10QSB/A 1 v07569.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D. C. 20549 FORM 10-QSB/A (Amendment No. 1) (Mark One) |X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarter Ended September 30, 2003 |_| TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT Commission File Number: 000-1084047 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. (Exact name of small business issuer as specified in its charter) California 95-4691878 --------------------------------- --------------------------------- (State or other jurisdiction (IRS Employer Identification No.) of incorporation or organization) 204 NW Platte Valley Dr. Riverside, MO 64150 (Address of principal executive offices) ---------------------------------------- (816) 584-8030 --------------------------- (Issuer's telephone number) 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 such shorter period that the Registrant was required to file such report(s)), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| There were 52,897,186 shares of common stock, $0.001 par value, outstanding as of November 19, 2003. INNOVATIVE SOFTWARE TECHNOLOGIES, INC. FORM 10-QSB QUARTER ENDED SEPTEMBER 30, 2003 TABLE OF CONTENTS Page ---- PART I-FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets - September 30, 2003 (Unaudited) and December 31, 2002............................................... 3 Condensed Consolidated Statements of Operations (Unaudited) for the Three and Nine Months Ended September 30, 2003 and 2002.............. 4 Condensed Consolidated Statement of Stockholders' Equity/(Deficiency) (Unaudited) for the Nine Months Ended September 30, 2003............ 5 Condensed Consolidated Statements of Cash Flows (Unaudited) for the Nine Months Ended September 30, 2003 and 2002....................... 6 Notes to the Condensed Consolidated Financial Statements (Unaudited).. 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................................................. 21 Item 3. Controls and Procedures.......................................... 30 PART II - OTHER INFORMATION Item 1. Legal Proceedings................................................ 32 Item 3. Defaults upon Senior Securities.................................. 33 Item 6. Exhibits and Reports on Form 8-K................................. 33 Signatures............................................................... 34 PART I - FINANCIAL INFORMATION Item 1. Financial Statements INNOVATIVE SOFTWARE TECHNOLOGIES, INC. CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited) September 30, December 31, 2003 2002 ------------ ------------ (RESTATED) ASSETS Current Assets Cash $ 3,857,987 $ 1,338,345 Accounts receivable 154,501 14,700 Investments - available for sale -- -- Other receivables 114,868 59,772 Prepaid expenses 23,586 67,179 Other assets 1,140,874 706,486 ------------ ------------ Total Current Assets 5,291,815 2,186,482 ------------ ------------ Property and Equipment, Net 455,167 379,349 ------------ ------------ Other Assets Goodwill 1,088,686 1,088,686 Deferred income taxes - Non-current -- -- Deposits 42,965 48,698 ------------ ------------ Total Assets $ 6,878,632 $ 3,703,215 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities Line of credit $ 3,740 $ 40,660 Current maturities of long-term debt 11,508 44,274 Accounts payable and accrued expenses 1,208,534 861,366 Deferred revenue 587,455 256,148 Other current liabilities 1,215,796 83,278 Accrued income taxes 1,134,890 -- Reserve for sales returns and allowances 1,010,686 220,266 ------------ ------------ Total Current Liabilities 5,172,609 1,505,992 ------------ ------------ Note payable - long-term 66,272 87,223 ------------ ------------ Total liabilities 5,238,881 1,593,215 Stockholders' Equity Preferred stock - authorized, 25,000,000 shares of $1.00 stated value; Series A preferred stock; issued and outstanding, 1,697,167 shares 1,650,500 1,650,500 Series B preferred stock; issued and outstanding, 328,491 shares 450,006 328,491 Common stock - authorized, 100,000,000 shares of $.001 par value; issued and outstanding, 52,897,186 and 52,481,289 shares, respectively 52,897 52,481 Additional paid-in-capital 13,216,970 13,119,719 Accumulated deficit (13,730,623) (13,041,191) ------------ ------------ Total Stockholders' Equity 1,639,751 2,110,000 ------------ ------------ Total Liabilities and Stockholders' Equity $ 6,878,632 $ 3,703,215 ============ ============
The accompanying notes are an integral part of these condensed consolidated financial statements. 3 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
For the For the Three Months Ended Nine Months Ended ------------------------------ ------------------------------ September 30, September 30, September 30, September 30, 2003 2002 2003 2002 ------------ ------------ ------------ ------------ (RESTATED) (RESTATED) Sales $ 9,076,162 $ 4,225,488 $ 21,648,365 $ 10,014,523 Cost of sales 4,612,375 1,528,534 10,674,800 3,650,218 ------------ ------------ ------------ ------------ Gross profit 4,463,787 2,696,954 10,973,565 6,364,305 Operating expenses: General and administrative 1,863,694 1,069,191 5,368,018 2,727,968 Selling 2,072,032 729,388 5,138,849 2,011,587 Loss on investment securities -- 687,750 -- 687,750 Non-recurring expenses -- -- -- 169,578 ------------ ------------ ------------ ------------ Total Operating Expenses 3,935,726 2,486,329 10,506,667 5,596,883 ------------ ------------ ------------ ------------ Income (Loss) from Operations 528,061 210,625 466,698 767,422 Other Income (Expense): Interest and penalties on late tax payments (73,000) -- (146,000) -- Other income 11,588 154,105 86,460 172,197 Interest income 26,131 -- 61,962 -- Interest expense (9,993) (2,500) (23,661) (9,055) ------------ ------------ ------------ ------------ Total Other Income (Expense) (45,274) 151,605 (21,239) 163,142 ------------ ------------ ------------ ------------ Income (Loss) before income taxes 482,787 362,230 445,459 930,564 Income Taxes (1,067,373) 137,048 (1,134,890) 357,048 ------------ ------------ ------------ ------------ Net Income ($ 584,586) $ 225,182 ($ 689,431) $ 573,516 ============ ============ ============ ============ Basic and Diluted Income (Loss) per Share ($ 0.01) $ 0.00 $ 0.00 $ 0.01 ============ ============ ============ ============ Weighted Average Number of Common Shares Used in Per Share Calculation (basic and diluted) 52,870,136 48,402,172 52,846,602 48,336,469 ============ ============ ============ ============
The accompanying notes are an integral part of these condensed consolidated financial statements. 4 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY/(DEFICIENCY) (UNAUDITED)
Preferred Stock Series A Preferred Stock Series B Common Stock Shares Amount Shares Amount Shares Amount --------- ---------- ------- ---------- ---------- ---------- Balance - December 31, 2001 1,850,000 $1,850,000 248,491 $ 248,491 48,285,283 $ 48,285 Issuance of Common stock for services provided -- -- -- -- 4,000 4 Issuance of Common stock -- -- -- -- 40,730 41 Issuance of Common stock for services provided -- -- -- -- 6,125 6 Issuance of Common Stock for software -- -- -- -- 53,845 54 Issuance of Common stock -- -- -- -- 24,375 24 Issuance of Common Stock for services provided -- -- -- -- 291,250 291 Conversion of Series A Preferred Stock to Common Stock (199,500) (199,500) -- -- 3,000,000 3,000 Issuance of Common stock for services provided -- -- -- -- 5,000 5 Issuance of Common stock -- -- -- -- 76,960 77 Issuance of Common stock -- -- -- -- 23,169 23 Issuance of Common stock for services provided -- -- -- -- 39,702 40 Series A Preferred Stock Dividend -- -- -- -- 107,568 108 Series A Preferred Stock Dividend -- -- -- -- 30,734 31 Series A Preferred Stock Dividend -- -- -- -- 420,054 420 Series B Preferred Stock Dividend -- -- -- -- 72,494 72 Issuance of Series B Preferred Stock for Executive Compensation -- -- 80,000 80,000 -- -- Unrealized loss on investments -- -- -- -- -- -- Unrealized loss on investments recognized in income due to other than temporary impairment -- -- -- -- -- -- Net income for the year ended ended December 31, 2002 -- -- -- -- -- -- --------- ---------- ------- ---------- ---------- ---------- Balance - December 31, 2002 1,650,500 1,650,500 328,491 328,491 52,481,289 52,481 ========= ========== ======= ========== ========== ========== Issuance of Common stock for prepaid public relations 233,333 233 Issuance of Common stock for charitable contribution 133,333 134 Issuance of Series B Preferred Stock for Executive Compensation 80,000 80,000 Issuance of Common Stock for services provided 49,231 49 Net income for the nine months Ended September 30, 2002 -- -- -- -- --------- ---------- ------- ---------- ---------- ---------- Balance as of September 30, 2003 1,650,500 $1,650,500 408,491 $ 408,491 52,897,186 $ 52,897 ========= ========== ======= ========== ========== ==========
The accompanying notes are an integral part of these condensed consolidated financial statements. 5 (table continued)
Retained Additional Accum. Earnings Total paid-in Comprehensive Accum. Stockholders' capital Loss Deficit) Equity ------------ ------------ ------------ ------------ (RESTATED) (RESTATED) Balance - December 31, 2001 $ 12,626,679 ($ 204,354) ($ 290,941) $ 14,278,160 Issuance of Common stock for services provided 14,196 -- -- 14,200 Issuance of Common stock 36,951 -- -- 36,992 Issuance of Common stock for services provided 20,644 -- -- 20,650 Issuance of Common Stock for software 69,946 70,000 Issuance of Common stock 23,219 23,243 Issuance of Common Stock for services provided 21,553 21,844 Conversion of Series A Preferred Stock to Common Stock 196,500 -- Issuance of Common stock for services provided 370 375 Issuance of Common stock 18,939 19,016 Issuance of Common stock 3,992 4,015 Issuance of Common stock for services provided 4,760 4,800 Series A Preferred Stock Dividend 13,892 (14,000) 0 Series A Preferred Stock Dividend 3,969 -- (4,000) (0) Series A Preferred Stock Dividend 54,250 -- (54,670) -- Series B Preferred Stock Dividend 9,859 -- (9,931) 1 Issuance of Series B Preferred Stock for Executive Compensation -- -- 80,000 Unrealized loss on investments -- (1,424,896) (1,424,896) Unrealized loss on investments recognized in income due to other than temporary impairment 1,629,250 1,629,250 Net income for the year ended ended December 31, 2002 -- -- (12,667,649) (12,667,649) ------------ ------------ ------------ ------------ Balance - December 31, 2002 $ 13,119,719 $ -- ($13,041,191) $ 2,110,000 ============ ============ ============ ============ Issuance of Common stock for prepaid public relations 2,017 2,250 Issuance of Common stock for charitable contribution 10,533 10,667 Issuance of Series B Preferred Stock for Executive Compensation 80,000 80,000 Issuance of Common Stock for services provided 4,701 4,750 Net (loss) for the nine months ended September 30, 2003 -- -- (689,432) (689,432) ------------ ------------ ------------ ------------ Balance as of September 30, 2003 $ 13,216,970 $ -- ($13,730,623) $ 1,639,751 ============ ============ ============ ============
The accompanying notes are an integral part of these condensed consolidated financial statements. 6 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
For the Nine Months Ended September 30, -------------------------- 2003 2002 ----------- ----------- Cash Flows From Operating Activities (Restated) Net income/(loss) ($ 689,431) $ 573,516 Adjustments to reconcile net income/(loss) to net cash provided by operating activities: Depreciation and amortization 150,498 83,016 Sale of software platform for investment securities -- (875,000) Write down on investment securities -- 687,750 Prepaid non-cash executive compensation 20,000 -- Stock base compensation 121,515 -- Allowance for doubtful accounts -- 132,000 Non-cash expenses 77,767 34,850 Net change in operating assets and liabilities: Accounts receivable (139,801) (594,133) Prepaid expenses 43,593 (13,664) Other receivables (55,095) (10,999) Other current assets (434,387) (428,336) Deposits and other assets 5,733 (20,397) Accounts payable and accrued expenses 347,169 396,700 Deferred revenue 331,307 252,956 Other current liabilities 1,132,518 -- Reserve for returns and allowances 1,031,420 179,472 Accrued federal and state income tax 893,890 374,362 ----------- ----------- Net Cash Provided by/(Used In) Operating Activities 2,836,595 772,093 ----------- ----------- Cash flows from investing activities Capital expenditures (226,316) (362,520) ----------- ----------- Net cash used in investing activities (226,316) (362,500) ----------- ----------- Cash Flows From Financing Activities Issuance of common stock -- 60,235 Proceeds from borrowings under line of credit -- 50,000 Proceeds from borrowing under note payable 8,085 155,360 Repayments under line of credit agreement (36,920) (6,758) Repayments on notes payable (61,802) (14,555) ----------- ----------- Net cash provided by/(used in) financing activities (90,537) 244,282 ----------- ----------- Net Increase /(Decrease) in Cash and Cash Equivalents 2,519,642 653,855 Cash and Cash Equivalents at Beginning of Year 1,338,345 282,307 ----------- ----------- Cash and Cash Equivalents at End of Year $ 3,857,987 $ 936,162 =========== =========== Supplemental Cash Flow Information: Unrealized loss on securities available for sale $ -- $ -- =========== =========== Issuance common stock for software -- $ 70,000 =========== =========== Issuance of common stock for services/charitable contributions 17,667 34,850 =========== =========== Issuance of Series B Preferred Stock as executive compensation $ 80,000 $ -- =========== ===========
The accompanying notes are an integral part of these condensed consolidated financial statements. 7 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE A - COMPANY DESCRIPTION Innovative Software Technologies, Inc. (the "Company" or "Innovative"), operating in one business segment, is a software company specializing in small business and financial eLearning tools and consulting services. The Company's main products are: EMS, a turnkey web builder, e-commerce solution and data management system targeted to small businesses; The Financial Toolkit 1.0, an integrated financial services and education program; Skills in Demand, consisting of eLearning courses that cater to small business owners and entrepreneurs; OneCrypt, an email and file encryption software product; and eTaxNet, a provider of online tax and consulting services. In addition for most of its software and learning products the Company offers technical support and coaching services. The Company's management combines its expertise in the field of direct marketing, software, coaching and sales management to small businesses and consumers. The combination of marketing and technological support offers clients complete end-to-end business services solutions designed to fit their e-business transactional technology training needs. On April 16, 2001, Innovative, with immaterial net assets, acquired 100% of the outstanding common stock of Hackett Media, Inc. (Hackett). The acquisition resulted in the owners and management of Hackett having effective operating control of the combined entity after the acquisition, with the prior Innovative investors continuing as passive investors. Under accounting principles generally accepted in the United States (US GAAP), the above noted acquisition is considered to be a capital transaction in substance, rather than a business combination. That is, the acquisition is equivalent to the issuance of stock by Hackett for the net monetary assets of Innovative, accompanied by a recapitalization, and is accounted for as a change in capital structure. Accordingly, the accounting for the acquisition is identical to that resulting from a reverse acquisition, except that no goodwill intangible is recorded. Under reverse takeover accounting, the post reverse-acquisition comparative historical financial statements of the "legal acquirer" (Innovative Software Technologies), are those of the "legal acquiree" (Hackett) (i.e. the accounting acquirer). On December 31, 2001, the Company purchased all of the outstanding shares of Energy Professional Marketing Group, Inc. (EPMG), a technology marketing company specializing in product fulfillment for outside vendors and technology and database marketing, based in Provo, Utah. In connection with the acquisition the Company issued 1,500,000 shares of Series A preferred stock and 3,529,412 shares of common stock. The purchase price for the acquisition of EPMG has been allocated on the fair value basis on the acquisition date as follows: Assets acquired: Goodwill $13,549,932 Net assets acquired $ 25,068 ----------- Total Assets Acquired $13,575,000 =========== Total Purchase Price $13,575,000 =========== The acquisition described above was accounted for as a purchase transaction in accordance with Statement of Financial Accounting Standards No. 141 (SFAS 141), "Business Combinations," and, accordingly, the results of operations and assets and liabilities of the acquired company are included in the consolidated financial statements from the acquisition date. A portion of the goodwill has been written down by the Company as of December 31, 2002. See Note B to the Condensed Consolidated Financial Statements (Unaudited). 8 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A summary of the Company's significant accounting policies applied in the preparation of the accompanying financial statements follows. 1. Recent Accounting Pronouncements In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") 141, Business Combinations, and SFAS 142, Goodwill and Intangible Assets. SFAS 141 is effective for all business combinations completed after June 30, 2001. SFAS 142 is effective for fiscal years beginning after December 15, 2001; however, certain provisions of this Statement apply to goodwill and other intangible assets acquired between July 1, 2001 and the effective date of SFAS 142. Major provisions of these Statements and their effective dates for the Company are as follows: o All business combinations initiated after June 30, 2001 must use the purchase method of accounting. The pooling of interests method of accounting is prohibited except for transactions initiated before July 1, 2001. o Intangible assets acquired in a business combination must be recorded separately from goodwill if they arise from contractual or other legal rights or are separable from the acquired entity and can be sold, transferred, licensed, rented or exchanged, either individually or as part of a related contract, asset or liability. o Goodwill, as well as intangible assets with indefinite lives, acquired after June 30, 2001, will not be amortized. o Effective January 1, 2002, all previously recognized goodwill and intangible assets with indefinite lives will no longer be subject to amortization. o Effective January 1, 2002, goodwill and intangible assets with indefinite lives will be tested for impairment annually and whenever there is an impairment indicator. o All acquired goodwill must be assigned to reporting units for purposes of impairment testing and segment reporting. As of January 1, 2002, which is the beginning of fiscal 2002, the Company will not amortize the goodwill which it recognized in connection with the acquisition of EPMG. The Company's goodwill was subject to a transitional impairment test as of December 31, 2001 and an annual impairment test, using a two-step process prescribed by SFAS No. 142. The Company completed the transitional impairment test for EPMG at September 30, 2002, the applicable reporting unit, and no impairment of goodwill was found to exist as of the beginning of fiscal 2002. During 2002, the trading price of the Company's stock declined significantly, raising questions about whether the fair value of goodwill exceeds its carrying amount. An evaluation of the carrying amount of goodwill was conducted during the 4th quarter 2002, which included an evaluation of whether the decline in the trading price of the Company's stock is other than temporary. The Company determined that the decline in its trading price was other than temporary and subsequent to December 31, 2002, engaged an independent valuation firm to perform a valuation of the Company. This resulted in a write-down in goodwill by the Company of $12,461,246 as of December 31, 2002. In August 2001, the FASB issued SFAS 143, "Accounting for Asset Retirement Obligations". SFAS 143 applies to all entities, including rate-regulated entities, that have legal obligations associated with the retirement of a tangible long-lived asset that result from acquisition, construction or development and (or) normal operations of the long-lived asset. A liability for an asset retirement obligation should be recognized if the obligation meets the definition of a liability and can be reasonably estimated. The initial recording should be at fair value. SFAS 143 is effective for financial statements issued for fiscal years beginning after June 15, 2002, with earlier application encouraged. The provisions of the Statement are not expected to have a material impact on the financial condition or results of operations of the Company. In August 2001, the FASB issued SFAS 144, "Accounting for the Impairment or Disposal of Long-Lived Assets". SFAS 144 retains the existing requirements to recognize and measure the impairment of long-lived assets to be held and used or to be disposed of by sale. However, SFAS 144 makes changes to the scope and certain measurement requirements of existing accounting guidance. SFAS 144 also changes the requirements relating to reporting the effects of a disposal or discontinuation of a segment of a business. SFAS 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001 and interim periods within those fiscal years. The adoption of this Statement did not have a significant impact on the financial condition or results of operations of the Company. 9 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) In April 2002, the FASB issued SFAS No. 145 (SFAS 145). Any gain or loss on extinguishment of debt that was classified as an extraordinary item in prior periods presented that does not meet the criteria in APB 30 for classification as an extraordinary item shall be reclassified. SFAS 145 also amends SFAS 13, Accounting for Leases as well as other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. Certain provisions of SFAS 145 are effective for transactions occurring after May 15, 2002 while other are effective for fiscal years beginning after May 15, 2002. The Company does not expect SFAS 145 to have a material effect on its financial condition or results of operations. In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" (SFAS 146). This standard addresses financial accounting and reporting for costs associated with exit or disposal activities. SFAS 146 requires that a liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. The provisions of SFAS 146 are effective for exit or disposal activities that are initiated by the Company after December 31, 2002. The Company does not expect SFAS 146 to have a material effect on its financial condition or results of operations. In October 2002, the FASB issued SFAS No. 147, "Acquisitions of Certain Financial Institutions" (SFAS 147). This standard relates to the application of the purchase method of accounting to all acquisitions of financial institutions, except transactions between two or more mutual enterprises. This standard also relates to the application of SFAS 144 to certain long-term customer-relationship intangible assets recognized in an acquisition of a financial institution, including those acquired in transactions between mutual enterprises. SFAS 147 is effective on October 1, 2002. The Company does not expect SFAS 147 to have a material effect on its financial condition or results of operations. In December 2002, the FASB issued SFAS No. 148 Accounting for Stock-Based Compensation--Transition and Disclosure (SFAS 148). This standard amends the disclosure and certain transition provisions of SFAS 123, Accounting for Stock-Based Compensation. Its disclosure provisions are effective for 2002 annual financial statements for calendar year-end companies. The Company does not expect that adoption of SFAS 148 will have a material impact on its financial condition or results of operations. 2. Interim Condensed Consolidated Financial Statements The accompanying condensed consolidated financial statements are unaudited. In the opinion of management, all necessary adjustments (which include only normal recurring adjustments) have been made to present fairly the financial position, results of operations and cash flows for the periods presented. Certain information and disclosures normally included in financial statements prepared in accordance with US GAAP have been condensed or omitted. Accordingly, these condensed consolidated financial statements should be read in conjunction with the Company's financial statements and notes thereto included in the Form 10-KSB dated December 31, 2002. The results of operations for the nine months ended September 30, 2003 are not necessarily indicative of the operating results to be expected for the full year. The balance sheet as of December 31, 2002 has been derived from the Company's audited consolidated balance sheet as of that date. 3. Principles of Consolidation The accompanying consolidated financial statements include the accounts of Innovative Software Technologies, Inc., and the accounts of its wholly-owned subsidiaries, Energy Professional Marketing Group, Inc. (EPMG), and Hackett Media, Inc., as of and for the nine months ended September 30, 2003. All significant intercompany transactions and balances have been eliminated in consolidation. 4. Revenue Recognition The Company recognizes revenue after delivery of the product. To the extent the Company sells software, revenue is recognized in accordance with Statement of Position 97-2, Software Revenue Recognition, as amended by SOP 98-4 and SOP 98-9 and clarified by Staff Accounting Bulletin (SAB) 101 Revenue Recognition in Financial Statements. In most cases this occurs the same day payment is received from our customers. The Company also reserves for sales returns and allowances based upon historical experience. 10 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) The Company provides support services for some of its products. Payments received by the Company for these services are generally recorded as deferred revenue and recognized over the term of the services. The Company also provides extended payment terms on the sale of its software and related coaching for up to two years. Since payments terms on these sales exceed 12 months, the fee for the software and license is presumed not to be determinable. In addition, the probability of collection decreases as the payment terms are extended. As a result, the Company recognizes revenue on these sales as the payments are collected from the customer. 5. Investment Securities All investment securities are classified as available-for-sale. These investment securities have been adjusted to their fair market value based upon quoted market prices. Unrealized holding gains and losses are reported as a separate component of stockholder's equity. The Company will regularly perform reviews of the fair value of its investment securities and assess whether there exists any other than temporary impairment. 6. Property and Equipment Property and equipment are stated at cost, net of accumulated depreciation. Depreciation is recognized using the straight-line and double-declining balance method over the estimated useful lives of the assets, which range from three to seven years. Leasehold improvements are amortized using the straight-line method over the lesser of the estimated useful lives or remaining lease term. 7. Use of Estimates To comply with US GAAP, the Company makes estimates and assumptions that effect the amounts reported in the financial statements and disclosures made in the accompanying notes. Estimates are used for, but not limited to reserves for product returns, the collectibility of accounts receivable and deferred taxes. The Company also uses estimates to determine the remaining economic lives and carrying value of goodwill and fixed assets. Despite our intention to establish accurate estimates and assumptions, actual results may differ from our estimates. 8. Software Development Costs In accordance with Statement of Financial Accounting Standards No. 86, "Accounting for Costs of Computer Software to be Sold, Leased, or otherwise Marketed," software development costs are expensed as incurred until the product is available for general release to customers. To date, the Company's software has been available for general release concurrent with the establishment of technological feasibility and, accordingly, no development costs have been capitalized. The Company capitalizes costs related to the development of computer software developed or obtained for internal use in accordance with the American Institute of Certified Public Accountants Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." Costs incurred in the application development phase are capitalized and amortized over their useful life, not to exceed five years. 9. Advertising Costs Advertising and promotion costs are expensed as incurred. 10. Impairment and Long-lived Assets The Company will regularly perform reviews to determine if the carrying values of our long-lived assets are impaired. The reviews take into account facts or circumstances, either internal or external, which indicate that the carrying value of the asset cannot be recovered. 11. Income Taxes The Company records its federal and state tax liability in accordance with Financial Accounting Standards Board Statement No. 109 "Accounting for Income Taxes". Deferred taxes payable are recorded for temporary differences between the recognition of income and expenses for tax and financial reporting purposes, using current tax rates. Deferred assets and liabilities represent the future tax consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. 11 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 12. Cash and Cash Equivalents For purposes of the statement of cash flows, the Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents to the extent the funds are not being held for investment purposes. NOTE C - INVESTMENT SECURITIES The Company held three investment securities during the fiscal quarter ended September 30, 2003, which the Company acquired in connection with strategic business transactions and relationships. Our available-for-sale securities are carried at fair value and unrealized gains or losses are included in stockholders' equity. The Company held the following investment securities at September 30, 2003 and December 31, 2002. The cost basis of our investment securities reflects adjustments for other than temporary impairments in value. Investment Cost Gross Unrealized Estimated Securities Basis Gains Losses Fair Value -------------------------- --------- --------- -------- ---------- September 30, 2003 EnSurge, Inc. common stock $ - $ - $ - $ - $ - $ - $ - $ - ========= ========= ======== ========== Investment Cost Gross Unrealized Estimated Securities Basis Gains Losses Fair Value -------------------------- --------- --------- -------- ---------- December 31, 2002 EnSurge, Inc. common stock $ - $ - $ - $ - $ - $ - $ - $ - ========= ========= ======== ========== The Company received EnSurge, Inc. common stock in consideration for the sale of certain vintage furniture in 2000. Due to the decline in market value of EnSurge, Inc. common stock, the Company considered the carrying value of $26,250 permanently impaired which resulted in a loss on investment securities of $26,250 during the year ended December 31, 2002. The Company received Knowledge Transfer Systems, Inc. common stock from EnSurge, Inc. in consideration for the sale of four software coaching platforms to EnSurge, Inc. in September - December, 2001. These investment securities were recorded at a 30% discount due to restrictions and limitations contained in Rule 144 of the Securities and Exchange Commission. The primary restriction relates to the one-year holding period of the investment securities after the effective date of sale. As of December 31, 2002, the one-year holding period on these investment securities expired and the investment securities were recorded at 100% of their fair market value. Due to the decline in market value of Knowledge Transfer Systems, Inc. common stock, the Company considered the value of these securities permanently impaired and wrote down the entire carrying value of these investment securities as of December 31, 2002. The reduction in carrying value on these investment securities resulted in a loss on investment of $728,000 during the year ended December 31, 2002. Shane Hackett, who is the President and Chief Executive Officer of the Company, was the President and Chief Executive Officer of EnSurge, Inc. from November 1, 1999 until February 28, 2001, and owned 7,725,000 shares of the common stock of EnSurge, Inc. during the time of the transactions in 2001, which then constituted approximately nine percent (9%), of the outstanding common stock of EnSurge, Inc. 12 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) The Company received 875,000 Knowledge Transfer Systems, Inc. preferred shares with a stated value of $1.00 per share from Knowledge Transfer Systems, Inc. on September 23, 2002 as consideration for the sale of the Business Development Series, e-learning content and software. The preferred shares are convertible, at the discretion of the Company, to Knowledge Transfer Systems, Inc. common stock at 95% of the fair market value of Knowledge Transfer System's common stock based on a five day average preceding the date of conversion. Due to the disclosure by the management of Knowledge Transfer Systems, Inc. of the possible bankruptcy of its wholly-owned subsidiary, KT Solutions, Inc., the Company considered the value of these securities permanently impaired and wrote down the entire carrying value of these investment securities as of December 31, 2002. The reduction in carrying value on these investment securities resulted in a loss on investment of $875,000 during the year ended December 31, 2002. The Company has retained a valuation firm to determine the value of the 875,000 shares of preferred stock of the Knowledge Transfer Systems, Inc., as of the time of their transfer to the Company on September 23, 2002, to determine the tax consequences of the transaction. See Note I - Commitments and Contingencies. At the time of the sale of the Business Development Series to Knowledge Transfer Systems, Inc. for 875,000 shares of Knowledge Transfer Systems, Inc. preferred stock, there was no related party relationship between the companies and/or the officers and directors of the companies except for the interest described below. According to the Form 10-KSB of Knowledge Transfer Systems, Inc. for the period ended December 31, 2002, EnSurge, Inc. beneficially owned 2,600,000 shares, or 5.1% of the outstanding common stock of Knowledge Transfer Systems, Inc., and according to the Form 10-KSB of Knowledge Transfer Systems, Inc. for the period ended December 31, 2001, EnSurge, Inc. beneficially owned 5,700,000 shares, or 14.1% of the outstanding common stock of Knowledge Transfer Systems, Inc. Shane Hackett, who is the President and Chief Executive Officer of the Company, was the President and Chief Executive Officer of EnSurge, Inc. from November 1, 1999 until February 28, 2001, and owned 7,725,000 shares of the common stock of EnSurge, Inc. during the time of the transaction between the Company and Knowledge Transfer Systems, Inc. in 2002, which then constituted approximately eight percent (8%), of the outstanding common stock of EnSurge, Inc. Mr. Hackett continues to own 7,725,000 shares of the common stock of EnSurge, Inc. During the quarter ended September 30, 2003, the Company entered into a Purchase and Sale Agreement (the "KT Purchase Agreement") with Knowledge Transfer Systems, Inc., and a Content License and Resale Agreement (the "KT License Agreement") with both KT Solutions, Inc. and Knowledge Transfer Systems, Inc. The transactions each occurred on August 25, 2003. KT Solutions, Inc. is a subsidiary of Knowledge Transfer Systems, Inc. Pursuant to the KT Purchase Agreement, the Company purchased the Business Development Series from Knowledge Transfer Systems, Inc. in exchange for the 875,000 shares of Knowledge Transfer Systems, Inc. preferred stock owned by the Company. The Business Development Series consists of multimedia software titles, hard copy titles, website, domain, copyright, titles, and all related interests, including certain product deliverables, product contracts and product licenses. Pursuant to the KT License Agreement, the Company obtained a non-exclusive, world-wide license to a line of KT Solutions, Inc. products for resale through the Company's on-line learning services, in exchange for a 35% royalty on product revenues recognized by the Company, subject to a $125,000 royalty credit as a start-up concession to the Company. The licensed product line consists of training materials suitable for access and use by a customer through on-line learning services. The initial license term is for five years and is renewable year-to-year thereafter unless canceled by either party. Due to concerns the Company had about the continued existence of KT Solutions, Inc. as an operating entity, the Company also obtained a guarantee by its parent, Knowledge Transfer Systems, Inc., of all of KT Solutions Inc.'s obligations under the KT License Agreement, in exchange for the 1,900,000 shares of Knowledge Transfer Systems, Inc. common stock owned by the Company. As a result of these transactions, among other things, the Company has reacquired full ownership of the Business Development Series previously sold by the Company to Knowledge Transfer Systems, Inc., and the Company no longer owns any common or preferred stock or any other equity interest in Knowledge Transfer Systems, Inc. The Company did not record any gain or loss with respect to the transactions that occurred during the quarter that ended September 30, 2003. 13 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE D - PROPERTY & EQUIPMENT Property and equipment are stated at cost, net of accumulated depreciation as follows: September 30, December 31 2003 2002 --------- --------- Machinery and Equipment $ 341,243 $ 246,594 Furniture and Fixtures 65,263 51,683 Computer Software 306,785 190,624 Leasehold improvements 36,018 34,092 --------- --------- 749,309 522,993 Less: Accumulated depreciation and amortization (294,142) (143,644) --------- --------- Property and Equipment, Net $ 455,167 $ 379,349 ========= ========= NOTE E - OTHER ASSETS The Company has established several merchant service accounts whereby the Company processes a high volume of customer sales transactions through certain credit card vendors. These merchant service companies typically hold a percentage of each sales transaction as a reserve against future cancellations. The amount held by these merchant service companies amounts to $1,073,850 and $706,486 as of September 30, 2003 and December 31, 2002, respectively. NOTE F - LONG-TERM DEBT Long-term debt consists of the following:
September 30, December 31 2003 2002 -------- -------- Notes payable, financial institution, collateralized by telephone equipment, principal and imputed interest payable in monthly installments of $1,250 and $385 respectively, due in August 2004, and January 2006 $ 18,606 $ 20,469 Notes payable, financial institution, secured by a lien on certain furniture and equipment, principal and interest payable in monthly installments of $2,464 due in July 2005 49,928 67,175 Notes payable, financial institution, collateralized by Vehicles, principal and accrued interest at 7.78% payable in monthly installments of principal and imputed interest maturing from $217 to $655 from November 2006 to February 2007 9,246 43,853 -------- -------- 77,780 131,497 Less Current Maturities 11,508 44,274 -------- -------- Long-term - net of current maturities $ 66,272 $ 87,223 ======== ========
The Company has an unsecured line of credit facility with a financial institution for borrowings up to $50,000 expiring August 31, 2005. Borrowings under the line bear interest at Prime plus 2% (the Prime rate of interest as of September 30, 2003 was 4.00%). As of September 30, 2003, there was $46,260 available on the credit facility 14 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE G - CAPITAL TRANSACTIONS Stock-split - Innovative's Board of Directors authorized a three-for-one stock split on July 11, 2001. This was effective on August 10, 2001 to stockholders of record on July 31, 2001. All share and per share amounts referred to in the financial statements and notes have been restated to reflect this stock split. Issuance of common stock - The Company issued 40,730, 24,375, 76,960, and 23,169 shares of its common stock in 2002 through private placements to individual foreign investors. Issuance of Series B preferred stock - The Company issued 80,000 shares of its Series B preferred stock to certain directors of the Company as compensation at a stated value of $1.00 per share in 2002. Issuance of common stock for software - The Company issued 53,845 shares of its common stock in 2002 as part of payment under the terms of a software purchase agreement entered into by the Company. The agreement stipulates that the Company receives business management software for both the Internet and real estate markets as well as hosting and maintenance services. Stock issued for services - The Company issued 4,000 shares of its common stock at a fair market value of $3.55 per share in the first quarter 2002. In addition, the Company issued 6,125 shares of its common stock during the second quarter 2002 at fair market value of $3.37 per share. Stock issued for services - The Company issued 291,250 and 5,000 shares of its common stock at a fair market value of $0.075 per share in the fourth quarter 2002. In addition, the Company issued 39,702 shares of its common stock during the first quarter 2003 for services rendered in fourth quarter 2002 at an average fair market value of $0.121 per share. Conversion of Series A Preferred Stock - Two directors of the Company converted 199,500 shares of Series A preferred stock to 3,000,000 shares of common stock during the fourth quarter 2002. The Series A preferred stock is convertible to the Company's common stock at 95% of the fair market value of the common stock at the date of conversion. The Market Price of the Company's common stock on the date of conversion was $0.07. Series A Preferred Stock Dividend - The Company issued 558,356 shares of its common stock as a Series A preferred stock dividend during the fourth quarter 2002. The holders of the shares of Series A Preferred received dividends at the rate of 4% per annum payable in shares of the Company's common stock. The number of shares of common stock distributed as a dividend was calculated by dividing such payment by 95% of the Market Price on the average of the first five trading days after January 1 of each year. The term "Market Price" means, as of any date, the average of the daily closing price for the five consecutive trading days ending on such date. The Company has withheld 137,942 of such shares of common stock payable to two stockholders in connection with a dispute with such stockholders. Series B Preferred Stock Dividend - The Company issued 72,494 shares of its common stock as a Series B preferred stock dividend during the fourth quarter 2002. The holders of the shares of Series B Preferred received dividends at the rate of 4% per annum payable in shares of the Company's common stock. The number of shares of common stock distributed as a dividend was calculated by dividing such payment by 100% of the Market Price on the average of the first five trading days after January 1 of each year. The term "Market Price" means, as of any date, the average of the daily closing price for the five consecutive trading days ending on such date. Financing Agreement - During 2001, Hackett Media, Inc. financed its operation primarily through a Financing Agreement of convertible debt and securities. The Financing Agreement calls for financing of up to $2.5 million of which $1 million would be received in increments in 2001, if necessary, and the remaining $1.5 million would be received based upon the Company's performance. As of September 30, 2002, $700,000 of the initial $1 million investment was received by the Company. These proceeds were converted to equity securities during 2001. During the fourth quarter 2001, all of the common shares issued in connection with the conversion of debt in connection with the Financing Agreement above were reissued as Series A preferred shares and common shares as follows: of the $700,000 invested in 2001, $350,000 was converted to Series A preferred shares at a stated value of $1 per share and the remaining $350,000 was reissued as 700,000 shares of common stock at $0.50 per share. During the fourth quarter 2002, the Company passed a Board of Directors' resolution to formally terminate the Financing Agreement with Iwasaka Investments, Ltd. due to the non-compliance by Iwasaka Investments, Ltd. with the terms of the agreement. The Company believes that the termination of this agreement will have no adverse effect on the operations of the Company. 15 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Issuance of Series B preferred stock - The Company issued 80,000 shares of its Series B preferred stock to certain directors of the Company as prepaid executive compensation and executive compensation at a stated value of $1.00 per share in the first quarter 2003. The Company recorded non-cash executive compensation of $60,000 for the nine months ended September 30, 2003. The remaining $20,000 will be incurred during the fourth quarter of 2003. Stock issued for prepaid services - The Company issued 233,333 shares of its common stock in exchange for $2,250 of prepaid public relation services in the first quarter 2003. Stock issued for charitable contribution - The Company issued 133,333 shares of its common stock as a charitable contribution at a fair market value of $0.08 per share in the first quarter 2003. Stock issued for services - The Company issued 49,231 shares of its common stock at a fair market value of $0.096 per share in the second quarter 2003 for professional services rendered. NOTE H - RELATED PARTY TRANSACTIONS On December 31, 2001, a Company executive and shareholder converted a non-interest bearing note payable amounting to $248,491 to Series B preferred stock at a conversion rate of a $1 per share stated value. There was no formal maturity date and there was no interest associated with the note. Also, in September - December 2001, the Company sold four software coaching platforms to NowSeven.com, Inc., Ziabon, Inc., SF Acquisition Corp., Inc., and Ishopper Internet Services, Inc., which are subsidiaries of EnSurge, Inc., in exchange for investment securities of Knowledge Transfer Systems, Inc. amounting to $308,000, $133,000, $147,000, and $140,000, respectively. Shane Hackett, who is the President and Chief Executive Officer of the Company, was the President and Chief Executive Officer of Ensurge, Inc. from November 1, 1999 until February 28, 2001, and owned 7,725,000 shares of the common stock of EnSurge, Inc. during the time of the transactions in 2001, which then constituted approximately nine percent (9%), of the outstanding common stock of EnSurge, Inc. Due to the decline in market value of Knowledge Transfer Systems, Inc. common stock, the Company considered the value of these securities permanently impaired and wrote down the entire carrying value of these investment securities as of December 31, 2002. At the time of the sale of the Business Development Series to Knowledge Transfer Systems, Inc. for 875,000 Knowledge Transfer Systems, Inc. preferred shares in 2002, EnSurge, Inc. was a stockholder of Knowledge Transfer Systems, Inc. According to the Form 10-KSB of Knowledge Transfer Systems, Inc. for the period ended December 31, 2002, EnSurge, Inc. beneficially owned 2,600,000 shares, or 5.1% of the outstanding common stock of Knowledge Transfer Systems, Inc., and according to the Form 10-KSB of Knowledge Transfer Systems, Inc. for the period ended December 31, 2001, EnSurge, Inc. beneficially owned 5,700,000 shares, or 14.1% of the outstanding common stock of Knowledge Transfer Systems, Inc. Shane Hackett, who is the President and Chief Executive Officer of the Company, was the President and Chief Executive Officer of Ensurge, Inc. from November 1, 1999 until February 28, 2001, and owned 7,725,000 shares of the common stock of EnSurge, Inc. during the time of the transaction between the Company and Knowledge Transfer Systems, Inc. in 2002, which then constituted approximately eight percent (8%), of the outstanding common stock of EnSurge, Inc. (See Note C: Investment Securities). During the quarter ended September 30, 2003, the Company entered into a Purchase and Sale Agreement (the "KT Purchase Agreement") with Knowledge Transfer Systems, Inc., and a Content License and Resale Agreement (the "KT License Agreement") with both KT Solutions, Inc. and Knowledge Transfer Systems, Inc. The transactions each occurred on August 25, 2003. KT Solutions, Inc. is a subsidiary of Knowledge Transfer Systems, Inc. Pursuant to the KT Purchase Agreement, the Company purchased the Business Development Series from Knowledge Transfer Systems, Inc. in exchange for the 875,000 shares of Knowledge Transfer Systems, Inc. preferred stock owned by the Company. The Business Development Series consists of multimedia software titles, hard copy titles, website, domain, copyright, titles, and all related interests, including certain product deliverables, product contracts and product licenses. Pursuant to the KT License Agreement, the Company obtained a non-exclusive, world-wide license to a line of KT Solutions, Inc. products for resale through the Company's on-line learning services, in exchange for a 35% royalty on product revenues recognized by the Company, subject to a $125,000 royalty credit as a start-up concession to the Company. The licensed product line consists of training materials suitable for access and use by a customer through on-line learning services. The initial license term is for five years and is renewable year-to-year thereafter unless canceled by either party. Due to concerns the Company had about the continued existence of KT Solutions, Inc. as an operating entity, the Company also obtained a guarantee by its parent, Knowledge Transfer Systems, Inc., of all of KT Solutions Inc.'s obligations under the KT License Agreement, in exchange for the 1,900,000 shares of Knowledge Transfer Systems, Inc. common stock owned by the 16 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Company. As a result of these transactions, among other things, the Company has reacquired full ownership of the Business Development Series previously sold by the Company to Knowledge Transfer Systems, Inc., and the Company no longer owns any common or preferred stock or any other equity interest in Knowledge Transfer Systems, Inc. The Company did not record any gain or loss with respect to the transactions that occurred during the quarter that ended September 30, 2003. During 2002, the Company initiated the purchase of sales leads from Education Success Institute, Inc. (ESI). ESI is owned and operated by two officers of the Company's operating subsidiary, Energy Professional Marketing Group Inc. (Ethan Andrew Willis and James Randolph Garn). The Company paid ESI a total of $3,894,816 for sales lead generation for the nine months ended September 30, 2003. In addition, the Company reserved for potential returned sales from ESI in the amount of $296,140 as of September 30, 2003. Also, revenue received by the Company for ESI's use of merchant accounts, office supplies and rent totaled $72,554 for the nine months ended September 30, 2003. NOTE I - COMMITMENTS AND CONTINGENCIES Leases In March, May and September 2002, the Company entered into operating leases for certain office space. In October 2003 we leased additional space for our coaching office. The Company leases space for three separate locations. The total monthly obligation is $23,601. Future minimum lease payments under these operating leases as of September 30, 2003 are as follows: Year Ending December 31: 2003 $ 71,261 2004 239,922 2005 173,853 2006 37,467 --------- Total $ 522,502 ========= SEC Investigation As described in Part II, Section 1, on June 24, 2003, the Securities and Exchange Commission ("SEC") issued a formal order of investigation with respect to the Company, authorizing the investigation of certain securities matters relating to the Company. The SEC staff has taken the testimony of certain officers of the Company and has informed the Company that it intends to take additional testimony. The SEC staff has also issued additional requests for the voluntary production of documents. Prior to the issuance of the order, the Company had voluntarily provided documents and information to the SEC staff in response to informal, non-public inquiries by the staff. The Company intends to fully cooperate with the SEC in its investigation. Legal Proceedings On or about September 5, 2003, a lawsuit was filed by Independent Marketing, Inc. (IMI) against certain employees of the Company. The lawsuit was filed in the Fourth Judicial District Court of Utah County, State of Utah as Case No. 030403929. While the Company was initially named as a Defendant, the Company was not named in the Amended Complaint filed in this lawsuit, In the lawsuit, IMI is claiming that these employees have breached certain employment and non-compete agreements and IMI is seeking compensatory damages and injunctive relief. Although the Company is not a party to the litigation, because the lawsuit affects certain employees of the Company, some or all of whom are key employees, the Company's operating results and competitive position may be adversely affected in the event of a Court ruling which limits those employees' involvement with the Company. As disclosed in Part II, Item 1, James Randolph Garn and Ethan Andrew Willis have resigned as officers of the Company and as members of the Company's Board of Directors and have informed the Company that they are prepared to file a suit to rescind the Company's December 31, 2001 acquisition from them of the Company's operating subsidiary, Energy Professional Marketing Group, Inc., unless the Company reaches a negotiated compromise with them effecting a rescission of the acquisition. The Company is not aware of any suit being filed. The Company is investigating this matter and the parties have attempted to negotiate a resolution of this matter. The commencement of litigation or any adverse determination in such litigation could have a material adverse effect on the Company's business, financial condition and results of operations. 17 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Valuation of the 2002 Sale of Business Development Series for Stock. As noted in Note C - Investment Securities, the Company has retained a valuation firm to determine the value of the 875,000 shares of preferred stock of the Knowledge Transfer Systems, Inc., as of the time of their transfer to the Company on September 23, 2002, to determine the tax consequences of the transaction. The results of this valuation cannot be predicted at this time. However, should the valuation be substantially lower than the previously reported amount, the Company may need to restate its SEC filing for the third quarter of 2002 and for the 2002 year. In the event such a restatement is required the Company expects the effect to be limited as the entire amount of this consideration was written off at the end of 2002. However, if the valuation of the preferred stock exceeds approximately $300,000, the Company will be required to accrue tax liability relating to the excess. NOTE J - CONCENTRATION OF CREDIT RISK The Company has increasingly relied on ESI to provide the Company with sales leads. As a percentage of the overall sales leads provided to the Company for the three months ended September 30, 2003, 89% of the leads were provided by ESI. This is compared to 57% for the three months ended June 30, 2003. NOTE K - SUBSEQUENT EVENTS In October of 2003 we entered into a capital lease for the amount of $139,940 for phone equipment, the term of which is 4 years. In November, 2003 the Company entered into an equipment lease in the amount of approximately $5,000 for 2 years. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The Company is a software company specializing in small business and financial eLearning tools and consulting services. The Company's main products are EMS, a turnkey web builder, e-commerce solution and data management system targeted to small businesses; The Financial Toolkit 1.0, an integrated financial services and education program; Skills in Demand, consisting of eLearning courses that cater to small business owners and entrepreneurs, and eTaxNet, a provider of online tax and consulting services. In addition, the Company offers, for most of its software and learning products, technical support and coaching services. When used in this discussion, the words "expect(s)", "feel(s)", "believe(s)", "will", "may", "anticipate(s)" and similar expressions are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties, and actual results could differ materially from those projected. Readers are cautioned not to place undue reliance on these forward-looking statements, and are urged to carefully review and consider the various disclosures elsewhere in this Form 10-QSB, including those set forth under "Cautionary Statement Concerning Forward-Looking Statements" below. Critical Accounting Policies The discussion and analysis of our financial condition and results of operations are based upon the Company's condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of the Company's financial statements. Actual results may differ from these estimates under different assumptions or conditions. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. The Company believes that its critical accounting policies include those described below. For a detailed discussion on the application of these and other accounting policies, see Note B in the Notes to the Consolidated Financial Statements included in the Company's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2002. 18 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Goodwill and Intangible Assets As discussed in Note A in the accompanying consolidated financial statements, the Company, on December 31, 2001, purchased all of the outstanding shares of Energy Professional Marketing Group Inc. (EPMG) for $13.5 million in Innovative common and Series A preferred stock. Purchase accounting requires extensive use of accounting estimates and judgments to allocate the purchase price to the fair market value of the assets purchased and liabilities assumed. The Company has accounted for its acquisitions using the purchase method of accounting. Values were assigned principally to goodwill based upon management's allocation of the purchase price to EPMG's workforce in place at the date of the transaction. Effective January 1, 2002, the Company adopted the provisions of SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142). This statement affects the Company's treatment of goodwill and other intangible assets. The statement requires that goodwill existing at the date of adoption be reviewed for possible impairment and that impairment tests be periodically repeated, with impaired assets written down to fair value. Additionally, existing goodwill and intangible assets must be assessed and classified within the statement's criteria. Intangible assets with finite useful lives will continue to be amortized over those periods. Amortization of goodwill and intangible assets with indeterminable lives will cease. During 2002, the trading price of the Company's stock declined significantly, raising questions about whether the fair value of goodwill exceeds its carrying amount. An evaluation of the carrying amount of goodwill was conducted during the 4th quarter 2002, which included an evaluation of whether the decline in the trading price of the Company's stock is other than temporary. The Company determined that the decline in its trading price was other than temporary and subsequent to December 31, 2002, engaged an independent valuation firm to perform a valuation of the Company. This resulted in a write-down in goodwill by the Company of $12,461,246 as of December 31, 2002. Goodwill amounts to $1,088,868 as of September 30, 2003. Investment Securities Investment securities are considered to be impaired when a decline in fair value below cost basis is determined to be other than temporary. The Company employs a methodology in evaluating whether a decline in fair value below cost basis is other than temporary that considers available evidence regarding its investment securities. In the event that the cost basis of a security exceeds its fair value, the Company evaluates, among other factors: the duration of the period that, and extent to which, the fair value is less than cost basis; the financial health of and business outlook for the investee, including industry and sector performance, changes in technology and operational and financing cash flow factors; overall market conditions and trends, and the Company's intent and ability to hold the investment. Once a decline in fair value is determined to be other than temporary, a write-down is recorded and a new cost basis in the security is established. Assessing the above factors involves inherent uncertainty. Accordingly, write-downs, if recorded, could be materially different from the actual market performance of investment securities in the Company's portfolio, if, among other things, relevant information related to the Company's investment securities was not publicly available or other factors not considered by the Company would have been relevant to the determination of impairment. As discussed in Note C to the accompanying financial statements, the Company wrote down the value of investment securities by $1,629,250 in 2002. The new cost basis in the investment securities written-down, as of December 31, 2002, is $0. Revenue Recognition The Company recognizes revenue after delivery of the product. To the extent the Company sells software, revenue is recognized in accordance with Statement of Position 97-2, Software Revenue Recognition, as amended by SOP 98-4 and SOP 98-9 and clarified by Staff Accounting Bulletin (SAB) 101 Revenue Recognition in Financial Statements. In most cases this occurs the same day payment is received from our customers. The Company also reserves for sales returns and allowances based upon historical experience. The Company provides support services for some of its products. Payments received by the Company for these services are generally recorded as deferred revenue and recognized over the term of the services. The Company estimates the amount earned for services based upon the period of time that has elapsed since the invoice date. For example, if an agreement provides for a ten-week course of coaching services, the Company estimates that one-half of the revenues for coaching services are earned after five weeks. If the ten-week course begins five weeks before the end of a fiscal quarter, the Company will recognize one-half of the coaching revenues as revenues received in the fiscal quarter and will record one-half as deferred revenue. The Company makes two assumptions in recognizing coaching revenues: (1) that coaching services begin immediately after the invoice date and (2) that customers do not make-up missed coaching sessions. The Company believes that these assumptions are reasonable based upon the Company's experience. 19 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) The Company also provides extended payment terms on the sale of its software and related coaching for up to two years. Since payments terms on these sales exceed 12 months, the fee for the software and license is presumed not to be determinable. In addition, the probability of collection decreases as the payment terms are extended. As a result, the Company recognizes revenue on these sales as the payments are collected from the customer. Results of Operations for the Three Months Ended September 30, 2003 Compared to Three Months Ended September 30, 2002 Sales Sales for the three months ended September 30, 2003 and 2002 were $9,076,162 and $4,225,488, respectively, which represents a 118% increase from the prior period. The Company's principal source of revenue for the three months ended September 30, 2003 consisted of software product and service sales. The primary reason for the increase in sales can be attributed to the consolidation of all of its administrative and accounting functions to the Provo, UT office in an effort to improve the Company's fulfillment and shipping operations and improve corporate responsiveness. This consolidation was completed in September 2002. This has enabled the Utah office to greatly improve its ability to service its customers. The Company has experienced substantial increases in sales per sales associate as a result of the consolidation. In conjunction with this consolidation, the Company has hired additional sales and marketing associates which has also positively impacted sales for the nine months ended September 30, 2003. Also, in first quarter 2003, the Company initiated the utilization of its training center in Orem, UT to assist its customers in maintaining and expanding their Internet presence. Among the Company's products and services, sales of the Company's personal finance products and services have been increasing at a faster rate than its other products and services. Cost of Sales Cost of sales for the three months ended September 30, 2003 and 2002 was $4,612,375 and $1,528,534, respectively, representing an increase of 202%. Cost of sales for the three months ended September 30, 2003 and 2002 represented costs associated with the generation of sales leads and the providing of coaching services to customers that purchase the Company's products. The main reason for the increase in cost of sales for the three months ended September 30, 2003, as compared to a year ago for the same period, can be attributed to cost of sales increasing in conjunction with the increase in sales for the period as well as the rise in the cost of generating sales leads and the providing of coaching services for the same period a year ago. See "Related Party Transactions - Relationship with ESI" below. Gross Margin Gross profit as a percentage of revenues was 50% for the three months ended September 30, 2003 and 63.8% for the three months ended September 30, 2002. The decrease was caused by the rise in costs of generating sales leads and the providing of coaching services. See "Cost of Sales" above. Selling Selling expenses for the three months ended September 30, 2003 and 2002 were $2,072,032 and $729,388, respectively, representing an increase of 168%. These costs consisted primarily of commissions paid to sales associates as well as marketing and advertising expenses associated with key products and services. The main reason for the increase in selling costs can be attributed to the increase in sales of products and services from new and existing sales associates. Selling costs have increased as a percentage of sales for the three months ended September 30, 2003 and 2002. General and Administrative General and administrative expenses for the three months ended September 30, 2003 and 2002 were $1,863,694 and $1,069,191, respectively, representing an increase of 71%. The Company's general and administration expenses consisted primarily of salaries and wages, professional and legal fees, rent, travel expenses, payroll taxes, telephone expenses and other general and administrative expenses necessary to support the operations of the Company in the current period. The 20 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) primary reason for the increase in general and administrative expenses was attributable to higher administrative wage costs and legal expenses for the three months ended September 30, 2003. The Company pays 40% of net earnings before taxes into a profit sharing pool that is divided equally among three executive officers of the Company and its subsidiaries. Income Taxes The Company accrued $1,067,373 and $137,048 for income taxes for the three months ended September 30, 2003 and 2002, respectively. The Company's effective income tax rates were 39% and 36% for the three months ended September 30, 2003 and 2002, respectively Net Income The Company had net loss of $584,586 for the three months ended September 30, 2003, a net margin of 5.7% of revenue, compared to net income of $225,182 for the three months ended September 30, 2002, a net margin of 5.3% of revenue. Net income increased over the comparable period in 2002 primarily due to a loss on investment securities during the comparable period in 2002. Results of Operations for the Nine Months Ended September 30, 2003 Compared to Nine Months Ended September 30, 2002 Sales Sales for the nine months ended September 30, 2003 and 2002 were $21,648,365 and $10,014,523, respectively, which represents a 117% increase from the prior period. The Company's principal source of revenue for the nine months ended September 30, 2003 consisted of software product and service sales. The primary reason for the increase in sales can be attributed to the consolidation of all of its administrative and accounting functions to the Provo, UT office in an effort to improve its fulfillment and shipping operations and improve corporate responsiveness. This consolidation was completed in September 2002. This has enabled the Utah office to greatly improve the Company's ability to service its customers. The Company has experienced substantial increases in sales per sales associate as a result of the consolidation. In conjunction with this consolidation, the Company has hired additional sales and marketing associates, which has also positively impacted sales for the first nine months of 2003. Also, in first quarter 2003, the Company initiated the utilization of its training center in Orem, UT to assist its customers in maintaining and expanding their Internet presence. Among the Company's products and services, sales of the Company's personal finance products and services have been increasing at a faster rate than its other products and services. Cost of Sales Cost of sales for the nine months ended September 30, 2003 and 2002 was $10,674,800 and $3,650,218, respectively, representing an increase of 192%. Cost of sales for the nine months ended September 30, 2003 and 2002 represented costs associated with the generation of sales leads and the providing of coaching services to customers that purchase the Company's products. The main reason for the increase in cost of sales for the nine months ended September 30, 2003, as compared to a year ago for the same period, can be attributed to cost of sales increasing in conjunction with the increase in sales for the period as well as the rise in the cost of generating sales leads and the providing of coaching services for the same period a year ago. See "Related Party Transactions - Relationship with ESI" below. Gross Margin Gross profit as a percentage of revenues was 50.9% for the nine months ended September 30, 2003 and 63.6% for the nine months ended September 30, 2002. The decrease was caused by the rise in the cost of generating sales leads and of providing of coaching services for the same period a year ago. 21 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Selling Selling expenses for the nine months ended September 30, 2003 and 2002 were $5,138,849 and $2,011,587, respectively, representing an increase of 134%. These costs consisted primarily of commissions paid to sales associates as well as marketing and advertising expenses associated with key products and services. The increase in selling costs can be attributed primarily to the increase in sales of products and services from new and existing sales associates. Selling costs have increased as a percentage of sales for the nine months ended September 30, 2003 and 2002. General and Administrative General and administrative expenses for the nine months ended September 30, 2003 and 2002 were $5,368,018 and $2,727,968, respectively, representing an increase of 92%. The Company's general and administration expenses consisted primarily of salaries and wages, professional fees, rent, travel expenses, payroll taxes, telephone expenses and other general and administrative expenses necessary to support the operations of the Company in the current period. The primary reason for the increase in general and administrative expenses was attributable to higher administrative wages and legal fees for the nine months ended September 30, 2003. The Company pays 40% of net earnings before taxes into a profit sharing pool that is divided equally among three executive officers of the Company and its subsidiaries. Non-recurring Expenses Non-recurring expense for the nine months ended September 30, 2003 and 2002 was $0 and $169,578, respectively. Non-recurring expense in 2002 represented back wages due to EPMG's employees. This cost resulted from a completed examination of the Company's labor practices by the United States Department of Labor. The period of examination covered the Company's operations from May 2000 to May 2002. Income Taxes The Company accrued $471,890 and $357,048 for income taxes for the nine months ended September 30, 2003 and 2002, respectively. The Company's effective income tax rates were 39% and 36% for the nine months ended September 30, 2003 and 2002, respectively. In its 10-QSB filing for the period ended June 30, 2003, the Company did not accrue income taxes as management believed at that time that a portion of the write-down in goodwill (See Note B in the "Notes to the Condensed Consolidated Financial Statements") provided an offset to Net Income for tax purposes. The Company now believes that the write-down in goodwill does not provide an offset to Net Income for tax purposes. The $471,890 income tax accrual recognizes the full amount of tax liability without consideration of the write-down in goodwill. The Company has retained a tax expert to confirm the Company's conclusion. Net Income We had net loss of $689,431 for the nine months ended September 30, 2003 compared to net income of $573,516 for the nine months ended September 30, 2002, an increase of 29%. The increase in net income was due to overall increased revenues and better cost controls. Net income increased over the comparable period in 2002 primarily due to a loss on investment securities during the comparable period in 2002. Related Party Transactions Relationship with ESI. In September 2002, Energy Professional Marketing Group, Inc. (EPMG), a wholly-owned subsidiary of the Company, entered into an Opportunity and Strategic Alliance Agreement with Education Success Institute (ESI). Under the agreement, EPMG purchases sales leads from ESI. ESI is owned and operated by Ethan A. Willis and James R. Garn, each of whom serves as a vice president and director of EPMG and served as an officer and director of the Company prior to September 26, 2003. Under the agreement, with respect to cash sales made by EPMG to sales leads generated by ESI, gross sales after a reserve of 4% are divided 66% to EPMG and 34% to ESI. The Company believes that the agreement is the product of arm's length negotiation between the parties. The Company was generating a significant portion of their sales leads internally; however, this was generally unprofitable for the 22 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Company and the decision was made to outsource the generation of sales leads to ESI. The Company paid ESI a total of $2,044,027 for sales lead generation for the three months ended September 30, 2003and $3,894,816 for sales lead generation for the nine months ended September 30, 2003. In addition, the Company reserved for potential returned sales from ESI in the amount of $296,140 as of September 30, 2003. Also, revenue received by the Company for ESI's use of merchant accounts, office supplies and rent totaled $39,876 for the three months ended September 30, 2003 and $72,554 for the nine months ended September 30, 2003. Liquidity and Capital Resources At September 30, 2003, the Company had cash and cash equivalents of $3,857,987, an increase of $2,519,642 from December 31, 2002. At September 30, 2003, the Company had net working capital of $1,425,205 compared to net working capital of $680,490 at December 31, 2002. The ratio of current assets to current liabilities decreased to 1.37 at September 30, 2003 from 1.45 at December 31, 2002. Cash provided by operations was $2,715,080 for the nine months ended September 30, 2003. The primary reason for the positive operating cash for the nine months ended September 30, 2003 can be attributed to the Company's higher sales volume during the first nine months of 2003. In addition, the Company's primary merchant service company ceased holding a percentage of each sales transaction as a reserve against future cancellations, which has positively impacted cash in the current quarter. The Company also experienced non-cash prepaid expenses and non-cash expenditures of $97,667 during the nine months ended September 30, 2003, which also positively effected cash. The Company paid down its note payable and line of credit balances by a net amount of $90,637 during the nine months ended September 30, 2003. The Company anticipates paying down additional notes payable amounts during 2003. Stockholders' equity amounts to $1,639,751 as of September 30, 2003. The Company issued 80,000 shares of its Series B preferred stock to certain directors of the Company as prepaid executive compensation and executive compensation at a stated value of $1.00 per share in the first quarter 2003. The Company recorded non-cash executive compensation of $60,000 for the nine months ended September 30, 2003, related to these Series B preferred shares. The remaining $20,000 will be incurred during the fourth quarter of 2003. The Company issued 233,333 shares of its common stock during the first quarter 2003 for prepaid public relation services to be provided in future periods. The Company issued 133,333 shares of its common stock as a charitable contribution during the first quarter 2003. The Company issued 39,702 shares of its common stock for professional services provided during the first quarter 2003. The Company issued 49,231 shares of its common stock for professional services provided during the second quarter 2003. The Company expects that its existing cash resources and cash flow generated from operations will be sufficient to meet its operating requirements and ordinary capital expenditure needs during the next twelve months. Trends The following is a description of certain trends, events and uncertainties that may affect the Company's future financial results. Due to the potential for change in factors associated with our business, it is impossible to predict or quantify future changes in the Company's business, results of operations and financial condition. See "-Cautionary Statement Concerning Forward-Looking Statements." Resignation of Garn & Willis and Threatened Litigation. As disclosed in Part II, Item 1, James Randolph Garn and Ethan Andrew Willis resigned as Officers of the Company and as members of the Company's Board of Directors and have informed the Company that they are prepared to file a suit to rescind the Company's December 31, 2001 acquisition from them of the Company's operating subsidiary, Energy Professional Marketing Group, Inc., unless the Company reaches a negotiated compromise with them effecting a rescission of the acquisition. The Company is not aware of any such complaint being filed. The Company is investigating this matter and the parties have attempted to negotiate a resolution of this matter. The commencement of litigation or any adverse determination in such litigation could have a material adverse effect on the Company's business, financial condition and results of operations. 23 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) SEC Investigation. As disclosed in Part II, Item 1, the Securities and Exchange Commission issued a formal order of investigation with respect to the Company, authorizing the investigation of certain securities matters relating to the Company. The Company cannot predict the length or potential outcome of the SEC investigation, or the potential impact of the investigation on the Company. If the SEC's investigation results in any formal adverse determination, which may include a fine or other remedies, the Company's financial condition, results of operations and business could be materially adversely affected. The Company has incurred, and may continue to incur, significant legal and other costs in connection with this investigation. Reliance on Education Success Institute, Inc. (ESI). As disclosed in the "Related Party Transactions" section above, the Company has increasingly relied on ESI to provide the Company with sales leads. As a percentage of the overall sales leads provided to the Company for the three months ended September 30, 2003, 89% of the leads were provided by ESI. This is compared to 57% for the three months ended June 30, 2003. ESI is owned by James Randolph Garn and Ethan Andrew Willis, who have threatened litigation against the Company relating to the Company's December 31, 2001 acquisition from them of the Company's operating subsidiary, Energy Professional Marketing Group, Inc. If the lead generation provided by ESI were to cease for any reason, the Company's financial condition, results of operations and business could be materially adversely affected. Internet Marketing Programs. A substantial portion of the Company's sales are developed through marketing programs on the Internet. In the Company's experience, specific marketing programs or methods of marketing on the Internet generally have limited periods of effectiveness. The Company may not rely upon any single marketing program or method of marketing for any significant period of time. In order to continue to market effectively on the Internet, the Company must continue to adapt its current marketing programs and develop new effective programs. Any failure by the Company to continue to develop effective Internet marketing programs could have a material adverse effect on the Company's business, results of operations and financial condition. Retention of Sales Personnel. The Company's business is substantially dependent upon the Company's ability to attract and retain effective sales personnel. Any substantial turnover among sales personnel or the loss of key sales personnel could have a material adverse effect on the Company's business, results of operations and financial condition. Valuation of the 2002 Sale of Business Development Series for Stock. As noted in Note C - Investment Securities, the Company has retained a valuation firm to determine the value of the 875,000 shares of preferred stock of the Knowledge Transfer Systems, Inc., as of the time of their transfer to the Company on September 23, 2002, to determine the tax consequences of the transaction. The results of this valuation cannot be predicted at this time. However, should the valuation be substantially lower than the previously reported amount, the Company may need to restate its SEC filing for the third quarter of 2002 and for the 2002 year. In the event such a restatement is required the Company expects the effect to be limited as the entire amount of this consideration was written off at the end of 2002. However, if the valuation of the preferred stock exceeds approximately $300,000, the Company will be required to accrue tax liability relating to the excess. Cautionary Statement Concerning Forward-Looking Statements Certain statements contained in this Quarterly Report on Form 10-QSB that are not statements of historical fact may constitute "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. These statements are subject to risks and uncertainties, as described below. Examples of forward-looking statements include, but are not limited to: (i) projections of revenues, income or loss, earnings or loss per share, capital expenditures, the payment or non-payment of dividends, capital structure and other financial items, (ii) statements of plans and objectives of the Company's management or Board of Directors, including plans or objectives relating to the Company's products or services, (iii) statements of future economic performance, and (iv) statements of assumptions underlying the statements described in (i), (ii) and (iii). Forward-looking statements can often be identified by the use of forward-looking terminology, such as "believes," "expects," "may," "will," "should," "could," "intends," "plans," "estimates" or "anticipates," variations thereof or similar expressions. 24 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Forward-looking statements are not guarantees of future performance or results. They involve risks, uncertainties and assumptions. The Company's future results of operations, financial condition and business operations may differ materially from those expressed in these forward-looking statements. Investors are cautioned not to put undue reliance on any forward-looking statement. There are a number of factors that could cause actual results to differ materially from those discussed in the forward-looking statements, including those factors described below. Other factors not identified herein could also have such an effect. The Company provides a detailed discussion of risk factors in various SEC filings, including its Form 10-KSB for the fiscal year ended December 31, 2002, and readers are encouraged to review these filings. Among the factors that could cause actual results to differ materially from those discussed in the forward-looking statements are the following: o the outcome of the current dispute between the Company and Garn and Willis regarding the acquisition of Energy Professional Marketing Group, Inc. by the Company from Garn and Willis; o the Company's ability to generate sales leads in a cost-effective manner; o the Company's ability to develop strategic relationships with other businesses; o the level of competition in the Company's industry; o the rate of growth of the Internet and online commerce; o the Company's ability to manage rapid growth in its business; o customer spending patterns; o the mix of products sold to customers; o the mix of net sales derived from products as compared with services; o the Company's ability to develop new products and services that keep up with rapid technological change; o the Company's ability to attract and retain qualified personnel; o the Company's ability to retain senior management and other key employees; o the outcome of the current SEC investigation involving the Company; o the effects, if any, of the valuation of the 2002 Sale of the Business Development Series eLearning Software for stock o changes in general economic conditions. All statements herein are made as of the date of this report. The Company does not undertake to publicly release any revisions to forward-looking statements to reflect events occurring or information obtained after the date of this report. Item 3. Controls and Procedures The Company maintains disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) that are designed to ensure that information required to be disclosed in the Company's reports under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms, and that such information is accumulated and communicated to the Company's management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. Any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of the Company's disclosure controls 25 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) and procedures as of September 30, 2003. Based upon that evaluation and subject to the foregoing, the Company's Chief Executive Officer and Chief Financial Officer concluded that the design and operation of the Company's disclosure controls and procedures provided reasonable assurance that the disclosure controls and procedures are effective to accomplish their objectives. In addition, there was no change in the Company's internal control over financial reporting that occurred during the quarter ended September 30, 2003 that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. PART II - OTHER INFORMATION Item 1. Legal Proceedings Resignation of Garn & Willis and Threatened Litigation. On September 26, 2003, the Company received, by certified mail and hand delivery, letters from James Randolph Garn and Ethan Andrew Willis stating that each was resigning immediately as an Officer of the Company and as a member of the Company's Board of Directors (the "Letters"). The Letters also indicate that neither Garn nor Willis is resigning from positions as an officer or director of the operating subsidiary, Energy Professional Marketing Group, Inc. (EPMG). The Letters did not state a reason for the resignations of Garn or Willis; however, the Company did receive a Memorandum dated September 26, 2003 ("Memorandum") from the law firm of Holme Roberts & Owen LLP, which represents Garn and Willis. The Memorandum alleges that Garn and Willis are entitled to rescind the Company's December 31, 2001 acquisition of EPMG from Garn and Willis because they were defrauded in connection with this acquisition. This acquisition was reported in the Company's Current Report on Form 8-K filed with the Securities and Exchange Commission on January 15, 2002. The Memorandum states that Garn and Wills are prepared to file a suit to effect this rescission unless the Company reaches a negotiated compromise with Garn and Willis affecting a rescission of the acquisition. The Company is not aware of any such complaint being filed. The Company is investigating this matter and the parties have attempted to negotiate a resolution of this matter. The commencement of litigation or any adverse determination in such litigation could have a material adverse effect on the Company's business, financial condition and results of operations. SEC Investigation. As previously disclosed, on June 24, 2003, the Securities and Exchange Commission ("SEC") issued a formal order of investigation with respect to the Company, authorizing the investigation of certain securities matters relating to the Company. The SEC staff has taken the testimony of certain officers of the Company and has informed the Company that it intends to take additional testimony. The SEC staff has also issued additional requests for the voluntary production of documents. Prior to the issuance of the order, the Company had voluntarily provided documents and information to the SEC staff in response to informal, non-public inquiries by the staff. The Company intends to fully cooperate with the SEC in its investigation. The Company cannot predict the length or potential outcome of the SEC investigation, or the potential impact of the investigation on the Company. If the SEC's investigation results in any formal adverse determination, which may include a fine or other remedies, the Company's financial condition, results of operations and business could be materially adversely affected. The Company has incurred, and may continue to incur, significant legal and other costs in connection with this investigation. In addition, the Company has formed a committee of independent directors of the Company to investigate the matters raised by Grant Thornton LLP in a letter to the Company dated April 4, 2003, which is filed as Exhibit 99.2 to the Current Report on Form 8-K filed by the Company on April 24, 2003. The committee is also authorized to investigate such other matters relating to the Company as it deems advisable. IMI Litigation. On or about September 5, 2003, a lawsuit was filed by Independent Marketing, Inc. (IMI) against certain employees of the Company. The lawsuit was filed in the Fourth Judicial District Court of Utah County, State of Utah as Case No. 030403929. While the Company was initially named as a Defendant, the Company was not named in the Amended Complaint filed in this lawsuit, In the lawsuit, IMI is claiming that these employees have breached certain employment and non-compete agreements and IMI is seeking compensatory damages and injunctive relief. Although the Company is not a party to the litigation, because the lawsuit affects certain employees of the Company, some or all of whom are key employees, the Company's operating results and competitive position may be adversely affected in the event of a Court ruling which limits those employees' involvement with the Company. 26 INNOVATIVE SOFTWARE TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) The Company is subject to various other claims and lawsuits from time to time in the ordinary course of business. Management does not believe that the outcome of these other matters will have a material adverse effect on the Company's financial condition, results of operations or business. Item 3. Defaults upon Senior Securities (b) There has not been any material arrearage in the payment of dividends on any preferred stock. The Company has withheld a dividend payment of 137,942 shares of common stock payable on Series A Preferred Stock to two stockholders in connection with a dispute with such stockholders. Item 6. Exhibits and Reports on Form 8-K. a. Exhibits The exhibits required by this item are listed in the Index to Exhibits set forth at the end of this Form 10-QSB. b. Reports of Form 8-K During the period covered by this report, the Company filed the following report on Form 8-K: On October 3rd, 2003, the Company filed a Current Report on Form 8-K regarding the receipt of letters of resignation from officers and directors James Randolph Garn and Ethan Andrew Willis, and the receipt of a Memorandum dated September 26, 2003 from the law firm of Holme Roberts & Owen LLP, which represents Garn and Willis. The Memorandum alleges that Garn and Willis are entitled to rescind the Company's December 31, 2001 acquisition of the Subsidiary from Garn and Willis because they were defrauded in connection with this acquisition. The Memorandum states that Garn and Wills are prepared to file a suit to effect this rescission unless the Company reaches a negotiated compromise with Garn and Willis affecting a rescission of the acquisition. 27 SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. INNOVATIVE SOFTWARE TECHNOLOGIES, INC. Date: October 19, 2004 /s/ Peter M. Peterson ------------------------ Peter M. Peterson Chief Executive Officer and Director /s/ Christopher J. Floyd ------------------------ Christopher J. Floyd Chief Financial Officer 28 INDEX TO EXHIBITS Exhibit Number Description ------ ----------- 3.1 Amendment to the Articles of Incorporation of Innovative Software Technologies, Inc.* 3.2 Articles of Incorporation of Innovative Software Technologies, Inc., as amended.* 3.3 Certificate of Designation of the Series A Preferred Stock of Innovative Software Technologies, Inc. (incorporated by reference from Exhibit 2.2 to the Company's Current Report on Form 8-K/A filed March 14, 2002). 3.4 Certificate of Designation of the Series B Preferred Stock of Innovative Software Technologies, Inc.* 3.5 By-laws of Innovative Software Technologies, Inc. (incorporated by reference from Exhibit 3(b) to the Company's Annual Report on Form 10-KSB for the year ended December 31, 1999). 4.1 Specimen Certificate of Common Stock (incorporated by reference from Exhibit 4(a) to the Company's Annual Report on Form 10-KSB for the year ended December 31, 1999). 4.2 Articles FOURTH and FIFTH of the Articles of Incorporation of Innovative Software Technologies, Inc., as amended (incorporated by reference from Exhibit 3.2 to this Quarterly Report on Form 10-QSB). 4.3 Certificate of Designation of the Series A Preferred Stock of Innovative Software Technologies, Inc. (incorporated by reference from Exhibit 2.2 to the Company's Current Report on Form 8-K/A filed March 14, 2002). 4.4 Certificate of Designation of the Series B Preferred Stock of Innovative Software Technologies, Inc. (incorporated by reference from Exhibit 3.4 to this Quarterly Report on Form 10-QSB). 4.5 Sections 3 - 17, 28, 39 - 46 and 51 - 53 of the By-laws of Innovative Software Technologies, Inc. (incorporated by reference from Exhibit 3(b) to the Company's Annual Report on Form 10-KSB for the year ended December 31, 1999). 4.6 Financing Agreement dated January 25, 2001 among Iwasaka Investments Limited, Shane Hackett and Hackett Media, Inc.* 4.7 Amendment to Finance Agreement dated December 31, 2001 between Iwasaka Investments Limited and Innovative Software Technologies Executive Compensation Plans and Arrangements: Exhibits 10.2, 10.3, 10.4, 10.5 and 10.6 to the Quarterly Report on Form 10-QSB for fiscal quarter ended September 30, 2003 29 10.1 Opportunity and Strategic Alliance Agreement dated September 1, 2002 by and between Energy Professional Marketing Group, Inc. and Education Success, Inc.* 10.2 Employment Agreement dated April 15, 2001 between Innovative Software Technologies, Inc. and Douglas S. Hackett.* 10.3 Employment Agreement dated December 31, 2001 between Energy Professional Marketing Group, Inc. and James R. Garn.* 10.4 Amendment dated July 15, 2002 to the Employment Agreement between Energy Professional Marketing Group, Inc. and James R. Garn.* 10.5 Employment Agreement dated December 31, 2001 between Energy Professional Marketing Group, Inc. and Ethan A. Willis.* 10.6 Amendment dated July 15, 2002 to the Employment Agreement between Energy Professional Marketing Group, Inc. and Ethan A. Willis.* 10.7 Indemnity Agreement dated August 17, 2001 between Innovative Software Technologies, Inc. and Douglas Shane Hackett.* 10.8 Indemnity Agreement/Hold Harmless Agreement dated August 17, 2001 among Innovative Software Technologies, Inc. and Scott Mehaffey, Shawn M. Thomas, Margie Hackett and Douglas S. Hackett.* 10.9 Indemnity Agreement dated August 17, 2001 between Innovative Software Technologies, Inc. and Margie Hackett.* 10.10 Indemnity Agreement dated August 17, 2001 between Innovative Software Technologies, Inc. and Scott Mehaffey.* 10.11 Indemnity Agreement dated August 17, 2001 between Innovative Software Technologies, Inc. and Margie Hackett.* 10.12 Indemnity Agreement dated August 17, 2001 between Innovative Software Technologies, Inc. and Shawn M. Thomas.* 10.13 Indemnity Agreement dated January 9, 2002 among Innovative Software Technologies, Inc. and Ethan Willis and Randy Garn.* 10.14 Indemnity Agreement dated August 16, 2002 among Innovative Software Technologies, Inc. and Ethan Willis and Randy Garn.* 30 10.15 Indemnity Agreement dated August 15, 2002 among Innovative Software Technologies, Inc. and Douglas Shane Hackett.* 10.16 Director Indemnification Agreement dated September 15, 2003 between Innovative Software Technologies, Inc. and Peter Justen 10.17 Director Indemnification Agreement dated August 14, 2003 between Innovative Software Technologies, Inc. and Peter M. Peterson 10.18 Director Indemnification Agreement dated August 4, 2003 between Innovative Software Technologies, Inc. and William E. Leathem 21 Subsidiaries of the Registrant.* 31.1 Certification of Chief Executive Officer of Innovative Software Technologies, Inc. dated November 19, 2003. 31.2 Certification of Chief Financial Officer of Innovative Software Technologies, Inc. dated November 19, 2003. 32.1 Certification of Chief Executive Officer of Innovative Software Technologies, Inc. dated November 19, 2003, which is accompanying this Quarterly Report on Form 10-QSB for the quarter ended September 30, 2003 and is not treated as filed in reliance on Section 601(b)(32) of Regulation S-B. 32.2 Certification of Chief Financial Officer of Innovative Software Technologies, Inc. dated November 19, 2003, which is accompanying this Quarterly Report on Form 10-QSB for the quarter ended September 30, 2003 and is not treated as filed in reliance on Section 601(b)(32) of Regulation S-B. 99.1 Resignation Letter dated September 26, 2003 from James Randolph Garn to the Company.** 99.2 Resignation Letter dated September 26, 2003 from Ethan Andrew Willis to the Company.** 99.3 Memorandum of Holme Roberts & Owen LLP dated September 26, 2003.** * Incorporated by reference from the exhibit to the Company's Quarterly Report on Form 10-QSB for the fiscal quarter ended June 30, 2003 which bears the same exhibit number. ** Incorporated by reference from the exhibit to the Company's Current Report on Form 8-K filed with the Commission on October 3, 2003 which bears the same exhibit number. 31