Task Force No 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock,” the fair value of the warrants was recorded as a liability at the closing date. Such fair value was remeasured at each subsequent cut-off date until we obtained stockholder approval. The fair value of these warrants was remeasured as at June 19, 2006 (the date of the stockholder approval) using the Black-Scholes pricing model assuming a risk free interest rate of 5.00%, a volatility factor of 72%, dividend yields of 0% and a contractual life of approximately 1.78 years. The change in the fair value of the warrants between the date of the grant and June 19, 2006 in the amount of $700,000 has been recorded as finance income.
 
Under the terms of our convertible notes, which have been paid in full, we had the option in respect of scheduled principal repayments to force conversion of the payment amount at a conversion price based upon the weighted average trading price of our common stock during the 20 trading days prior to the conversion, less a discount of 8%.
 
On April 7, 2006, we and each holder of our convertible notes agreed that we would force immediate conversion of an aggregate of $6,148,904 principal amount of the convertible notes into 1,098,019 shares of our common stock. The amount converted eliminated our obligation to make the installment payments under the convertible notes on each of March 31, 2008, January 31, 2008, November 30, 2007 and September 30, 2007 (aggregating a total of $5,833,333). In addition, as a result of the conversion an additional $315,570 was applied against part of the installment payment due July 31, 2007. After giving effect to the conversion, $8,434,430 of principal remained outstanding under the convertible notes.

 
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During the remainder of 2006, we converted $1,458,333 of principal remaining outstanding under our convertible notes by forcing conversion of this principal amount into 526,444 shares of or common stock. During 2007, we converted the remaining $6,976,097 of principal remaining outstanding under our convertible notes by forcing conversion of this principal amount into 930,125 shares of our common stock.
 
Additionally, in an effort to improve our cash situation and our shareholders’ equity, we have periodically induced holders of certain of our warrants to exercise their warrants by lowering the exercise price of the warrants in exchange for immediate exercise of such warrants, and by issuing to such investors new warrants. Under such circumstances, we record a deemed dividend in an amount determined based upon the fair value of the new warrants (using the Black-Scholes pricing model). As and to the extent that we engage in similar warrant repricings and issuances in the future, we would incur similar non-cash charges.
 
During 2007 and 2006, the Company recorded expenses of $19,000 and $1.5 million, respectively, attributable to amortization related to warrants issued to the holders of convertible debentures and the beneficial conversion feature. During 2007 and 2006, the Company also recorded expenses of $280,000 and $5.4 million, respectively, attributable to financial expenses in connection with convertible debenture principle repayment. Additionally, during 2007 and 2006, the Company recorded expenses of $44,000 and $781,000, respectively, attributable to amortization of deferred charges related to convertible debentures issuance that were recorded as a general and administrative expense.
 
Overview of Operating Performance and Backlog
 
Overall, our net loss before minority interest earnings, earnings from an affiliated company and tax expenses for 2007 was $2.8 million on revenues of $57.7 million, compared to a net loss of $15.7 million on revenues of $43.1 million during 2006. As of December 31, 2007, our overall backlog totaled $48.7 million.
 
In our Training and Simulation Division, revenues increased from approximately $22.0 million in 2006 to $27.8 million in 2007. As of December 31, 2007, our backlog for our Training and Simulation Division totaled $21.7 million.
 
In our Battery and Power Systems Division, revenues increased from approximately $8.6 million in 2006 to approximately $11.2 million in 2007. As of December 31, 2007, our backlog for our Battery and Power Systems Division totaled $12.9 million.
 
 In our Armor Division, revenues increased from approximately $12.6 million in 2006 to approximately $18.7 million in 2007. As of December 31, 2007, our backlog for our Armor Division totaled $14.1 million.
 
Results of Operations
 
Preliminary Note
 
Summary
 
Following is a table summarizing our results of operations for the years ended December 31, 2007 and 2006, after which we present a narrative discussion and analysis:

 
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Year Ended December 31,
 
   
2007
   
2006
 
Revenues:
           
Training and Simulation Division
  $ 27,760,858     $ 21,951,337  
Armor Division
    18,724,107       12,571,779  
Battery and Power Systems Division
    11,234,596       8,597,623  
    $ 57,719,561     $ 43,120,739  
Cost of revenues:
         
Training and Simulation Division
  $ 15,528,023     $ 14,196,298  
Armor Division
    15,906,071       12,299,756  
Battery and Power Systems Division
    8,205,718       5,997,592  
    $ 39,639,812     $ 32,493,646  
Research and development expenses:
               
Training and Simulation Division
  $ 629,430     $ 308,738  
Armor Division
    115,500       20,546  
Battery and Power Systems Division
    1,132,233       1,272,170  
    $ 1,877,163     $ 1,601,454  
Sales and marketing expenses:
               
Training and Simulation Division
  $ 2,956,995     $ 2,514,981  
Armor Division
    634,237       366,923  
Battery and Power Systems Division
    570,768       656,604  
All Other
    2,464       175,814  
    $ 4,164,464     $ 3,714,322  
General and administrative expenses:
               
Training and Simulation Division
  $ 3,400,013     $ 2,562,868  
Armor Division
    1,295,079       1,031,333  
Battery and Power Systems Division
    1,658,968       994,136  
All Other
    6,804,237       7,104,479  
    $ 13,158,297     $ 11,692,816  
Other income:
               
Training and Simulation Division
  $ 122,934     $ 361,560  
Armor Division
    152,206        
All Other
    342,812        
    $ 617,952     $ 361,560  
Financial expense (income):
               
Training and Simulation Division
  $ 14,610     $ (129,908 )
Armor Division
    93,292       54,476  
Battery and Power Systems Division
    176,834       (50,590 )
All Other
    621,152       7,645,922  
    $ 905,888     $ 7,519,900  
Tax expenses (credits):
               
Training and Simulation Division
  $ 69,930     $ 49,383  
Armor Division
    2,639        
Battery and Power Systems Division
    (28,653 )      
All Other
    120,000       182,776  
    $ 163,916     $ 232,159  
Amortization of intangible assets:
               
Training and Simulation Division
  $ 776,736     $ 1,049,136  
Armor Division
    95,907       295,067  
Battery and Power Systems Division
    509,239       509,239  
    $ 1,381,882     $ 1,853,442  
Impairment of goodwill and other intangible assets:
               
Armor Division
          316,024  
    $     $ 316,024  
Gain  (loss) from affiliated company:
               
Training and Simulation Division
  $ (40,230 )   $ 354,898  
    $ (40,230 )   $ 354,898  
Minority interest in loss (profit) of subsidiaries:
               
Armor Division
    (62,296 )     17,407  
    $ (62,296 )   $ 17,407  
Net income (loss):
               
Training and Simulation Division
  $ 4,467,825     $ 2,116,299  
Armor Division
    671,292       (1,794,939 )
Battery and Power Systems Division
    (990,511 )     (964,304 )
All Other
    (7,205,041 )     (14,926,215 )
    $ (3,056,435 )   $ (15,569,159 )

 
- 10 - -

 
 
Fiscal Year 2007 compared to Fiscal Year 2006
 
Revenues. During 2007, we (through our subsidiaries) recognized revenues as follows:
 
 
Ø
IES and FAAC recognized revenues from the sale of interactive use-of-force training systems and from the provision of maintenance services in connection with such systems.
 
 
Ø
MDT, MDT Armor and AoA recognized revenues from payments under vehicle armoring contracts, for service and repair of armored vehicles, and on sale of armoring products.
 
 
Ø
EFB and Epsilor recognized revenues from the sale of batteries, chargers and adapters to the military, and under certain development contracts with the U.S. Army.
 
 
Ø
EFL recognized revenues from the sale of water-activated battery (WAB) lifejacket lights.
 
Revenues for 2007 totaled $57.7 million, compared to $43.1 million in 2006, an increase of $14.6 million, or 33.9%. This increase was primarily attributable to the following factors:
 
 
Ø
Increased revenues from our Training and Simulation Division ($5.8 million more in 2007 versus 2006).
 
 
Ø
Increased revenues from our Battery and Power Systems Division ($2.6 million more in 2007 versus 2006).
 
 
Ø
Increased revenues from our Armor Division ($6.2 million more in 2007 versus 2006).
 
In 2007, revenues were $27.8 million for the Training and Simulation Division (compared to $22.0 million in 2006, an increase of $5.8 million, or 26.5%, due primarily to increased sales of military vehicle simulators and use of force simulators); $11.2 million for the Battery and Power Systems Division (compared to $8.6 million in 2006, an increase of $2.6 million, or 30.7%, due primarily to increased sales of our battery products at Epsilor and EFB); and $18.7 million for the Armor Division (compared to $12.6 million in 2006, an increase of $6.2 million, or 48.9%, due primarily to increased revenues from MDT and MDT Armor, mostly in respect of orders for the “David” Armored Vehicle).

 
- 11 - -

 

Cost of revenues. Cost of revenues totaled $39.6 million during 2007, compared to $32.5 million in 2006, an increase of $7.1 million, or 22.0%, due primarily to increased sales in all divisions, particularly in the production of the “David” Armored Vehicle in our Armor Division, which accounted for over $2.0 million of the increase. Total cost of revenues and cost of revenues as a percentage of revenue also increased in the Battery and Power Systems Division due to several factors, primarily the production of new products.
 
Cost of revenues for our three divisions during 2007 were $15.5 million for the Training and Simulation Division (compared to $14.2 million in 2006, an increase of $1.3 million, or 9.4%, due primarily to increased revenues); $8.2 million for the Battery and Power Systems Division (compared to $6.0 million in 2006, an increase of $2.1 million, or 36.8%, due primarily to increased revenues); and $15.9 million for the Armor Division (compared to $12.3 million in 2006, an increase of $3.6 million, or 29.3%, due primarily to production of the “David” Armored Vehicle).
 
Amortization of intangible assets. Amortization of intangible assets totaled $1.4 million in 2007, compared to $1.9 million in 2006, a decrease of $472,000, or 25.4%, due primarily to completion of the amortization of certain intangible assets at our FAAC and AoA subsidiaries.
 
Research and development expenses. Research and development expenses for 2007 were $1.9 million, compared to $1.6 million during 2006, an increase of $276,000, or 17.2%, due primarily to an increase in expenses at FAAC for expenses associated with the improvements to our simulator products.
 
Selling and marketing expenses. Selling and marketing expenses for 2007 were $4.2 million, compared to $3.7 million 2006, an increase of $450,000, or 12.1%. This increase was primarily attributable to the overall increase in revenues and their associated sales and marketing expenses in our Training and Simulation Division and Armor Division, partially offset by a reduction in expense in our Battery and Power Systems Division.
 
General and administrative expenses. General and administrative expenses for 2007 were $13.2 million, compared to $11.7 million in 2006, an increase of $1.5 million, or 12.5%. This increase was primarily attributable to additional expenses in all three operating divisions, partially offset by a reduction in corporate expenses.
 
Financial expenses, net. Financial expenses totaled approximately $900,000 in 2007 compared to $7.5 million in 2006, a decrease of $6.6 million, or 88.0%. The difference was due primarily to decreased interest related to our convertible notes that were issued in September 30, 2006 as a result of payments of principal during 2006, and financial expenses in 2006 related to repayment by forced conversion of our convertible notes at an 8% discount to average market price as provided under the terms of the convertible notes that did not occur to the same extent in 2007.
 
Income taxes. We and certain of our subsidiaries incurred net operating losses during 2007 and, accordingly, no provision for income taxes was recorded for these losses. With respect to some of our subsidiaries that operated at a net profit during 2007, we were able to offset federal taxes against our accumulated loss carry forward. We recorded a total of $164,000 in tax expenses in 2007, compared to $232,000 in tax expenses in 2006, mainly due to state taxes. We also set up a tax liability for the impact of the deductions taken for good will amounted to $120,000 in 2007.  We also adjusted the 2006 accumulated deficit in the amount of $900,000 to correct the balances in prior years.

 
- 12 - -

 

Impairment of goodwill and other intangible assets. Current accounting standards require us to test goodwill for impairment at least annually, and between annual tests in certain circumstances; when we determine goodwill is impaired, it must be written down, rather than being amortized as previous accounting standards required. Goodwill is tested for impairment by comparing the fair value of our reportable units with their carrying value. Fair value is determined using discounted cash flows. Significant estimates used in the methodologies include estimates of future cash flows, future short-term and long-term growth rates, weighted average cost of capital and estimates of market multiples for the reportable units. We performed the required annual impairment test of goodwill, based on our management’s projections and using expected future discounted operating cash flows. We did not identify any impairment of goodwill during 2007. In the corresponding period of 2006, we identified in AoA an impairment of goodwill in the amount of $316,000.
 
Net loss. Due to the factors cited above, net loss from operations decreased from $15.6 million in 2006 to $3.1 million in 2007, an improvement of $12.7 million, or 81.1%. (Net loss attributable to common stockholders was $16.0 million in 2006, due to a deemed dividend that was recorded in the amount of $434,000 in 2006 due to the repricing of existing warrants and the issuance of new warrants.)
 
Liquidity and Capital Resources
 
As of December 31, 2007, we had $3.4 million in cash, $320,000 in restricted collateral securities, $1.5 million in an escrow receivable and $47,000 in available-for-sale marketable securities, as compared to at December 31, 2006, when we had $2.4 million in cash, $649,000 in restricted collateral securities, $1.4 million in an escrow receivable and $41,000 in available-for-sale marketable securities. We also had $2.9 million available in unused bank lines of credit, including funds drawn under a $7.5 million line of credit in favor of our FAAC subsidiary, which line of credit is secured by our assets and the assets of our other subsidiaries and guaranteed by us and our other subsidiaries.
 
We used available funds in 2007 primarily for sales and marketing, continued research and development expenditures, and other working capital needs. We increased our investment in fixed assets (including the purchase of two buildings in Alabama) by $2.8 million during the year ended December 31, 2007. Our net fixed assets amounted to $5.1 million as at year end.
 
Net cash provided by (used in) operating activities for 2007 and 2006 was $1.4 million and $(3.6) million, respectively, an increase of $5.0 million, due primarily to the reduction of our net loss in 2007, offset in part by an increase in our accounts receivable.
 
Net cash used in investing activities for 2007 and 2006 was $1.6 million and $487,000, respectively. This increase was primarily the result of the purchase of fixed assets along with the payment of promissory notes in respect of an arbitration settlement related to the acquisition of FAAC.
 
Net cash provided by financing activities for 2007 and 2006 was $1.1 million and $452,000, respectively, an increase of $650,000. This increase was primarily due to the changes in the debenture-related activity.

 
- 13 - -

 

As of December 31, 2007, we had (based on the contractual amount of the debt and not on the accounting valuation of the debt, not taking into consideration trade payables, other accounts payables and accrued severance pay) approximately $4.6 million in bank debt outstanding.
 
Subject to all of the reservations regarding “forward-looking statements” set forth above, we believe that our present cash position, anticipated cash flows from operations and lines of credit should be sufficient to satisfy our current estimated cash requirements through the remainder of the year. In this connection, we note that from time to time our working capital needs are partially dependent on our subsidiaries’ lines of credit. In the event that we are unable to continue to make use of our subsidiaries’ lines of credit for working capital on economically feasible terms, our business, operating results and financial condition could be adversely affected.
 
Over the long term, we will need to become profitable, at least on a cash-flow basis, and maintain that profitability in order to avoid future capital requirements. Additionally, we would need to raise additional capital in order to fund any future acquisitions.
 
Effective Corporate Tax Rate
 
We and certain of our subsidiaries incurred net operating losses during the years ended December 31, 2007 and 2006, and accordingly no provision for income taxes was required. With respect to some of our U.S. subsidiaries that operated at a net profit during 2007, we were able to offset federal taxes against our net operating loss carryforward, which amounted to approximately $7.2 million as of December 31, 2007. These subsidiaries are, however, subject to state taxes that cannot be offset against our net operating loss carryforward. With respect to certain of our Israeli subsidiaries that operated at a net profit during 2007, we were unable to offset their taxes against our net operating loss carryforward, and we are therefore exposed to Israeli taxes, at a rate of up to 29% in 2007 (less, in the case of companies that have “approved enterprise” status as discussed in Note 14.b. to the Notes to Financial Statements). We also set up a tax liability for the impact of the deductions taken for goodwill.
 
As of December 31, 2007, we had a U.S. net operating loss carryforward of approximately $7.2 million that is available to offset future taxable income under certain circumstances, expiring primarily from 2009 through 2026, and foreign net operating and capital loss carryforwards of approximately $106 million, which are available indefinitely to offset future taxable income under certain circumstances.
 
Contractual Obligations
 
The following table lists our contractual obligations and commitments as of December 31, 2007, not including trade payables and other accounts payable:
 
- 14 - -

 
   
Payment Due by Period
 
Contractual Obligations
 
Total
   
Less Than 1 Year
   
1-3 Years
   
3-5 Years
   
More than 5 Years
 
Long-term debt
  $
1,192,342
    $ 103,844     $ 72,182     $ 66,215     $ 950,101  
Short-term debt*
  $
4,557,890
    $ 4,557,890     $     $     $  
Promissory note due to purchase of subsidiaries
  $
151,450
    $ 151,450     $     $     $  
Operating lease obligations**
  $
4,302,191
    $ 637,760     $ 997,535     $ 1,021,224     $ 1,645,672  
Capital lease obligations
  $
154,532
    $ 67,543     $ 72,411     $ 14,578     $  
Severance obligations***
  $
4,853,231
    $     $ 4,853,231     $     $  

Primarily in short-term bank debt.
** 
Includes operating lease obligations related to rent.
*** 
Includes obligations related to special severance pay arrangements in addition to the severance amounts due to certain employees pursuant to Israeli severance pay law (the amount shown in the table above with payment due during the next 1-3 years might not be paid in the period stated in the event the employment agreements to which such severance obligations relate are extended).

ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
Index to Financial Statements
 
Page
Consolidated Financial Statements
 
Report of Independent Registered Public Accounting Firm
F-1
Consolidated Balance Sheets
F-2
Consolidated Statements of Operations
F-4
Statements of Changes in Stockholders’ Equity
F-5
Consolidated Statements of Cash Flows
F-7
Notes to Consolidated Financial Statements
F-9
Financial Statement Schedule
 
Schedule II – Valuation and Qualifying Accounts
F-45
 
The financial statements have been restated to give effect to a one-for-fourteen reverse stock split effected on June 21, 2006.

 
- 15 - -

 

PART IV
 
ITEM 15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES
 
(a)
The following documents are filed as part of this report:
 
(1)
Financial Statements – See Index to Financial Statements on page 15 above and the financial pages following page 19 below.
 
(2)
Financial Statements Schedules – Schedule II - Valuation and Qualifying Accounts. All schedules other than those listed above are omitted because of the absence of conditions under which they are required or because the required information is presented in the financial statements or related notes thereto.
 
(3)
Exhibits – The following Exhibits are either filed herewith or have previously been filed with the Securities and Exchange Commission and are referred to and incorporated herein by reference to such filings:
 
 
 
 
Exhibit No.
 
Description
(1)
 
3.1
 
Amended and Restated Certificate of Incorporation
(3)
 
3.1.1
 
Amendment to our Amended and Restated Certificate of Incorporation
(8)
 
3.1.2
 
Amendment to our Amended and Restated Certificate of Incorporation
(9)
 
3.1.3
 
Amendment to our Amended and Restated Certificate of Incorporation
(18)
 
3.1.4
 
Amendment to our Amended and Restated Certificate of Incorporation
(2)
 
3.2
 
Amended and Restated By-Laws
(9)
 
4.1
 
Specimen Certificate for shares of common stock, $.01 par value
(14)
 
10.1
 
Promissory Note dated December 3, 1999, from Robert S. Ehrlich to us
(14)
 
10.2
 
Promissory Note dated February 9, 2000, from Robert S. Ehrlich to us
(14)
 
10.3
 
Promissory Note dated January 12, 2001, from Robert S. Ehrlich to us
(4)
 
10.4
 
Agreement of Lease dated December 6, 2000 between Janet Nissim et al. and M.D.T. Protection (2000) Ltd. [English summary of Hebrew original]
(4)
 
10.5
 
Agreement of Lease dated August 22, 2001 between Aviod Building and Earthworks Company Ltd. et al. and M.D.T. Protective Industries Ltd. [English summary of Hebrew original]
(5)
 
10.6
 
Form of Warrant dated September 30, 2003
(6)
 
10.7
 
Form of Warrant dated January __, 2004
(7)
 
10.8
 
Promissory Note dated July 1, 2002 from Robert S. Ehrlich to us
(7)
 
10.9
 
Lease dated April 8, 1997, between AMR Holdings, L.L.C. and FAAC Incorporated
†(9)
 
10.10
 
Consulting Agreement, effective as of January 1, 2005, between us and Sampen Corporation
†(19)
 
10.11
 
Fourth Amended and Restated Employment Agreement, dated April 16, 2007, between us, EFL and Robert S. Ehrlich
†(10)
 
10.12
 
Employment Agreement, effective as of January 1, 2005, between EFL and Steven Esses
 
- 16 - -

 
 
 
Exhibit No.
 
Description
†(21)
 
10.12.1
 
Amended and Restated Employment Agreement, dated April 14, 2008 and effective as of January 1, 2008, between EFL and Steven Esses
(16)
 
10.13
 
Conversion Agreement dated April 7, 2006 between us and the Investors named therein
(11)
 
10.14
 
Form of Warrant dated September 29, 2005
† (12)
 
10.15
 
Employment Agreement between the Company and Thomas J. Paup dated December 30, 2005
†(21)
 
10.15.1
 
Amended and Restated Employment Agreement between the Company and Thomas J. Paup dated April 14, 2008 and effective as of January 1, 2008
† (12)
 
10.16
 
Separation Agreement and Release of Claims among the Company, EFL and Avihai Shen dated January 5, 2006
(13)
 
10.17
 
Form of Warrant dated February 15, 2006
(14)
 
10.18
 
Lease dated February 10, 2006 between Arbor Development Company LLC and FAAC Incorporated
(15)
 
10.19
 
Form of Warrant dated March 27, 2006
(17)
 
10.20
 
Form of Warrant dated April 11, 2006
(20)
 
10.21
 
Loan Agreement between FAAC Incorporated and Keybank National Association dated December 27, 2007
(20)
 
10.22
 
Security Agreement between us and Keybank National Association dated December 27, 2007
(20)
 
10.23
 
Guaranty from us to Keybank National Association dated December 27, 2007
*(21)
 
10.24
 
Agreement with Yossi Bar in respect of our purchase of the minority interest of M.D.T. Protective Industries Ltd. and MDT Armor Corporation dated January 15, 2008
*(21)
 
10.25
 
Stock Purchase Agreement among FAAC Incorporated, Realtime Technologies Ltd. and Richard Romano dated February 4, 2008
(9)
 
21.1
 
List of Subsidiaries of the Registrant
**
 
23.1
 
Consent of BDO Seidman, LLP
**
 
31.1
 
Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
**
 
31.2
 
Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
**
 
32.1
 
Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
**
 
32.2
 
Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

*
English translation or summary from original Hebrew
**
Filed herewith
Includes management contracts and compensation plans and arrangements
(1)
Incorporated by reference to our Registration Statement on Form S-1 (Registration No. 33-73256), which became effective on February 23, 1994
(2)
Incorporated by reference to our Registration Statement on Form S-1 (Registration No. 33-97944), which became effective on February 5, 1996
 
- 17 - -

 
(3)
Incorporated by reference to our Current Report on Form 8-K filed January 6, 2003
(4)
Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 2002
(5)
Incorporated by reference to our Current Report on Form 8-K filed October 3, 2003
(6)
Incorporated by reference to our Current Report on Form 8-K filed January 9, 2004
(7)
Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 2003
(8)
Incorporated by reference to our Current Report on Form 8-K filed July 15, 2004
(9)
Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 2004
(10)
Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2004
(11)
Incorporated by reference to our Current Report on Form 8-K filed September 30, 2005
(12)
Incorporated by reference to our Current Report on Form 8-K filed January 5, 2006
(13)
Incorporated by reference to our Current Report on Form 8-K filed February 16, 2006
(14)
Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 2005
(15)
Incorporated by reference to our Current Report on Form 8-K filed March 30, 2006
(16)
Incorporated by reference to our Current Report on Form 8-K filed April 7, 2006
(17)
Incorporated by reference to our Current Report on Form 8-K filed April 12, 2006
(18)
Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2006
(19)
Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 2006
(20)
Incorporated by reference to our Current Report on Form 8-K filed January 3, 2008
(21)
 Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 2007

 
- 18 - -

 

SIGNATURES
 
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this amended report to be signed on its behalf by the undersigned, thereunto duly authorized, on April 28, 2008.
 
 
AROTECH CORPORATION
       
       
 
By: 
/s/  Robert S. Ehrlich
   
Name: 
Robert S. Ehrlich
   
Title:
Chairman and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this amended report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
 
Signature
Title
Date
     
/s/  Robert S. Ehrlich
Robert S. Ehrlich
Chairman Chief Executive Officer and Director
(Principal Executive Officer)
April 28, 2008
 
   
/s/  Thomas J. Paup

Thomas J. Paup
Vice President – Finance
(Principal Financial Officer)
April 28, 2008
 
   
/s/  Norman Johnson

Norman Johnson
Controller
(Principal Accounting Officer)
April 28, 2008
 
   
/s/  Steven Esses

Steven Esses
President, Chief Operating Officer and Director
April 28, 2008
     
 

Dr. Jay M. Eastman
Director
April __, 2008
 
   
/s/  Lawrence M. Miller

Lawrence M. Miller
Director
April 28, 2008
 
   
/s/  Jack E. Rosenfeld

Jack E. Rosenfeld
Director
April 28, 2008
 
   
 

Edward J. Borey
Director
April __, 2008
     
 

Seymour Jones
Director
April __, 2008
     
 

Elliot Sloyer
Director
April __, 2008
     
/s/  Michael E. Marrus

Michael E. Marrus
Director
April 28, 2008


 
- 19 - -

 

Report of Independent Registered Public Accounting Firm


To the Board of Directors and Shareholders of Arotech Corporation:

We have audited the accompanying consolidated balance sheets of Arotech Corporation and subsidiaries as of December 31, 2007 and 2006 and the related consolidated statements of operations, changes in stockholders’ equity and cash flows for the years then ended. In connection with our audits of the financial statements, we have also audited the financial statement schedule listed in the accompanying index.  These financial statements and schedule are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financial statements and schedules based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.  An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and schedule.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Arotech Corporation and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

Also, in our opinion, the financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.



Grand Rapids, Michigan
/s/ BDO Seidman, LLP
 
April 14, 2008
BDO Seidman, LLP
 

 
 

 
 
AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

In U.S. dollars
 
   
December 31,
 
   
2007
   
2006
 
             
ASSETS
           
             
CURRENT ASSETS:
           
Cash and cash equivalents
  $ 3,447,671     $ 2,368,872  
Restricted collateral deposits
    320,454       648,975  
Escrow receivable
    1,479,826       1,479,826  
Available for sale marketable securities
    47,005       41,166  
Trade receivables (net of allowance for doubtful accounts in the amounts of $25,000 and $159,000 as of December 31, 2007 and 2006, respectively)
    14,583,213       7,780,965  
Unbilled receivables
    3,271,594       6,902,533  
Other accounts receivable and prepaid expenses
    1,614,614       1,134,622  
Inventories
    7,887,820       7,851,820  
                 
Total current assets
    32,652,197       28,208,779  
                 
SEVERANCE PAY FUND
    2,815,040       2,246,457  
                 
OTHER LONG-TERM RECEIVABLES
    386,899       262,608  
                 
PROPERTY AND EQUIPMENT, NET
    5,079,796       3,740,593  
                 
INVESTMENT IN AFFILIATED COMPANY
    352,168       392,398  
                 
OTHER INTANGIBLE ASSETS, NET
    7,837,076       9,502,214  
                 
GOODWILL
    31,358,131       30,715,225  
                 
Total long term assets
    47,829,110       46,859,495  
                 
    $ 80,481,307     $ 75,068,274  
 
The accompanying notes are an integral part of the consolidated financial statements.
 
 
F-2

 

AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

In U.S. dollars

   
December 31,
 
   
2007
   
2006
 
             
LIABILITIES AND STOCKHOLDERS’ EQUITY
           
             
CURRENT LIABILITIES:
           
Trade payables
  $ 4,233,288     $ 2,808,131  
Other accounts payable and accrued expenses
    4,889,729       5,171,055  
Current portion of capitalized leases
    67,543       55,263  
Current portion of promissory notes due to purchase of subsidiaries
    151,450       302,900  
Current portion of long term debt
    103,844        
Short term bank credit
    4,557,890       3,496,008  
Deferred revenues
    2,903,166       1,321,311  
Convertible debenture
          2,583,629  
                 
Total current liabilities
    16,906,910       15,738,297  
                 
LONG TERM LIABILITIES
               
Accrued severance pay
    4,853,231       4,039,049  
Long term portion of promissory notes due to purchase of subsidiaries
          151,450  
Long term portion of capitalized leases
    86,989       158,120  
Long term portion of long term debt
    1,088,498        
Other long term liabilities
    110,255        
Deferred Taxes
    1,020,000       900,000  
Total long-term liabilities
    7,158,973       5,248,619  
                 
MINORITY INTEREST
    83,816       21,520  
                 
STOCKHOLDERS’ EQUITY:
               
Share capital –
               
Common stock – $0.01 par value each;
               
Authorized: 250,000,000 shares as of December 31, 2007 and 2006; Issued: 13,544,819 shares and 12,023,242 shares as of December 31, 2007 and 2006, respectively; Outstanding – 13,544,819 shares and 11,983,575 shares as of December 31, 2007 and 2006, respectively
    135,448       120,232  
Preferred shares – $0.01 par value each;
               
Authorized: 1,000,000 shares as of December 31, 2007 and 2006; No shares issued and outstanding as of December 31, 2007 and 2006
           
Additional paid-in capital
    218,551,110       217,735,860  
Accumulated deficit
    (162,522,558 )     (159,466,123 )
Treasury stock, at cost (common stock – none as of December 31, 2007 and 39,667 shares as of December 31, 2006)
          (3,537,106 )
Notes receivable from shareholders
    (1,333,833 )     (1,304,179 )
Accumulated other comprehensive income
    1,501,441       511,154  
                 
Total stockholders’ equity
    56,331,608       54,059,838  
                 
    $ 80,481,307     $ 75,068,274  

The accompanying notes are an integral part of the consolidated financial statements.
 
 
F-3

 
 
AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS

In U.S. dollars

   
2007
   
2006
 
             
Revenues
  $ 57,719,561     $ 43,120,739  
                 
Cost of revenues, exclusive of amortization of intangibles
    39,639,812       32,493,646  
Research and development
    1,877,163       1,601,454  
Selling and marketing expenses
    4,164,464       3,714,322  
General and administrative expenses
    13,158,297       11,692,816  
Amortization of intangible assets
    1,381,882       1,853,442  
Impairment of goodwill and other intangible assets
          316,024  
                 
Total operating costs and expenses
    60,221,618       51,671,704  
                 
Operating loss
    (2,502,057 )     (8,550,965 )
Other income
    617,952       361,560  
Financial expenses, net
    (905,888 )     (7,519,900 )
                 
Loss before minority interest in earnings of a subsidiaries, earnings from affiliated company, and income tax expenses
    (2,789,993 )     (15,709,305 )
Income taxes
    (163,916 )     (232,159 )
Gain (loss) from affiliated company
    (40,230 )     354,898  
Minority interest in loss (earnings) of subsidiaries
    (62,296 )     17,407  
Net loss
  $ (3,056,435 )   $ (15,569,159 )
                 
Deemed dividend to certain stockholders
  $     $ (434,185 )
                 
Net loss attributable to common stockholders
  $ (3,056,435 )   $ (16,003,344 )
                 
Basic and diluted net loss per share
  $ (0.27 )   $ (1.87 )
                 
Weighted average number of shares used in computing basic and diluted net loss per share
    11,274,387       8,569,191  
 
The accompanying notes are an integral part of the consolidated financial statements.
 
 
F-4

 
 
AROTECH CORPORATION AND ITS SUBSIDIARIES
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

In U.S. dollars
 
                                             
Accumulated
             
                                       
Notes
   
other
   
Total
       
               
Additional
         
Deferred
         
receivable
   
comprehensive
   
comprehensive
   
Total
 
 
 
Common stock
   
paid-in
   
Accumulated
   
stock
   
Treasury
   
from
   
income
   
income
   
stockholders’
 
 
 
Shares
   
Amount
   
capital
   
deficit
   
compensation
   
stock
   
stockholders
   
(loss)
   
(loss)
   
equity
 
Balance as of January 1, 2006, as previously reported
    6,221,194     $ 870,969     $ 193,949,882     $
(142,996,964
)   $ (389,303 )   $ (3,537,106 )   $ (1,256,777 )   $ (375,445 )   $     $ 46,265,256  
Prior Period Adjustment                       (900,000                                   (900,000 )
Balance of January 1, 2006, as adjusted     6,221,194     $ 870,969     $ 193,949,882     $ (143,896,964 )   $ (389,303 )   $ (3,537,106 )   $ (1,256,777 )   $ (375,445 )         $ 45,365,256  
Adjustment of fractional shares due to reverse split
    (142 )     (808,757 )     808,757      
                                     
FAS 123R reclassification
                (389,303 )    
      389,303                                
Principal installment of convertible debenture payment in shares
    4,184,855       41,848       18,477,301      
                                    18,519,149  
Warrants exercise
    745,549       7,455       4,343,180      
                                    4,350,635  
Stock based compensation
                500,545      
                                    500,545  
Stock options and restricted stock
    871,786       8,717       (1,904 )    
                                    6,813  
Interest accrued on notes receivable from shareholders
                47,402      
                    (47,402 )                  
Other comprehensive loss – foreign currency translation adjustment
                     
                        885,733       885,733       885,733  
Other comprehensive loss – unrealized gain on available for sale marketable securities
                     
                        866       866       866  
Net loss
                     
(15,569,159
)                             (15,569,159 )     (15,569,159 )
Total comprehensive loss
                     
                              (14,682,560 )      
Balance as of December 31, 2006
    12,023,242     $ 120,232     $ 217,735,860     $
(159,466,123
)   $ 0     $ (3,537,106 )   $ (1,304,179 )   $ 511,154             $ 54,059,838  

The accompanying notes are an integral part of the consolidated financial statements.
 
 
F-5

 

AROTECH CORPORATION AND ITS SUBSIDIARIES
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

In U.S. dollars
 
                     
 
               
Accumulated
             
                     
 
         
Notes
   
other
   
Total
       
 
 
           
Additional
   
 
         
receivable
   
comprehensive
   
comprehensive
   
Total
 
 
 
Common stock
   
paid-in
   
Accumulated
   
Treasury
   
from
   
income
   
income
   
stockholders’
 
   
Shares
   
Amount
   
capital
   
deficit
   
stock
   
stockholders
   
(loss)
   
(loss)
   
equity
 
Balance as of January 1, 2007
   
12,023,242
    $
120,232
    $
217,735,860
    $
(159,466,123
)   $
(3,537,106
)   $
(1,304,179
)   $
511,154
    $
    $
54,059,838
 
Principal installment of convertible debenture payment in shares
   
930,125
     
9,301
     
2,873,454
     
     
     
     
     
     
2,882,755
 
Treasury shares cancellation
   
(39,666
)    
(396
)    
(3,536,710
)    
     
3,537,106
     
     
     
     
 
Stock based compensation
   
     
     
1,417,521
     
     
     
     
     
     
1,417,521
 
Stock options and restricted stock
   
631,118
     
6,311
     
31,331
     
     
     
     
 
   
     
37,642
 
Interest accrued on notes receivable from shareholders
   
     
     
29,654
     
     
 
     
(29,654
)    
     
     
 
Other comprehensive loss – foreign currency translation adjustment
   
     
     
     
     
     
     
988,740
     
988,740
     
988,740
 
Other comprehensive loss – unrealized gain on available for sale marketable securities
   
     
     
     
     
     
     
1,547
     
1,547
     
1,547
 
Net loss
   
 
   
     
   
 
(3,056,435
)    
     
     
     
(3,056,435
)    
(3,056,435
)
Total comprehensive loss
   
     
     
     
     
     
     
     
(2,066,148
)    
 
Balance as of December 31, 2007
   
13,544,819
    $
135,448
    $
218,551,110
    $
(162,522,558
)   $
0
    $
(1,333,833
)   $
1,501,441
     
 
    $
56,331,608
 
 
The accompanying notes are an integral part of the consolidated financial statements.
 
 
F-6

 

AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS

In U.S. dollars

   
2007
   
2006
 
Cash flows from operating activities:
           
Net loss
  $ (3,056,435 )   $ (15,569,159 )
Adjustments required to reconcile net loss to net cash used in operating activities:
               
Minorities interests in loss (earnings) of subsidiary
    62,296       (17,407 )
Loss (gain) from affiliated company
    40,230       (354,898 )
Depreciation
    1,376,749       1,966,748  
Amortization of intangible assets, capitalized software costs and impairment of intangible assets
    1,953,164       2,857,891  
Remeasurement of liability in connection to warrants granted
          (700,113 )
Accrued severance pay, net
    245,599       194,810  
Compensation related to shares issued to employees, consultants and directors
    1,417,521       507,081  
Impairment of property and equipment
          32,485  
Financial expenses in connection with convertible debenture principle repayment
    280,382       5,395,338  
Amortization related to warrants issued to the holders of convertible debentures and beneficial conversion feature
    18,745       1,485,015  
Amortization of deferred charges related to convertible debentures issuance
    44,253       780,719  
Capital loss (gain) from sale of property and equipment
    56,224       (1,842 )
Decrease (increase) in trade receivables
    (6,802,248 )     3,631,978  
Decrease (increase) in other accounts receivable and prepaid expenses
    (706,569 )     605,610  
Decrease in deferred taxes
    100,323       6,788  
Decrease (increase) in inventories
    (36,000 )     83,926  
Increase (decrease) in unbilled revenues
    3,630,939       (1,674,029 )
Increase in deferred revenues
    1,581,854       718,290  
Increase (decrease) in trade payables
    1,425,156       (3,156,665 )
Decrease in other accounts payable and accrued expenses
    (137,834 )     (296,866 )
Net cash provided by (used in) operating activities from continuing operations
    1,494,349       (3,504,300 )
Net cash used in operating activities from discontinued operations
          (120,000 )
Net cash provided by (used in) operating activities
  $ 1,494,349     $ (3,624,300 )
                 
Cash flows from investing activities:
               
Purchase of property and equipment
    (1,594,426 )     (1,412,383 )
Increase in capitalized software costs
    (15,750 )     (688,443 )
Payment of additional required payout for FAAC acquisition
          (630,350 )
Repayment of promissory notes related to acquisition of subsidiaries
    (302,900 )      
Proceeds from sale of property and equipment
    36,061        
Increase in escrow receivable
          (1,479,826 )
Decrease in restricted cash
    322,682       3,723,611  
Net cash used in investing activities
  $ (1,554,333 )   $ (487,391 )
 
The accompanying notes are an integral part of the consolidated financial statements.
 
 
F-7

 

AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS

In U.S. dollars

   
2007
   
2006
 
Forward
    (59,985 )     (4,111,691 )
                 
Cash flows from financing activities:
               
Proceeds from exercise of options
    37,642       250  
Proceeds from exercise of warrants
   
      4,350,635  
Repayment of convertible debentures
          (5,204,167 )
Repayment of long term loan
    (21,468 )     (149,414 )
Increase in short term bank credit
    1,061,883       1,455,309  
Net cash provided by financing activities
    1,078,057       452,613  
Increase (decrease) in cash and cash equivalents
    1,018,073       (3,659,078 )
Cash accretion (erosion) due to exchange rate differences
    60,726       (122,702 )
Cash and cash equivalents at the beginning of the year
    2,368,872       6,150,652  
Cash and cash equivalents at the end of the year
  $ 3,447,671     $ 2,368,872  
Supplementary information on non-cash transactions:
               
Payment of principle installment of convertible debenture in shares
  $ 2,882,753     $ 18,519,149  
Mortgage note payable (seller financed) issued for purchase of building
  $ 1,115,000     $  
Interest paid during the period
  $ 662,789     $ 2,018,061  
 
The accompanying notes are an integral part of the consolidated financial statements.
 
 
F-8

 
 
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In U.S. dollars
 
NOTE 1:–   GENERAL

a.                 Corporate structure:

Arotech Corporation (“Arotech” or the “Company”) and its subsidiaries are engaged in the development, manufacture and marketing of defense and security products, including advanced high-tech multimedia and interactive digital solutions for training of military, law enforcement and security personnel and sophisticated lightweight materials and advanced engineering processes to armor vehicles, and in the design, development and commercialization of its proprietary zinc-air battery technology for electric vehicles and defense applications. The Company is primarily operating through FAAC Corporation, a wholly-owned subsidiary based in Ann Arbor, Michigan; Electric Fuel Battery Corporation, a wholly-owned subsidiary based in Auburn, Alabama; Electric Fuel Ltd. (“EFL”) a wholly-owned subsidiary based in Beit Shemesh, Israel; Epsilor Electronic Industries, Ltd., a wholly-owned subsidiary located in Dimona, Israel; M.D.T. Protective Industries, Ltd. (“MDT”), a majority-owned (now wholly-owned; see Note 18.b.) subsidiary based in Lod, Israel; MDT Armor Corporation, a majority-owned (now wholly-owned; see Note 18.b.) subsidiary based in Auburn, Alabama; and Armour of America, Incorporated, a wholly-owned subsidiary based in Auburn, Alabama.

Revenues derived from the Company’s largest customers in 2007 and 2006 are described in Note 16.d.

b.                 Acquisition of FAAC:

The Company had a contingent earnout obligation in an amount equal to the net income realized by the Company from certain specific programs that were identified by the Company and the former shareholders of FAAC as appropriate targets for revenue increases in 2005. During 2005 and 2006, the Company accrued an amount of $603,764 and $630,000, respectively, in respect of such earnout obligation to increase FAAC’s goodwill. The $151,450 shown as promissory notes in the balance sheet is the portion of the 2006 earnout that is paid in equal installments that started in January 2007 and will be paid in full in June 2008 .The promissory note is non-interest bearing.

c.                 Acquisition of AoA:

The total purchase price consisted of $19,000,000 in cash, with additional possible earn-outs if AoA was awarded certain material contracts. An additional $3,000,000 was to be paid into an escrow account pursuant to the terms of an escrow agreement, to secure a portion of the Earnout Consideration. These funds are currently being held by the seller of AoA. As of December 31, 2007, the Company had reduced the $3.0 million escrow held by the seller of AoA by $1,520,174 for a putative claim against such escrow in respect of such earn-out obligation.  When the contingency on the earn-out provision is resolved, the additional consideration, if any, will be recorded as additional purchase price.  Any recovery of the previously expensed escrow amount will be recorded as income in the period received.

In March 2007, the Company filed a Demand for Arbitration with the American Arbitration Association against the seller of AoA. The Company sought the return of the $3.0 million escrow, plus interest. The seller of AoA asserted counterclaims against the Company in the arbitration, alleging (i) that he is entitled to keep the $3.0 million, (ii) that he is entitled to an additional $3.0 million in

 
F-9

 
 
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In U.S. dollars

NOTE 1:–   GENERAL (Cont.)
 
post-sale earnouts, and (iii) that he is entitled to $70,000 in compensation (plus interest and statutory penalties) wrongfully withheld by the Company when it constructively terminated his employment.

In December 2007, the matter was brought before an arbitration panel and in February 2008, the arbitration panel issued a decision, granting the seller’s counterclaim for $70,000 in compensation, awarding the Company the entire $3.0 million escrow (less the $70,000 in compensation (with simple interest but without statutory penalties)), and awarding the Company $135,000 in attorneys’ fees. The federal district court for the Southern District of New York has not yet ruled upon the Company’s petition to confirm the arbitration award.

d.                 Impairment of goodwill and other intangible assets:

SFAS No. 142 requires goodwill to be tested for impairment on adoption of the Statement, at least annually thereafter, and between annual tests in certain circumstances, and written down when impaired, rather than being amortized as previous accounting standards required. Goodwill is tested for impairment by comparing the fair value of the Company’s reportable units with their carrying value. Fair value is determined using discounted cash flows. Significant estimates used in the methodologies include estimates of future cash flows, future short-term and long-term growth rates, weighted average cost of capital and estimates of market multiples for the reportable units.

In 2007, the Company evaluated all goodwill and it was determined that there was no impairment.

In 2006, the Company identified an additional $316,024 in potential earn-out obligations in an amount equal to the revenues realized by the Company from certain specific programs at AoA.  This expense is shown as impairment expense since the full amount of AoA goodwill had been previously written off in 2005.

The Company and its subsidiaries’ long-lived assets and certain identifiable intangibles are reviewed for impairment in accordance with Statement of Financial Accounting Standard No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of the carrying amount of assets to be held and used is measured by a comparison of the carrying amount of the assets to the future undiscounted cash flows expected to be generated by the assets. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets.

e.                 Reverse stock split:

On June 20, 2006, the Company filed a Certificate of Amendment with the Delaware Secretary of State which served to effect, as of 7:00 a.m. e.d.t. on June 21, 2006, a one-for-fourteen reverse split of the Company’s common stock. As a result of the reverse stock split, every fourteen shares of the Company’s common stock were combined into one share of common stock; any fractional shares created by the reverse stock split were eliminated. The par value of the shares remained unchanged. The reverse stock split affected all of the Company’s common stock, stock options, warrants

 
F-10

 
 
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In U.S. dollars

NOTE 1:–   GENERAL (Cont.)
 
and convertible debt outstanding immediately prior to the effective date of the reverse stock split. The reverse split reduced the number of shares of the Company’s common stock outstanding at June 21, 2006 from 118,587,361 shares to 8,468,957 shares. All references to common share and per common share amounts for all periods presented have been retroactively restated to reflect this reverse split.

f.                 Related parties

The Company has a consulting agreement with Sampen Corporation that it executed in March 2005, effective as of January 1, 2005. Sampen is a New York corporation owned by members of the immediate family of one of the Company’s executive officers, and this executive officer is an employee of both the Company and of Sampen. The term of this consulting agreement as extended expires on December 31, 2008, and is extended automatically for additional terms of two years each unless either Sampen or the Company terminate the agreement sooner.

Pursuant to the terms of the Company’s agreement with Sampen, Sampen provides one of its employees to the Company for such employee to serve as the Company’s Chief Operating Officer. The Company pays Sampen $12,800 per month, plus an annual bonus, on a sliding scale, in an amount equal to a minimum of 20% of Sampen’s annual base compensation then in effect, up to a maximum of 75% of its annual base compensation then in effect if the results the Company actually attains for the year in question are 120% or more of the amount the Company budgeted at the beginning of the year. The Company also pays Sampen, to cover the cost of the Company’s use of Sampen’s offices as an ancillary New York office and the attendant expenses and insurance costs, an amount equal to 16% of each monthly payment of base compensation.

During the years ended December 31, 2007 and 2006 the Company paid Sampen a total of $219,354 and $208,896, respectively.

On December 3, 1999, Robert S. Ehrlich purchased 8,928 shares of the Company’s common stock out of the Company’s treasury at the closing price of the Company’s common stock on December 2, 1999. Payment was rendered by Mr. Ehrlich in the form of non-recourse promissory notes due in 2009 in the amount of $167,975, bearing simple annual interest at a rate of 2%, secured by the shares of common stock purchased and other shares of common stock previously held by him. As of December 31, 2007, the aggregate amount outstanding pursuant to this promissory note was $201,570.

On February 9, 2000, Mr. Ehrlich exercised 9,404 stock options. Mr. Ehrlich paid the exercise price of the stock options and certain taxes that the Company paid on his behalf by giving the Company a non-recourse promissory note due in 2025 in the amount of $789,991, bearing annual interest (i) as to $329,163, at 1% over the then-current federal funds rate announced from time to time by the Wall Street Journal, and (ii) as to $460,828, at 4% over the then-current percentage increase in the Israeli consumer price index between the date of the loan and the date of the annual interest calculation, secured by the shares of the Company’s common stock acquired through the exercise of the options and certain compensation due to Mr. Ehrlich upon termination. As of

 
F-11

 
 
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In U.S. dollars

NOTE 1:–   GENERAL (Cont.)
 
December 31, 2007, the aggregate amount outstanding pursuant to this promissory note was $820,809.

On June 10, 2002, Mr. Ehrlich exercised 3,571 stock options. Mr. Ehrlich paid the exercise price of the stock options by giving the Company a non-recourse promissory note due in 2012 in the amount of $36,500, bearing simple annual interest at a rate equal to the lesser of (i) 5.75%, and (ii) 1% over the then-current federal funds rate announced from time to time, secured by the shares of the Company’s common stock acquired through the exercise of the options. As of December 31, 2007, the aggregate amount outstanding pursuant to this promissory note was $45,388.

NOTE 2:–   SIGNIFICANT ACCOUNTING POLICIES

The consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States (“U.S. GAAP”).

a.                 Use of estimates:

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

b.                 Financial statements in U.S. dollars:

A majority of the revenues of the Company and most of its subsidiaries and its subsidiaries’ affiliates is generated in U.S. dollars. In addition, a substantial portion of the Company’s and most of its subsidiaries costs are incurred in U.S. dollars (“dollar”). Management believes that the dollar is the primary currency of the economic environment in which the Company and most of its subsidiaries operate. Thus, the functional and reporting currency of the Company and most of its subsidiaries is the dollar. Accordingly, monetary accounts maintained in currencies other than the U.S. dollar are remeasured into U.S. dollars in accordance with Statement of Financial Accounting Standards No. 52 “Foreign Currency Translation” (“SFAS No. 52”). All transaction, gains and losses from the remeasured monetary balance sheet items are reflected in the consolidated statements of operations as financial income or expenses, as appropriate.

The majority of transactions of MDT and Epsilor are in New Israel Shekels (“NIS”) and a substantial portion of MDT’s and Epsilor’s costs is incurred in NIS. Management believes that the NIS is the functional currency of MDT and Epsilor. Accordingly, the financial statements of MDT and Epsilor have been translated into U.S. dollars. All balance sheet accounts have been translated using the exchange rates in effect at the balance sheet date. Statement of operations amounts has been translated using the weighted average exchange rate for the period. The resulting translation adjustments are reported as a component of accumulated other comprehensive income in stockholders’ equity

 
F-12

 
 
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In U.S. dollars
 
NOTE 2:–   SIGNIFICANT ACCOUNTING POLICIES (Cont.)
 
c.                 Principles of consolidation:

The consolidated financial statements include the accounts of the Company and its wholly and majority owned subsidiaries. Intercompany balances and transactions have been eliminated upon consolidation.

d.                 Cash equivalents:

Cash equivalents are short-term highly liquid investments that are readily convertible to cash with maturities of three months or less when acquired.

e.                 Restricted collateral deposits

Restricted cash is primarily invested in highly liquid deposits which are used as a security for the Company’s guarantee performance, its liability to a former shareholder of its acquired subsidiary and for the company’s liability for interest payments related to its convertible debentures.

f.                 Marketable securities

The Company and its subsidiaries account for investments in debt and equity securities in accordance with Statement of Financial Accounting Standard No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”). Management determines the appropriate classification of its investments in debt and equity securities at the time of purchase and reevaluates such determinations at each balance sheet date.

At December 31, 2007 the Company and its subsidiaries classified its investment in marketable securities as available-for-sale.

Investment in trust funds are classified as available-for-sale and stated at fair value, with unrealized gains and losses reported in accumulated other comprehensive income (loss), a separate component of stockholders’ equity, net of taxes. Realized gains and losses on sales of investments, as determined on a specific identification basis, are included in the consolidated statements of income.

g.                 Inventories:

Inventories are stated at the lower of cost or market value. Inventory write-offs and write-down provisions are provided to cover risks arising from slow-moving items or technological obsolescence and for market prices lower than cost. The Company periodically evaluates the quantities on hand relative to current and historical selling prices and historical and projected sales volume. Based on this evaluation, provisions are made to write inventory down to its market value. In 2007 and 2006, the Company wrote off $150,681 and $292,864, of obsolete inventory respectively, which has been included in the cost of revenues.
 
Cost is determined as follows:

Raw and packaging materials – by the average cost method or FIFO.

 
F-13

 
 
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In U.S. dollars
 
NOTE 2:–   SIGNIFICANT ACCOUNTING POLICIES (Cont.)
Work in progress – represents the cost of manufacturing with additions of allocable indirect manufacturing cost.

Finished products – on the basis of direct manufacturing costs with additions of allocable indirect manufacturing costs.

h.                 Property and equipment:

Property and equipment are stated at cost net of accumulated depreciation and investment grants received from the State of Israel for investments in fixed assets under the Investment Law (no investment grants were received during 2007 and 2006).

Depreciation is calculated by the straight-line method over the estimated useful lives of the assets, at the following annual rates:

 
%
   
Computers and related equipment
33
Motor vehicles
15
Office furniture and equipment
6 - 10
Machinery and equipment
10 - 25 (mainly 10)
Leasehold improvements
By the shorter of the term of the lease or the life of the asset

i.                 Revenue recognition:

The Company is a defense and security products and services company, engaged in three business areas: interactive simulation for military, law enforcement and commercial markets; batteries and charging systems for the military; and high-level armoring for military, paramilitary and commercial vehicles. During 2007 and 2006, the Company and its subsidiaries recognized revenues as follows: (i) from the sale and customization of interactive training systems and from the maintenance services in connection with such systems (Training and Simulation Division); (ii) from revenues under armor contracts and for service and repair of armored vehicles (Armor Division); (iii) from the sale of batteries, chargers and adapters to the military, and under certain development contracts with the U.S. Army (Battery and Power Systems Division); and (iv) from the sale of lifejacket lights (Battery and Power Systems Division).

Revenues from the Battery and Power Systems Division products and Armor Division are recognized in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition” when persuasive evidence of an agreement exists, delivery has occurred, the fee is fixed or determinable, collectability is probable, and no further obligation remains.

Revenues from contracts that involve customization of FAAC’s simulation system to customer specific specifications are recognized in accordance with Statement Of Position 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts,” using contract accounting on a percentage of completion method, in accordance with the “Input Method.” The amount of revenue recognized is based on the percentage to completion achieved. The percentage to completion is measured by monitoring progress using records of actual time incurred

 
F-14

 
 
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In U.S. dollars
 
NOTE 2:–   SIGNIFICANT ACCOUNTING POLICIES (Cont.)
 
to date in the project compared to the total estimated project requirement, which corresponds to the costs related to earned revenues. Estimates of total project requirements are based on prior experience of customization, delivery and acceptance of the same or similar technology and are reviewed and updated regularly by management. Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are first determined, in the amount of the estimated loss on the entire contract. During 2006 $741,165 in estimated losses were identified and expensed.

The Company believes that the use of the percentage of completion method is appropriate as the Company has the ability to make reasonably dependable estimates of the extent of progress towards completion, contract revenues and contract costs. In addition, contracts executed include provisions that clearly specify the enforceable rights regarding services to be provided and received by the parties to the contracts, the consideration to be exchanged and the manner and the terms of settlement, including in cases of terminations for convenience. In all cases the Company expects to perform its contractual obligations and its customers are expected to satisfy their obligations under the contract.

Revenues from simulators, which do not require significant customization, are recognized in accordance with Statement of Position 97-2, “Software Revenue Recognition,” (“SOP 97-2”). SOP 97-2 generally requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair value of the elements. The Company has adopted Statement of Position 98-9, “Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions” (“SOP 98-9”). According to SOP No. 98-9, revenues are allocated to the different elements in the arrangement under the “residual method” when Vendor Specific Objective Evidence (“VSOE”) of fair value exists for all undelivered elements and no VSOE exists for the delivered elements. Under the residual method, at the outset of the arrangement with the customer, the Company defers revenue for the fair value of its undelivered elements (maintenance and support) and recognizes revenue for the remainder of the arrangement fee attributable to the elements initially delivered in the arrangement (software product) when all other criteria in SOP 97-2 have been met.

Revenue from such simulators is recognized when persuasive evidence of an agreement exists, delivery has occurred, no significant obligations with regard to implementation remain, the fee is fixed or determinable and collectibility is probable.

Maintenance and support revenue included in multiple element arrangements is deferred and recognized on a straight-line basis over the term of the maintenance and support services. Revenues from training are recognized when it is performed. The VSOE of fair value of the maintenance, training and support services is determined based on the price charged when sold separately or when renewed.

Unbilled receivables include cost and gross profit earned in excess of billing.

Deferred revenues include unearned amounts received under maintenance and support services and billing in excess of costs and estimated earnings on uncompleted contracts.

 
F-15

 
 
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In U.S. dollars
 
NOTE 2:–   SIGNIFICANT ACCOUNTING POLICIES (Cont.)
 
j.                 Right of return:

When a right of return exists, the Company defers its revenues until the expiration of the period in which returns are permitted.

k.                 Warranty:

The Company offers up to one year warranty for most of its products. The specific terms and conditions of those warranties vary depending upon the product sold and country in which the Company does business. The Company estimates the costs that may be incurred under its basic limited warranty, including parts and labor. The Company estimates the costs that may be incurred under its basic limited warranty and records a liability in the amount of such costs as the time product revenue is recognized. Factors that affect the Company’s warranty liability include the number of installed units, historical and anticipated rates of warranty claims, and cost per claim. The Company periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary. See Note 18.

l.                 Research and development cost:

SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,” requires capitalization of certain software development costs, subsequent to the establishment of technological feasibility. Based on the Company’s product development process, technological feasibility is established upon the completion of a working model or a detailed program design. Research and development costs incurred in the process of developing product improvements or new products, are generally charged to expenses as incurred, when applicable. Significant costs incurred by the Company between completion of the working model or a detailed program design and the point at which the product is ready for general release, have been capitalized.  Capitalized software costs will be amortized by the greater of the amount computed using the: (i) ratio that current gross revenues from sales of the software bears to the total of current and anticipated future gross revenues from sales of that software, or (ii) the straight-line method over the estimated useful life of the product (two to five years). The Company assesses the net realizable value of this intangible asset on a regular basis by determining whether the amortization of the asset over its remaining life can be recovered through undiscounted future operating cash flows from the specific software product sold. Based on its most recent analyses, management believes that no impairment of capitalized software development costs exists as of December 31, 2007.

m.                 Income taxes:

The Company and its subsidiaries account for income taxes in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS No. 109”). This Statement prescribes the use of the liability method, whereby deferred tax assets and liability account balances are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The Company and its subsidiaries provide a valuation allowance, if necessary, to reduce deferred tax assets to its estimated realizable value.

 
F-16

 
 
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In U.S. dollars
 
NOTE 2:–   SIGNIFICANT ACCOUNTING POLICIES (Cont.)
 
n.                 Concentrations of credit risk:

Financial instruments that potentially subject the Company and its subsidiaries to concentrations of credit risk consist principally of cash and cash equivalents, restricted collateral deposits, trade receivables and available for sale marketable securities. Cash and cash equivalents are invested mainly in U.S. dollar deposits with major Israeli and U.S. banks. Such deposits in the U.S. may be in excess of insured limits and are not insured in other jurisdictions. Management believes that the financial institutions that hold the Company’s investments are financially sound and, accordingly, minimal credit risk exists with respect to these investments.

The trade receivables of the Company and its subsidiaries are mainly derived from sales to customers located primarily in the United States, Europe and Israel. Management believes that credit risks are moderated by the diversity of its end customers and geographical sales areas. The Company performs ongoing credit evaluations of its customers’ financial condition. An allowance for doubtful accounts is determined with respect to those accounts that the Company has determined to be doubtful of collection.

The Company’s available for sale marketable securities include investments in debentures of U.S. and Israeli corporations and state and local governments. Management believes that those corporations and states are institutions that are financially sound, that the portfolio is well diversified, and accordingly, that minimal credit risk exists with respect to these marketable securities.

The Company and its subsidiaries had no off-balance-sheet concentration of credit risk such as foreign exchange contracts, option contracts or other foreign hedging arrangements.

o.                 Basic and diluted net loss per share:

Basic net loss per share is computed based on the weighted average number of shares of common stock outstanding during each year. Diluted net loss per share is computed based on the weighted average number of shares of common stock outstanding during each year, plus dilutive potential shares of common stock considered outstanding during the year, in accordance with Statement of Financial Standards No. 128, “Earnings Per Share.”

All outstanding stock options, non vested restricted stock and warrants have been excluded from the calculation of the diluted net loss per common share because all such securities are anti-dilutive for all periods presented. The total weighted average number of shares related to the outstanding options and warrants excluded from the calculations of diluted net loss per share was 1,791,562 and 1,781,984, for the years ended December 31, 2007 and 2006, respectively.

p.                 Accounting for stock-based compensation

Effective January 1, 2006, the Company started to account for stock options and awards issued to employees in accordance with the fair value recognition provisions of Financial Accounting Standards Board (“FASB”) Statement No. 123(R) (“SFAS No. 123(R)”), “Share-Based Payment,” using the modified prospective transition method. Under SFAS No. 123(R), stock-based

 
F-17

 
 
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In U.S. dollars
 
NOTE 2:–   SIGNIFICANT ACCOUNTING POLICIES (Cont.)
 
awards to employees are required to be recognized as compensation expense, based on the calculated fair value on the date of grant. The Company determines the fair value using the Black Scholes option pricing model. This model requires subjective assumptions, including future stock price volatility and expected term, which affect the calculated values. The adoption of SFAS No. 123(R) resulted in a reduction in income of $500,445 in 2006, which reduced basic and diluted EPS for the year by $0.06.

The fair value for the 2006 options granted to employees was estimated at the date of grant, using the Black-Scholes Option Valuation Model, with the following weighted-average assumptions: risk-free interest rates of 4.64% (based on three-year U.S. Treasury bonds); a dividend yield of 0.0%, a volatility factor of the expected market price of the common stock of 1.33 (based on historical volatility of the stock over the previous three years); and a weighted-average expected life of the option of three years. The Company did not grant any options in 2007.  The Company assumed a 20% forfeiture rate for options for both years.  The Company uses a 10% forfeiture rate for restricted stock.

q.                 Fair value of financial instruments:

The following methods and assumptions were used by the Company and its subsidiaries in estimating their fair value disclosures for financial instruments:

The carrying amounts of cash and cash equivalents, restricted collateral deposits, trade receivables, short-term bank credit, and trade payables approximate their fair value due to the short-term maturity of such instruments.

The fair value of available for sale marketable securities is based on the quoted market price.

Long-terms promissory notes are estimated by discounting the future cash flows using current interest rates for loans or similar terms and maturities. The carrying amount of the long-term liabilities approximates their fair value.

r.                 Severance pay:

The Company’s liability for severance pay for its Israeli employees is calculated pursuant to Israeli severance pay law based on the most recent salary of the employees multiplied by the number of years of employment as of the balance sheet date. Israeli employees are entitled to one month’s salary for each year of employment, or a portion thereof. The Company’s liability for all of its Israeli employees is fully provided by monthly deposits with severance pay funds, insurance policies and by an accrual. The value of these policies is recorded as an asset in the Company’s balance sheet.

In addition and according to certain employment agreements, the Company is obligated to provide for a special severance pay in addition to amounts due to certain employees pursuant to Israeli severance pay law. The Company has made a provision for this special severance pay in accordance with EITF 88-1: “Determination of Vested Benefit Obligation for a Defined Benefit

 
F-18

 
 
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In U.S. dollars
 
NOTE 2:–   SIGNIFICANT ACCOUNTING POLICIES (Cont.)
 
Pension Plan” As of December 31, 2007 and 2006, the accumulated severance pay in that regard amounted to $2,081,587 and $2,163,264, respectively.

Pursuant to the terms of the employment agreement between the Company and its Chief Executive Officer, funds to secure payment of the Chief Executive Officer’s contractual severance are to be deposited for the benefit of the Chief Executive Officer, with payments to be made pursuant to an agreed-upon schedule. As of December 31, 2007, a total of $618,097 had been deposited. These funds continue to be owned by the Company, which benefits from all gains and bears the risk of all losses resulting from investments of these funds.

The deposited funds include profits accumulated up to the balance sheet date. The deposited funds may be withdrawn only upon the fulfillment of the obligation pursuant to Israeli severance pay law or labor agreements. The value of the deposited funds is based on the cash surrendered value of these policies and includes immaterial profits.

Severance expenses for the years ended December 31, 2007 and 2006 amounted to $334,749 and $563,302, respectively.

s.                 Advertising costs:

The Company and its subsidiaries expense advertising costs as incurred. Advertising expense for the years ended December 31, 2007 and 2006 was approximately $92,775 and $21,000, respectively.

t.                 New accounting pronouncements:

In December 2007, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 141(R), Business Combinations, to further enhance the accounting and financial reporting related to business combinations.  SFAS No. 141(R) establishes principles and requirements for how the acquirer in a business combination (1) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree, (2) recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase, and (3) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination.  SFAS No. 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Therefore, the effects of the Corporation’s adoption of SFAS No. 141(R) will depend upon the extent and magnitude of acquisitions after December 31, 2008.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements.  This Statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements.  SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements, the Board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute.  The Statement does not require any new fair value measurements and was initially effective for the Corporation

 
F-19

 
 
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In U.S. dollars
 
NOTE 2:–   SIGNIFICANT ACCOUNTING POLICIES (Cont.)
 
beginning January 1, 2008.  In February 2008, the FASB approved the issuance of FASB Staff Position (FSP) FAS 157-2. FSP FAS 157-2 defers the effective date of SFAS No. 157 until January 1, 2009 for nonfinancial assets and nonfinancial liabilities except those items recognized or disclosed at fair value on an annual or more frequently recurring basis.  Management has not completed its review of the new guidance; however, the effect of the Statement’s implementation is not expected to be material to the Corporation’s results of operations or financial position.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities.  This Statement permits entities to choose to measure eligible items at fair value at specified election dates.  For items for which the fair value option has been elected, unrealized gains and losses are to be reported in earnings at each subsequent reporting date.  The fair value option is irrevocable unless a new election date occurs, may be applied instrument by instrument, with a few exceptions, and applies only to entire instruments and not to portions of instruments.  SFAS No. 159 provides an opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting.  SFAS No. 159 is effective for the Corporation beginning January 1, 2008.  Management has not completed its review of the new guidance; however, the effect of the Statement’s implementation is not expected to be material to the Corporation’s results of operations or financial position.

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statementsan amendment of ARB No. 51, to create accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary.  SFAS No. 160 establishes accounting and reporting standards that require (1) the ownership interest in subsidiaries held by parties other than the parent to be clearly identified and presented in the consolidated balance sheet within equity, but separate from the parent’s equity, (2) the amount of consolidated net income attributable to the parent and the noncontrolling interest to be clearly identified and presented on the face of the consolidated statement of income, (3) changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary to be accounted for consistently, (4) when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary to be initially measured at fair value, and (5) entities to provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners.  SFAS No. 160 applies to fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008, and prohibits early adoption.  Management has not completed its review of the new guidance; however, the effect of the Statement’s implementation is not expected to be material to the Corporation’s results of operations or financial position.

u.                 Reclassification:

Certain prior period amounts have been reclassified to conform to the current period presentation.

 
F-20

 
 
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In U.S. dollars
 
NOTE 3:–   RESTRICTED COLLATERAL DEPOSITS

   
December 31,