10-Q

U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2011

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the transition period from __________ to __________.

Commission file number 001-31972

TELKONET, INC.

(Exact name of Issuer as specified in its charter)

Utah	87-0627421
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)
10200 Innovation Drive, Suite 300, Milwaukee, WI	53226
(Address of Principal Executive Offices)	(Zip Code)

(414) 223-0473

(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

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

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

Large accelerated filer o	Accelerated filer o
Non-accelerated filer o	Smaller reporting company x
(Do not check if a smaller reporting company)

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

Indicate the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: 102,037,171 shares of Common Stock ($.001 par value) as of August 04, 2011.

TELKONET, INC.

FORM 10-Q for the Quarter Ended June 30, 2011

Index

	Page
PART I. FINANCIAL INFORMATION	2
Item 1. Financial Statements (Unaudited)	2
Condensed Consolidated Balance Sheets:	2
June 30, 2011 and December 31, 2010
Condensed Consolidated Statements of Operations:	3
Three And Six Months Ended June 30, 2011 and 2010
Condensed Consolidated Statement of Stockholders’ Equity:	4
January 1, 2011 through June 30, 2011
Condensed Consolidated Statements of Cash Flows:	5
Six Months Ended June 30, 2011 and 2010
Notes to Condensed Consolidated Financial Statements (Unaudited)	7
Item 2. Management’s Discussion and Analysis	19
Item 4. Controls and Procedures	26
PART II. OTHER INFORMATION	26
Item 1. Legal Proceedings	26
Item 1A. Risk Factors	27
Item 2. Unregistered Sales of Equity Securities	27
Item 6. Exhibits	27

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

TELKONET, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

	(Unaudited) June 30, 2011				December 31, 2010
ASSETS
Current assets:
Cash and cash equivalents		$	882,484		$	136,030
Accounts receivable, net			1,245,055			799,185
Inventories			595,968			599,402
Other current assets			265,475			197,565
Total current assets			2,988,982			1,732,182
Property and equipment, net			64,177			112,997
Other assets:
Deferred financing costs, net			-			56,732
Goodwill			11,670,446			11,670,446
Intangible assets, net			1,862,817			1,983,657
Total other assets			13,533,263			13,710,835
Total Assets		$	16,586,422		$	15,556,014
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	1,871,198		$	2,402,950
Accrued liabilities and expenses			1,110,529			1,157,873
Note payable – current			85,768			47,536
Note payable – related party			-			25,114
Convertible debentures, net of debt discounts of $134,625			-			1,471,398
Derivative liability - current			-			619,698
Other current liabilities			89,063			170,033
Total current liabilities			3,156,558			5,894,602
Long-term liabilities:
Derivative liability – long term			-			1,282,077
Deferred lease liability			98,218			-
Note payable – long term			928,322			252,464
Total long-term liabilities			1,026,540			1,534,541
Commitments and contingencies
Temporary Equity:
Redeemable preferred stock, Series A; par value $.001 per share; 215 shares     authorized, issued and outstanding at June 30, 2011 and December 31, 2010, net			968,701			890,475
Redeemable preferred stock, Series B; par value $.001 per share; 538 shares authorized and issued,  533 outstanding at June 30, 2011, 267 shares authorized, issued and outstanding at December 31, 2010, net			1,363,222			653,371
Stockholders’ Equity
Permanent Equity:
Preferred stock, undesignated, par value $.001 per share; 15,000,000 shares authorized; 748 issued and outstanding at June 30, 2011; 482 issued and outstanding at December 31, 2010			-			-
Common stock, par value $.001 per share; 190,000,000 shares authorized; 102,037,171 and 101,258,725  shares issued and outstanding at June 30, 2011 and December 31, 2010, respectively			102,039			101,261
Additional paid-in-capital			124,387,048			121,995,117
Accumulated deficit			(114,417,686	)		(115,513,353	)
Total stockholders’ equity			10,071,401			6,583,025
Total Liabilities and Stockholders’ Equity		$	16,586,422		$	15,556,014

See accompanying notes to the condensed consolidated financial statements

2

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

	For The Three Months Ended June 30,						For The Six Months Ended June 30,
	2011			2010			2011			2010
Revenues, net:
Product	$	1,776,888		$	1,970,286		$	3,127,960		$	3,536,737
Recurring		1,151,048			1,213,115			2,282,675			2,230,704
Total Revenue		2,927,936			3,183,401			5,410,635			5,767,441
Cost of Sales:
Product		1,017,894			1,012,124			1,726,164			1,911,907
Recurring		291,247			326,062			555,116			631,907
Total Cost of Sales		1,309,141			1,338,186			2,281,280			2,543,814
Gross Profit		1,618,795			1,845,215			3,129,355			3,223,627
Operating Expenses:
Research and development		184,207			264,049			371,318			529,900
Selling, general and administrative		1,224,178			1,304,845			2,310,722			2,995,584
Depreciation and amortization		86,235			77,790			165,180			158,200
Total Operating Expenses		1,494,620			1,646,684			2,847,220			3,683,684
Income (Loss) from Operations		124,175			198,531			282,135			(460,057	)
Other Income (Expenses):
Financing expense, net		(10,986	)		(155,547	)		(190,406	)		(324,293	)
Gain on derivative liability		-			541,326			172,477			696,793
Gain on sale of asset		-			-			829,296			-
Gain (loss) on disposal of fixed asset		-			(100,744	)		2,165			(100,744	)
Total Other Income (Expense)		(10,986	)		285,035			813,532			271,756
Income (Loss) Before Provision for Income Taxes		113,189			483,566			1,095,667			(188,301	)
Provision for Income Taxes		-			-			-			-
Net Income (Loss)		113,189			483,566			1,095,667			(188,301	)
Accretion of preferred dividends and discount		(170,800	)		(39,347	)		(313,867	)		(78,460	)
Net income (loss) attributable to common shareholders	$	(57,611	)	$	444,219		$	781,800		$	(266,761	)
Net income  per share:
Income per share from continuing operations - basic	$	0.00		$	0.00		$	0.01		$	0.00
Income per share from continuing operations - diluted	$	0.00		$	0.00		$	0.01		$	0.00
Weighted Average Common Shares Outstanding - basic		102,878,097			96,916,357			101,475,906			96,714,804
Weighted Average Common Shares Outstanding - diluted		104,404,580			97,140,595			103,002,389			96,714,804

See accompanying notes to the condensed consolidated financial statements

3

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (UNAUDITED)

FOR THE PERIOD FROM JANUARY 1, 2011 THROUGH JUNE 30, 2011

	Common Shares		Common Stock Amount		Additional Paid in Capital			Accumulated Deficit			Total Stockholders’ Equity
Balance at January 1, 2011		101,258,725	$	101,261	$	121,995,117		$	(115,513,353	)	$	6,583,025
Shares issued to director and management at approximately $0.125 per share		409,056		409		55,091			-			55,500
Shares issued to director for consulting fees at approximately $0.15 per share (1)		177,083		177		24,823			-			25,000
Shares issued on conversion of preferred stock at approximately $0.18 per share		192,307		192		24,808			-			25,000
Stock-based compensation expense related to employee stock options		-		-		15,988			-			15,988
Warrants issued with redeemable convertible preferred stock		-		-		427,895			-			427,895
Beneficial conversion feature of redeemable convertible preferred stock		-		-		427,895			-			427,895
Retirement of secured convertible debentures		-		-		1,158,729			-			1,158,729
Retirement of derivative liability related to warrant obligation		-		-		570,569			-			570,569
Accretion of preferred stock discount		-		-		(193,797	)		-			(193,797	)
Accretion of preferred stock dividend		-		-		(120,070	)		-			(120,070	)
Net Income									1,095,667			1,095,667
Balance at June 30, 2011		102,037,171	$	102,039	$	124,387,048		$	(114,417,686	)	$	10,071,401

See accompanying notes to the condensed consolidated financial statements 

(1) Fees incurred prior to, but not paid until after, election to Board of Directors

4

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

	For the Six Months Ended June 30,
	2011			2010
Cash Flows from Operating Activities:
Net income (loss)	$	1,095,667		$	(188,301	)
Adjustments to reconcile net income (loss) from operations to cash used in operating activities:
Amortization of debt discounts and financing costs		191,357			254,120
Gain on sale of asset		(829,296	)		-
Gain on derivative liability		(172,477	)		(696,793	)
(Gain) loss on disposal of fixed assets		(2,165	)		100,744
Stock based compensation		96,488			88,181
Depreciation and amortization		165,180			158,200
Bad debt expense (recoveries)		(56,620	)		31,879
Increase / decrease in:
Accounts receivable, trade and other		(389,250	)		(762,451	)
Inventories		(117,270	)		219,051
Other current assets		(67,910	)		(187,713	)
Other current liabilities		(80,970	)		42,212
Accounts payable, accrued liabilities & expenses, net		(579,096	)		827,855
Deferred lease liability		98,218			-
Net Cash Used In Operating Activities		(648,144	)		(113,016	)
Cash Flows From Investing Activities:
Proceeds on disposal of asset		6,645			-
Proceeds from sale of assets		1,000,000			-
Net Cash Provided by Investing Activities		1,006,645			-
Cash Flows From Financing Activities:
Repayment on line of credit		-			(288,417	)
Proceeds from issuance of note payable		700,000			-
Payments on long term note payable		(35,910	)		-
Payments on note payable – related party		(25,114	)		-
Proceeds from issuance of preferred stock		1,355,000			-
Repayment of Convertible Debentures		(1,606,023	)		-
Net Cash Provided By (Used In) Financing Activities		387,953			(288,417	)
Net increase (decrease) in cash and cash equivalents		746,454			(401,433	)
Cash and cash equivalents at the beginning of the period		136,030			503,870
Cash and cash equivalents at the end of the period	$	882,484		$	102,437

See accompanying notes to the condensed consolidated financial statements

5

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(UNAUDITED)

	For the Six Months Ended June 30,
Supplemental Disclosures of Cash Flow Information:	2011		2010
Cash transactions:
Cash paid during the period for financing expenses	$	203,174	$	301,351
Income taxes paid		-		-
Non-cash transactions:
Common stock issuance to pay off accounts payable	$	-	$	62,957
Issuance of note payable in conjunction with warrant cancellation		50,000		-
Beneficial conversion feature of redeemable convertible preferred stock		427,895		-
Value of warrants issued with redeemable convertible preferred stock		427,895		-
Accretion of discount on redeemable preferred stock		193,797		35,802
Accretion of dividend on redeemable preferred stock		120,070		42,658

See accompanying notes to the condensed consolidated financial statements

6

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

  

NOTE A - SUMMARY OF ACCOUNTING POLICIES

A summary of the significant accounting policies applied in the preparation of the accompanying consolidated financial statements follows.

General

The accompanying unaudited condensed consolidated financial statements of Telkonet, Inc. (the “Company”) have been prepared in accordance with Rule S-X of the Securities and Exchange Commission (the “SEC”) and with the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  However, the results from operations for the three and six month periods ended June 30, 2011, are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.  The unaudited condensed consolidated financial statements should be read in conjunction with the consolidated December 31, 2010 financial statements and footnotes thereto included in the Company's Form 10-K filed with the SEC.

Business and Basis of Presentation

Telkonet, Inc., formed in 1999 and incorporated under the laws of the state of Utah, has evolved into a Clean Technology company that develops, manufactures and sells proprietary energy efficiency and SmartGrid networking technology. Prior to January 1, 2007, the Company was primarily engaged in the business of developing, producing and marketing proprietary equipment enabling the transmission of voice and data communications over a building’s internal electrical wiring.

In March 2007, the Company acquired substantially all of the assets of Smart Systems International (SSI), a leading provider of energy management products and solutions to customers in the United States and Canada.

In March 2007, the Company acquired 100% of the outstanding membership units of EthoStream, LLC, a network solutions integration company that offers installation, sales and service to the hospitality industry. The EthoStream acquisition enabled Telkonet to provide installation and support for PLC products and third party applications to customers across North America.

In March 2011, the Company sold all its Series 5 PLC product line assets to Wisconsin-based Dynamic Ratings, Inc. under an Asset Purchase Agreement.

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Telkonet Communications, Inc., and EthoStream, LLC. Significant intercompany transactions have been eliminated in consolidation.

Going Concern

The accompanying condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplate continuation of the Company as a going concern. The Company has reported net income from continuing operations of $1,095,667 for the six month period ended June 30, 2011, accumulated deficit of $114,417,686 and total current liabilities in excess of current assets of $167,576 as of June 30, 2011.

Concurrent with the first quarter debenture retirement, the second quarter equity raise and our year to date operating results, the Company believes anticipated revenues and its’ continued operational efficiencies will be sufficient to satisfy its ongoing capital and cash flow requirements for the remainder of fiscal 2011.  However, the Company also believes there remains sufficient uncertainty, both in the economic environment and our current deficit position, that the Company cannot make any representations for fiscal 2012.   

7

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

   
Fair Value of Financial Instruments

The company accounts for the fair value of financial instruments in accordance with ASC 820, which defines fair value for accounting purposes, established a framework for measuring fair value and expand disclosure requirements regarding fair value measurements.  Fair value is defined as an exit price, which is the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date.  The degree of judgment utilized in measuring the fair value of assets and liabilities generally correlates to the level of pricing observability.  Financial assets and liabilities with readily available, actively quoted prices or for which fair value can be measured from actively quoted prices in active markets generally have more pricing observability and require less judgment in measuring fair value.  Conversely, financial assets and liabilities that are rarely traded or not quoted have less price observability and are generally measured at fair value using valuation models that require more judgment.  These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency of the asset, liability or market and the nature of the asset or liability.  We have categorized our financial assets and liabilities that are recurring, at fair value into a three-level hierarchy in accordance with these provisions.

Goodwill and Other Intangibles

Goodwill represents the excess of the cost of businesses acquired over fair value or net identifiable assets at the date of acquisition.  Goodwill is subject to a periodic impairment assessment by applying a fair value test based upon a two-step method.  The first step of the process compares the fair value of the reporting unit with the carrying value of the reporting unit, including any goodwill.  We utilize a discounted cash flow valuation methodology to determine the fair value of the reporting unit.  If the fair value of the reporting unit exceeds the carrying amount of the reporting unit, goodwill is deemed not to be impaired in which case the second step in the process is unnecessary.  If the carrying amount exceeds fair value, we perform the second step to measure the amount of impairment loss.  Any impairment loss is measured by comparing the implied fair value of goodwill with the carrying amount of goodwill at the reporting unit, with the excess of the carrying amount over the fair value recognized as an impairment loss.

Long-Lived Assets

We review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable in accordance with ASC 360-10. Recoverability is measured by comparison of the carrying amount to the future net cash flows which the assets are expected to generate.  If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the projected discounted future cash flows arising from the asset using a discount rate determined by management to be commensurate with the risk inherent to our current business model.

Income per Common Share

The Company computes earnings per share under ASC 260-10, Earnings Per Share.  Basic net income per common share is computed by dividing net income (loss) by the weighted average number of shares of common stock.  Diluted earnings per share is computed using the weighted average number of common and common stock equivalent shares outstanding during the period. There is no effect on diluted income per share since the common stock equivalents are anti-dilutive. Dilutive common stock equivalents consist of shares issuable the exercise of the Company's stock options and warrants.

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect certain reported amounts and disclosures.  Accordingly, actual results could differ from those estimates.

Income Taxes

The Company accounts for income taxes in accordance with ASC 740-10 “Income Taxes.” Under this method, deferred taxes (when required) are provided based on the difference between the financial reporting and income tax bases of assets and liabilities and net operating losses at the statutory rates enacted for future periods. The Company has a policy of establishing a valuation allowance when it is more likely than not that the Company will not realize the benefits of its deferred tax assets in the future.

The Company has adopted the Financial Accounting Standards Board (“FASB”) issued ASC 740-10-25, which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC 740-10-25 also provides guidance on derecognition, classification, treatment of interest and penalties, and disclosure of such positions. 

8

  

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

Revenue Recognition

For revenue from product sales, we recognize revenue in accordance with ASC 605-10, and ASC Topic 13 guidelines that require that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the selling price is fixed and determinable; and (4) collectability is reasonably assured.  Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the selling prices of the products delivered and the collectability of those amounts.  Provisions for discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period the related sales are recorded.  We defer any revenue for which the product has not been delivered or is subject to refund until such time that we and the customer jointly determine that the product has been delivered or no refund will be required.  The guidelines also address the accounting for arrangements that may involve the delivery or performance of multiple products, services and/or rights to use assets.

Stock Based Compensation

We account for our stock based awards in accordance with ASC 718-10, Compensation, which requires a fair value measurement and recognition of compensation expense for all share-based payment awards made to our employees and directors, including employee stock options and restricted stock awards. We estimate the fair value of stock options granted using the Black-Scholes valuation model. This model requires us to make estimates and assumptions including, among other things, estimates regarding the length of time an employee will retain vested stock options before exercising them, the estimated volatility of our common stock price and the number of options that will be forfeited prior to vesting. The fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. Changes in these estimates and assumptions can materially affect the determination of the fair value of stock-based compensation and consequently, the related amount recognized in our consolidated statements of operations.

The expected term of the options represents the estimated period of time until exercise and is based on historical experience of similar awards, giving consideration to the contractual terms, vesting schedules and expectations of future employee behavior. For 2011 and prior years, expected stock price volatility is based on the historical volatility of the Company’s stock for the related vesting periods.

Stock-based compensation expense in connection with options granted to employees for the six months ended June 30, 2011 and 2010 was $15,988 and $88,181, respectively.

Deferred Lease Liability

Rent expense is recorded on a straight-line basis over the term of the lease. Rent escalations and rent abatement periods during the term of the lease create a deferred lease liability which represents the excess of cumulative rent expense recorded to date over the actual rent paid to date.

Reclassifications

Certain reclassifications have been made in prior year's financial statements to conform to classifications used in the current year.

NOTE B - NEW ACCOUNTING PRONOUNCEMENTS

During December 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2010-28, “Intangibles—Goodwill and Other (Topic 350):  When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts—a consensus of the FASB Emerging Issues Task Force.”  ASU No. 2010-28 requires entities with reporting units with zero or negative carrying amounts to perform step 2 of the goodwill impairment test if qualitative factors indicate that it is more likely than not that a goodwill impairment exists.  Any goodwill impairment recorded upon the adoption of ASU No. 2010-28 is required to be recorded as a cumulative-effect adjustment to beginning retained earnings.  ASU No. 2010-28 is effective for fiscal years beginning after December 15, 2010. The company is currently assessing the effect that ASU No. 2010-28 will have on its results of operations, financial position and cash flows.

9

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

NOTE C - INTANGIBLE ASSETS AND GOODWILL

Total identifiable intangible assets acquired and their carrying values at June 30, 2011 are:

	Cost		Accumulated Amortization			Net Book Value		Residual Value		Weighted Average Amortization Period (Years)
Amortized Identifiable Intangible Assets:
Subscriber lists – EthoStream	$	2,900,000	$	(1,037,183	)	$	1,862,817	$	-		12.0
Total Amortized Identifiable Intangible Assets		2,900,000		(1,037,183	)		1,862,817		-
Goodwill – EthoStream	5,796,430			-			5,796,430		-
Goodwill – SSI	5,874,016			-			5,874,016		-
Total	$	14,570,446	$	(1,037,183	)	$	13,533,263	$	-

Total identifiable intangible assets acquired and their carrying values at December 31, 2010 are:

	Cost		Accumulated Amortization			Net Book Value		Residual Value		Weighted Average Amortization Period (Years)
Amortized Identifiable Intangible Assets:
Subscriber lists – EthoStream	$	2,900,000	$	(916,343	)	$	1,983,657	$	-		12.0
Total Amortized Identifiable Intangible Assets		2,900,000		(916,343	)		1,983,657		-
Goodwill – EthoStream	5,796,430			-			5,796,430		-
Goodwill – SSI	5,874,016			-			5,874,016		-
Total	$	14,570,446	$	(916,343	)	$	13,654,103	$	-

Total amortization expense charged to operations for both the three and six months ended June 30, 2011 and 2010 was $60,420 and $120,840, respectively.

Estimated amortization expense as of June 30, 2011 is as follows:

Remainder of 2011	$	120,840
2012		241,680
2013		241,680
2014		241,680
2015 and after		1,016,937
Total	$	1,862,817

The Company does not amortize goodwill. The Company recorded goodwill in the amount of $14,670,455 as a result of the acquisitions of EthoStream and SSI during the year ended December 31, 2007.   The Company evaluates goodwill for impairment based on the fair value of the operating business units to which this goodwill relates at least once a year. The Company generally determines the fair value of a reporting unit using a combination of the income approach, which is based on the present value of estimated future cash flows, and the market approach, which compares the business unit's multiples to its competitors.  

NOTE D - ACCOUNTS RECEIVABLE

Components of accounts receivable as of June 30, 2011 and December 31, 2010 are as follows:

	June 30, 2011			December 31, 2010
Accounts receivable	$	1,370,055		$	974,185
Allowance for doubtful accounts		(125,000	)		(175,000	)
Total	$	1,245,055		$	799,185

10

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

   

NOTE E - INVENTORY

Inventories as of June 30, 2011 and December 31, 2010 are as follows:

	June 30, 2011			December 31, 2010
Inventory, gross	$	735,968		$	799,402
Reserve for obsolescence		(140,000	)		(200,000	)
Inventory, Net	$	595,968		$	599,402

NOTE F - LONG TERM DEBT

Senior Convertible Debenture

A summary of convertible debentures payable at June 30, 2011 and December 31, 2010 is as follows:

	June 30, 2011		December 31, 2010
Senior Convertible Debentures, accrue interest at 13% per annum and mature on May 29, 2011	$	-	$	1,606,023
Debt Discount - beneficial conversion feature, net of accumulated amortization of $733,756 at December 31, 2010.		-		(73,208	)
Debt Discount - value attributable to warrants attached to notes, net of accumulated amortization of $616,593 at December 31, 2010.		-		(61,417	)
Total	$	-	$	1,471,398
Less: current portion		-		(1,471,398	)
Total Long Term Portion	$	-	$	-

On March 4, 2011, the Company sold its Series 5 Power Line Carrier product line and related business assets to Dynamic Ratings, Inc. (“Dynamic Ratings”).  The purchase price was $1,000,000 in cash.  In connection with the sale, Dynamic Ratings lent the Company an additional $700,000 in the form of a 6% promissory note dated March 4, 2011. The Company used the proceeds to retire substantially all of its obligations under its $1.6 million senior convertible debenture due May 29, 2011 and to cancel the related warrants covering 11.7 million shares of the Company’s common stock.  In exchange for the early retirement of debt and cancellation of warrants, the Company provided the lender with an unsecured one-year promissory note for $50,000 (Promissory Note#2).

Business Loan

On September 11, 2009, the Company entered into a Loan Agreement in the aggregate principal amount of $300,000 with the Wisconsin Department of Commerce (the “Department”).  The outstanding principal balance bears interest at the annual rate of two (2.00) percent. Payment of interest and principal is to be made in the following manner:   (a) payment of any and all interest that accrues from the date of disbursement commenced on January 1, 2010 and continued on the first day of each consecutive month thereafter through and including December 31, 2010; (b) commencing on January 1, 2011 and continuing on the first day of each consecutive month thereafter through and including November 1, 2016, the Company shall pay equal monthly installments of $4,426 each; followed by a final installment on December 1, 2016 which shall include all remaining principal, accrued interest and other amounts owed by the Company to the Department under the Loan Agreement.  The Company may prepay amounts outstanding under the credit facility in whole or in part at any time without penalty.  The credit facility is secured by substantially all of the Company’s assets and the proceeds from this loan were used for the working capital requirements of the Company.  The outstanding borrowing under the agreement at June 30, 2011 was $276,346.

Promissory Note #1

On March 4, 2011, the Company sold all its Series 5 PLC product line assets to Wisconsin-based Dynamic Ratings, Inc. (“Purchaser”) under an Asset Purchase Agreement (“APA”).  Per the APA, the Company signed a Promissory Note (“Note #1”) due to Purchaser in the aggregate principal amount of $700,000. The outstanding principal balance bears interest at the annual rate of six (6) percent and is due on March 31, 2014.   Note #1 may be prepaid in whole or in part, without penalty at any time, however scheduled payments are due on June 30, 2012 and June 30, 2013.  Payments shall be applied first to accrued but unpaid interest and then to principal.Note #1 contains certain earn-out provisions that encompass both the Company’s and Purchaser’s revenue volumes.  Provided these provisions are met, the Company could potentially retire Note #1 prior to its expiration date.  Payments not made when due, by maturity acceleration or otherwise, shall bear interest at the rate of 12% per annum from the date due until fully paid

11

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

   
Promissory Note #2

From the sale of its Series 5 PLC product line assets, the Company used the proceeds received to retire substantially all of its obligations under its $1.6 million senior convertible debenture due May 29, 2011 and to cancel the related warrants covering 11.7 million shares of the Company’s common stock.  In exchange for the early retirement of debt and cancellation of warrants, the Company provided the lender with an unsecured one-year promissory note (“Note #2”) for $50,000.  The outstanding principal balance bears interest at the annual rate of five and one-quarter (5.25) percent and is due on March 4, 2012. The monthly payment of principal and interest is $4,385.  However Note #2 is due immediately if the Company (a) receives three million ($3,000,000) dollars in aggregate in new debt or equity financing, (b) attains one million ($1,000,000) dollars in EBITDA for any reporting quarter or (3) becomes insolvent.  The Note may be prepaid in whole or in part, without penalty at any time.  Payments shall be applied first to accrued but unpaid interest and then to principal.

Aggregate maturities of long-term debt as of June 30, 2011 are as follows:

As of June 30,	Amount
2011 (Remainder of)	$	48,890
2012		61,253
2013		49,485
2014		750,483
2015 and thereafter		103,979
	$	1,014,090
Less: Current portion		(85,768	)
Total Long term portion	$	928,322

12

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

     

NOTE G - REDEEMABLE PREFERRED STOCK

Series A

The Company has designated 215 shares of preferred stock as Series A Preferred Stock (“Series A”). Each share of Series A shall be convertible, at the option of the holder thereof, at any time, into shares of our Common Stock at an initial conversion price of $0.363 per share, subject to adjustments for anti-dilution provisions.  In the event of a change of control (as defined in the purchase agreement with respect to the Series A), or at the holder’s option, on November 19, 2014 and for a period of 180 days thereafter, provided that at least fifty percent (50%) of the shares of Series A issued on the Series A Original Issue Date remain outstanding as of November 19, 2014, and the holders of at least a majority of the then outstanding shares of Series A provide written notice requesting redemption of all shares of Series A, we are required to redeem the Series A for the purchase price plus any accrued but unpaid dividends. The Series A accrues dividends at an annual rate of 8% of the original purchase price, and shall be payable only when, as, and if declared by our Board of Directors.

On November 16, 2009, the Company sold 215 shares of Series A with attached warrants to purchase an aggregate of 1,628,800 shares of the Company’s common stock at $0.33 per share.  The Series A shares were sold at a price per share of $5,000 and each Series A share is convertible into approximately 13,774 shares of common stock at a conversion price of $0.363 per share. The Company received $1,075,000 from the sale of the Series A shares.  Since the Series A may ultimately be redeemable at the option of the holder, the carrying value of the preferred stock, net of discount and accumulated dividends, has been classified as Commitments and Contingencies on the balance sheet at June 30, 2011 and December 31, 2010.

In accordance with ASC 470 Topic “Debt”, a portion of the proceeds were allocated to the warrants based on their relative fair value, which totaled $287,106 using the Black Scholes option pricing model. Further, the Company attributed a beneficial conversion feature of $70,922 to the Series A preferred shares based upon the difference between the effective conversion price of those shares and the closing price of the Company’s common stock on the date of issuance. The assumptions used in the Black-Scholes model are as follows:  (1) dividend yield of 0%; (2) expected volatility of 123%, (3) weighted average risk-free interest rate of 2.2%, (4) expected life of 5 years, and (5) estimated fair value of Telkonet common stock of $0.24 per share. The expected term of the warrants represents the estimated period of time until exercise and is based on historical experience of similar awards and giving consideration to the contractual terms. The amounts attributable to the warrants and beneficial conversion feature, aggregating $358,028, have been recorded as a discount and deducted from the face value of the preferred stock. Since the preferred stock is classified as temporary equity, the discount will be amortized over the period from issuance to November 19, 2014 (the initial redemption date) as a charge to additional paid-in capital (since there is a deficit in retained earnings).

The charge to additional paid in capital for amortization of Series A discount and costs for the period ended June 30, 2011 was $35,802.  

For the six months ended June 30, 2011 we have accrued dividends in the amount of $42,424 and cumulative accrued dividends of $138,356. The accrued dividends have been charged to additional paid-in capital (since there is a deficit in retained earnings) and the net unpaid accrued dividends have been added to the carrying value of the Series A shares.

Series B

The Company has designated 567 shares of preferred stock as Series B Preferred Stock (“Series B”). Each share of Series B shall be convertible, at the option of the holder thereof, at any time, into shares of our Common Stock at an initial conversion price of $0.13 per share, subject to adjustments for anti-dilution provisions.  In the event of a change of control (as defined in the purchase agreement with respect to the Series B), or at the holder’s option, on November 19, 2014 and for a period of 180 days thereafter, provided that at least fifty percent (50%) of the shares of Series B issued on the Series B Original Issue Date remain outstanding as of November 19, 2014, and the holders of at least a majority of the then outstanding shares of Series B provide written notice requesting redemption of all shares of Series B, we are required to redeem the Series B for the purchase price plus any accrued but unpaid dividends. The Series B accrues dividends at an annual rate of 8% of the original purchase price, and shall be payable only when, as, and if declared by our Board of Directors.

On August 4, 2010, the Company sold 267 shares of Series B with attached warrants to purchase an aggregate of 10,269,219 shares of the Company’s common stock at $0.13 per share.  The Series B shares were sold at a price per share of $5,000 and each Series B share is convertible into approximately 38,461 shares of common stock at a conversion price of $0.13 per share. The Company received $1,335,000 from the sale of the Series B shares.  Since the Series B shares may ultimately be redeemable at the option of the holder, the carrying value of the Series B shares, net of discount and accumulated dividends, has been classified as temporary equity on the balance sheet at June 30, 2011 and December 31, 2010.

13

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

In accordance with ASC 470 Topic “Debt”, a portion of the proceeds were allocated to the warrants based on their relative fair value, which totaled $394,350 using the Black Scholes option pricing model. Further, the Company attributed a beneficial conversion feature of $394,350 to the Series B shares based upon the difference between the effective conversion price of those shares and the closing price of the Company’s common stock on the date of issuance. The assumptions used in the Black-Scholes model are as follows:  (1) dividend yield of 0%; (2) expected volatility of 123%, (3) weighted average risk-free interest rate of 1.76%, (4) expected life of 5 years, and (5) estimated fair value of Telkonet common stock of $0.109 per share. The expected term of the warrants represents the estimated period of time until exercise and is based on historical experience of similar awards and giving consideration to the contractual terms. The amounts attributable to the warrants and beneficial conversion feature, aggregating $788,700, have been recorded as a discount and deducted from the face value of the Series B shares. Since the Series B is classified as temporary equity, the discount will be amortized over the period from issuance to November 19, 2014 (the initial redemption date) as a charge to additional paid-in capital (since there is a deficit in retained earnings).

On April 8, 2011, the Company sold 271 additional shares of Series B with attached warrants to purchase an aggregate of 10,423,067 shares of the Company’s common stock at $0.13 per share.  The Series B shares were sold at a price per share of $5,000 and each Series B share is convertible into approximately 38,461 shares of common stock at a conversion price of $0.13 per share. The Company received $1,355,000 from the sale of the Series B shares.  Since the Series B shares may ultimately be redeemable at the option of the holder, the carrying value of the Series B shares, net of discount and accumulated dividends, has been classified as temporary equity on the balance sheet at June 30, 2011.

In accordance with ASC 470 Topic “Debt”, a portion of the proceeds were allocated to the warrants based on their relative fair value, which totaled $427,895 using the Black Scholes option pricing model. Further, the Company attributed a beneficial conversion feature of $427,895 to the Series B shares based upon the difference between the effective conversion price of those shares and the closing price of the Company’s common stock on the date of issuance. The assumptions used in the Black-Scholes model are as follows:  (1) dividend yield of 0%; (2) expected volatility of 129%, (3) weighted average risk-free interest rate of 0.26%, (4) expected life of 5 years, and (5) estimated fair value of Telkonet common stock of $0.12 per share. The expected term of the warrants represents the estimated period of time until exercise and is based on historical experience of similar awards and giving consideration to the contractual terms. The amounts attributable to the warrants and beneficial conversion feature, aggregating $855,790, have been recorded as a discount and deducted from the face value of the Series B shares. Since the Series B is classified as temporary equity, the discount will be amortized over the period from issuance to November 19, 2014 (the initial redemption date) as a charge to additional paid-in capital (since there is a deficit in retained earnings).

The charge to additional paid in capital for amortization of Series B discount and costs for the period ended June 30, 2011 was $157,995.

For the six months ended June 30, 2011, we have accrued dividends for Series B in the amount of $77,646 and cumulative accrued dividends of $120,683. The accrued dividends have been charged to additional paid-in capital (since there is a deficit in retained earnings) and the net unpaid accrued dividends been added to the carrying value of the preferred stock.

NOTE H - CAPITAL STOCK

The Company has authorized 15,000,000 shares of preferred stock, with a par value of $.001 per share. As of June 30, 2011, the Company has 215 shares of Series A preferred stock issued and outstanding and 538 shares of Series B preferred stock issued and 533 shares outstanding.  The Company has authorized 190,000,000 shares of common stock, with a par value of $.001 per share. As of June 30, 2011 and December 31, 2010, the Company has 102,037,171 and 101,258,725, respectively, shares of common stock issued and outstanding.

During the six months ended June 30, 2011, the Company issued 409,056 shares of common stock to directors and management for services performed through June 30, 2011.  These shares were valued at $55,500, which approximated the fair value of the shares when they were issued.   In addition, 177,083 shares were issued to a current member of the Company’s Board of Directors for consulting fees incurred prior to, but not paid until after, his election to Board of Directors.  These shares were valued at $25,000.

During the three months ended June 30, 2011, five shares of Series B redeemable preferred stock were converted to 192,307 shares of common stock.

NOTE I - STOCK OPTIONS AND WARRANTS

Employee Stock Options

The Company maintains two stock option plans. The first plan initiated in the year 2000 and was established as a long term incentive plan for employees and consultants, including board of director members. The second plan was established in 2010 also as an incentive plan for officers, employees, non employee directors, prospective employees and other key persons. It is anticipated that providing such persons with a direct stake in the Company’s welfare will assure a better alignment of their interests with those of the Company and its’ stockholders.

14

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

The following table summarizes the changes in options outstanding and the related prices for the shares of the Company’s common stock issued to employees of the Company under a non-qualified employee stock option plan.

Options Outstanding								Options Exercisable
Exercise Prices		Number Outstanding		Weighted Average Remaining Contractual Life  (Years)		Weighted Average Exercise Price		Number Exercisable		Weighted Average Exercise Price
$	1.00 - $1.99		1,783,800		2.17	$	1.04		1,600,858	$	1.04
$	2.00 - $2.99		145,000		3.82	$	2.47		126,665	$	2.46
$	3.00 - $3.99		40,000		4.71	$	3.09		40,000	$	3.09
$	4.00 - $4.99		35,000		4.24	$	4.27		35,000	$	4.27
$	5.00 - $5.99		30,000		3.89	$	5.43		30,000	$	5.43
			2,033,800		2.40	$	1.31		1,832,523	$	1.31

Transactions involving stock options issued to employees are summarized as follows:

	Number of Shares			Weighted Average Price Per Share
Outstanding at January 1, 2010		6,120,883		$	1.56
Granted		-			-
Exercised		-			-
Cancelled or expired		(3,572,083	)		1.62
Outstanding at December 31, 2010		2,548,800		$	1.57
Granted		-			-
Exercised		-			-
Cancelled or expired		(515,000	)		2.69
Outstanding at June 30, 2011		2,033,800		$	1.31

The expected life of awards granted represents the period of time that they are expected to be outstanding.  We determine the expected life based on historical experience with similar awards, giving consideration to the contractual terms, vesting schedules, exercise patterns and pre-vesting and post-vesting forfeitures.  We estimate the volatility of our common stock based on the calculated historical volatility of our own common stock using the trailing 24 months of share price data prior to the date of the award.  We base the risk-free interest rate used in the Black-Scholes-Merton option valuation model on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term equal to the expected life of the award.  We have not paid any cash dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future.  Consequently, we use an expected dividend yield of zero in the Black-Scholes-Merton option valuation model. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation for those awards that are expected to vest. In accordance with ASC 718-10, we adjust share-based compensation for changes to the estimate of expected equity award forfeitures based on actual forfeiture experience.

There were no options granted or exercised during the six months ended June 30, 2011 and 2010.  

Total stock-based compensation expense in connection with options granted to employees recognized in the condensed consolidated statement of operations for the three and six months ended June 30, 2011 and 2010 was $7,994 and $41,401, and $15,988 and $88,181, respectively.

Non-Employee Stock Options

The following table summarizes the changes in options outstanding and the related prices for the shares of the Company’s common stock issued to the Company consultants.  These options were granted in lieu of cash compensation for services performed.

Options Outstanding								Options Exercisable
Exercise Prices		Number Outstanding		Weighted Average Remaining Contractual Life (Years)		Weighted Average Exercise Price		Number Exercisable		Weighted Average Exercise Price
$	1.00		425,000		.62	$	1.00		425,000	$	1.00

15

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

Transactions involving options issued to non-employees are summarized as follows:

	Number of Shares			Weighted Average Price Per Share
Outstanding at January 1, 2010		675,000		$	1.00
Granted		-			-
Exercised		-			-
Canceled or expired		(250,000	)		1.00
Outstanding at December 31, 2010		425,000		$	1.00
Granted		-			-
Exercised		-			-
Canceled or expired					-
Outstanding at June 30, 2011		425,000		$	1.00

There were no non-employee stock options vested during the periods ended June 30, 2011 and 2010.

Warrants

The following table summarizes the changes in warrants outstanding and the related prices for the shares of the Company’s common stock issued to non-employees of the Company.  These warrants were granted in lieu of cash compensation for services performed or financing expenses and in connection with placement of convertible debentures.

		Warrants Outstanding						Warrants Exercisable
Exercise Prices		Number Outstanding		Weighted Average Remaining Contractual Life (Years)		Weighed Average Exercise Price		Number Exercisable		Weighted Average Exercise Price
$	0.13		10,346,168		4.46	$	0.13		10,346,168	$	0.13
$	0.33		1,705,539		3.26	$	0.33		1,705,539	$	0.33
$	0.60		800,000		1.85	$	0.60		800,000	$	0.60
$	1.00		500,000		.53	$	1.00		500,000	$	1.00
$	2.59		431,226		.12	$	2.59		431,226	$	2.59
$	3.05		1,135,140		2.52	$	3.05		1,135,140	$	3.05
$	4.17		359,712		1.06	$	4.17		359,712	$	4.17
			15,277,785		3.72	$	.59		15,277,785	$	.59

Transactions involving warrants are summarized as follows:

	Number of Shares			Weighted Average Price Per Share
Outstanding at January 1, 2010		12,158,941		$	1.60
Issued		12,819,897			0.28
Exercised		-			-
Canceled or expired		(2,874,096	)		3.29
Outstanding at December 31, 2010		22,104,742		$	.51
Issued		5,322,847			.13
Exercised		-			-
Canceled or expired		(12,149,804	)		.23
Outstanding at June 30, 2011		15,277,785		$	.59

On April 8, 2011, the Company issued 271 shares of Series B Preferred Stock (“Series B”) with attached warrants to purchase 5,211,538 shares of the Company’s common stock at $0.13 per share.  

The Company did not issue any warrants during the period ended June 30, 2010.

16

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

NOTE J - RELATED PARTIES

In connection with the Series A Preferred Stock private placement transaction, on November 16, 2009, the Company entered into an Executive Officer Reimbursement Agreement with each of (i) Jason L. Tienor, the Company’s President and Chief Executive Officer, (ii) Richard J. Leimbach, the Company’s then Chief Financial Officer, and (iii) Jeffrey J. Sobieski, the Company’s Chief Operating Officer (collectively, the “Executive Officers”), pursuant to which the Executive Officers agreed to convert a portion of outstanding indebtedness of the Company owed to such Executive Officers into Series A shares and Warrants pursuant to the Securities Purchase Agreement.  Mr. Tienor converted $20,000 of outstanding indebtedness into 4 Series A shares and Warrants to purchase 30,304 shares of Common Stock. Mr. Leimbach converted $10,000 of outstanding indebtedness into 2 Series A shares and Warrants to purchase 15,152 shares of Common Stock. Mr. Sobieski converted $20,000 of outstanding indebtedness into 4 Series A shares and Warrants to purchase 30,304 shares of Common Stock.

Anthony Paoni, Chairman of the Company’s Board of Directors, participated in the private placement of Series A Preferred Stock, purchasing five shares of Series A convertible redeemable preferred stock (convertible into 68,870 shares of common stock) and warrants to purchase 37,880 shares of common stock, for an aggregate purchase price of $25,000.

NOTE K - COMMITMENTS AND CONTINGENCIES

Office Leases Obligations

The Company presently leases approximately 14,000 square feet of office space in Milwaukee, WI for its corporate headquarters.  The Milwaukee lease expires in March 2020.  

The Company presently leases 16,416 square feet of commercial office space in Germantown, MD.  The lease commitments expire in December 2015.  On July 15, 2011, Telkonet executed a sublease agreement for 11,626 square feet of its former corporate headquarters located in Germantown, MD.  The sublease term will expire on January 31, 2013.  The subtenant received a one month rent abatement and has the option to extend the sublease from January 31, 2013 to December 31, 2015.

Commitments for minimum rentals under non cancelable leases at June 30, 2011 are as follows:

2011 (Remainder of)	$	180,264
2012		384,651
2013		402,951
2014		414,267
2015 and thereafter		1,179.837
Total	$	2,561,970

Rental expenses charged to operations for the six months ended June 30, 2011 and 2010 are $405,637 and $325,116, respectively.

Employment and Consulting Agreements

The Company has employment agreements with certain of its key employees which include non-disclosure and confidentiality provisions for protection of the Company’s proprietary information.

Jason Tienor, President and Chief Executive Officer, is employed pursuant to an employment agreement dated April 11, 2011.  Mr. Tienor’s employment agreement is for a term expiring on April 10, 2012, is renewable at the agreement of the parties and provides for a base salary of $200,000 per year.

Jeff Sobieski, Chief Operating Officer, is employed pursuant to an employment agreement, dated April 11, 2011. Mr. Sobieski’s employment agreement is for a term expiring on April 10, 2012, is renewable at the agreement of the parties and provides for a base salary of $190,000 per year. 

Litigation

The Company is subject to legal proceedings and claims which arise in the ordinary course of its business.  Although occasional adverse decisions or settlements may occur, the Company believes that the final disposition of such matters should not have a material adverse effect on its financial position, results of operations or liquidity.

17

     

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

Linksmart Wireless Technology, LLC v. T-Mobile USA, Inc.

On July 1, 2008, Linksmart Wireless Technology, LLC, or Linksmart, filed a civil lawsuit in the Eastern District of Texas against EthoStream, LLC, our wholly-owned subsidiary and 22 other defendants (Linksmart Wireless Technology, LLC v. T-Mobile USA, Inc., et al, U.S. District Court, for the Eastern District of Texas, Marshall Division, No.2:08-cv-00264-TJW-CE).  This lawsuit alleges that the defendants’ services infringe a wireless network security patent held by Linksmart. Linksmart seeks a permanent injunction enjoining the defendants from infringing, inducing the infringement of, or contributing to the infringement of its patent, an award of damages and attorney’s fees.

On August 1, 2008, we timely filed an answer to the complaint denying the allegations. On February 27, 2009, the USPTO granted a reexamination request with respect to the patent in issue in this lawsuit.  Based upon four highly relevant and material prior art references that had not been considered by the USPTO in its initial examination, it found a “substantial new question of patentability” affecting all claims of the patent in suit.  On August 2, 2010, the USPTO issued a Final Office Action rejecting every claim of the patent in suit.  If this action is upheld on appeal it will result in the elimination of all of the issues in the pending litigation. There is a possibility that the claims of the patent will be reinstated on appeal either in their original form or as amended.  

Defendant Ramada Worldwide, Inc. provided us with notice of the suit and demanded that we defend and indemnify it pursuant to a vendor direct supplier agreement between EthoStream and WWC Supplier Services, Inc., a Ramada affiliate (wherein we agreed to indemnify, defend and hold Ramada harmless from and against claims of infringement).  After a review of that agreement, it was determined that EthoStream owes the duty to defend and indemnify with respect to services provided by Telkonet to Ramada and it has assumed Ramada’s defense.  An answer on Ramada’s behalf was filed in U.S. District Court, for the Eastern District of Texas, Marshall Division on September 19, 2008.

On September 1, 2010, the court entered a 60 day stay at the plaintiff’s request. On September 15, 2010 we, along with other defendants, filed a motion seeking a stay of the litigation pending the conclusion of the reexamination proceeding. Subject to certain conditions, Linksmart agreed to entry of a stay. The court granted the defendants’ motion on October 26, 2010 and, subject to the agreed upon conditions, the matter is now stayed pending conclusion of the reexamination, including all appeals. A mandatory mediation was held in October, 2010 which did not achieve any results.  As of June 30, 2011, the case continued to be in stay pending a dismissal or appeal.  Because of the above, the Company is unable to estimate potential damages.

Robert P. Crabb v. Telkonet Inc.

On November 9, 2010, a former executive, Robert P. Crabb, served Telkonet, Inc. and Telkonet Communications, Inc. ("Telkonet") with a Complaint in the Circuit Court for Montgomery County, MD alleging  (1) violation of Maryland’s Wage Payment and Collection Act  (2) Breach of Contract and  (3) Promissory Estoppel/Detrimental Reliance.  The claims in his Complaint arise out of his retirement in September 2007.  On December 6, 2010, Telkonet filed an Answer and Counterclaim, alleging “Recoupment.” Mr. Crabb filed an Answer to the Counterclaim on January 10, 2011.  In terms of relief, Mr. Crabb is seeking "severance compensation" in the amount of $156,000, treble damages, interest, and attorneys’ fees.  Treble damages and attorneys’ fees are only available under the Maryland Wage Payment and Collection Act.  Mr. Crabb's Complaint provides no specific accounting for the relief sought.  A pre-trial conference was held on July 28, 2011, during which time the Court scheduled a four day jury trial beginning on December 12, 2011.  On July 28, Plaintiff also filed a Motion for Partial Summary Judgment on his claims and Defendants' Counterclaim.  Defendants' Opposition is due on August 12, 2011.  Although discovery in this matter has closed, there are two discovery motions pending before the Court.  

Stephen L. Sadle v. Telkonet, Inc

On April 15, 2011, a former executive, Stephen L. Sadle, served Telkonet, Inc. and Telkonet Communications, Inc. ("Telkonet") with a Complaint in the Circuit Court for Montgomery County, MD alleging (1) Breach of Contract, (2) Promissory Estoppel/Detrimental Reliance and (3) violation of Maryland's Wage Payment and Collection Act.  The three claims in his Complaint each arise out of his retirement in 2007.  On May 27, 2011 Defendants filed a motion to dismiss Mr. Sadle's claims.  A hearing on Defendants' motion to dismiss will be held on August 10, 2011.   In terms of relief, Mr. Sadle is seeking "severance compensation" in the amount of $195,000, treble damages, interest, and attorneys’ fees.  Treble damages and attorneys’ fees are only available under the Maryland Wage Payment and Collection Act.  Mr. Sadle's Complaint provides no specific accounting for the relief sought. The trial in this case will likely be scheduled between February and June 2012.

Sales Tax

The Company believes there exists the possibility of sales tax exposure in multiple states covering multiple years. At the quarter ended June 30, 2011, the Company has approximately $225,000 accrued for any potential sales tax exposure. However the Company is unable to estimate if there will be any additional sales tax exposure in excess of this accrual.

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TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

NOTE L - BUSINESS CONCENTRATION

Revenue from one (1) major customer approximated $658,109 or 11% of total revenues for the period ended June 30, 2010. Total accounts receivable of $532,190 or 29% of total accounts receivable, was due from this customer as of June 30, 2010. For the period ended June 30, 2011, the Company did not have a customer with revenue greater to 10% of total revenues.

Purchases from two (2) major suppliers approximated $1,254,804, or 35%, of purchases, and two (2) major suppliers approximated $1,028,314, or 33%, of purchases, for the six months ended June 30, 2011 and 2010, respectively. Total accounts payable of approximately $149,055, or 7%, of total accounts payable, was due to these suppliers as of June 30, 2011, and $543,572, or 15%, of total accounts payable, was due to these suppliers as of June 30, 2010.

NOTE M - FAIR VALUE MEASUREMENTS

The financial assets of the Company measured at fair value on a recurring basis are cash equivalents and long-term marketable securities. The Company’s long term marketable securities are generally classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency. The Company’s long-term investments are classified within Level 3 of the fair value hierarchy because they are valued using unobservable inputs, due to the fact that observable inputs are not available, or situations in which there is little, if any, market activity for the asset or liability at the measurement date.  The Company’s derivative liabilities and convertible debentures are classified within Level 3 of the fair value hierarchy because they are valued using inputs which are not actively observable, either directly or indirectly.

● Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

● Level 2: Quoted prices in markets that are not active, or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability; or

● Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and are unobservable.

The following table sets forth the Company’s short and long-term investments as of December 31, 2010 which are measured at fair value on a recurring basis by level within the fair value hierarchy. These are classified based on the lowest level of input that is significant to the fair value measurement:

	Level 1		Level 2		Level 3		Total
Derivative liabilities		-		-		1,901,775		1,901,775
Total	$	-	$	-	$	1,901,775	$	1,901,775

The table below sets forth a summary of changes in the fair value of the Company’s Level 3 financial liabilities (derivative liability) for the six months ended June 30, 2011.

	2011
Balance at beginning of year	$	1,901,775
Repayment of debt, cancellation of warrants and related derivative liability		(1,158,729	)
Change in fair value of derivative liability		(172,477	)
Retirement of derivative liability related to warrant obligation		(570,569	)
Balance at end of period	$	-

NOTE N - SUBSEQUENT EVENTS

On July 15, 2011, Telkonet executed a sublease agreement for 11,626 square feet of its’ former corporate headquarters located in Germantown, MD.  The sublease term will expire on January 31, 2013.  The subtenant received a one month rent abatement and has the option to extend the sublease from January 31, 2013 to December 31, 2015.

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the accompanying condensed consolidated financial statements and related notes thereto for the quarter ended June 30, 2011, as well as the Company’s condensed consolidated financial statements and related notes thereto and management’s discussion and analysis of financial condition and results of operations in the Company’s Form 10-K for the year ended December 31, 2010 filed on March 30, 2011.

Business

Telkonet, Inc., formed in 1999 and incorporated under the laws of the state of Utah, is a Clean Technology company that designs, develops and markets proprietary energy efficiency and smart grid networking products and services.  Our SmartEnergy, EcoSmart and Series 5 SmartGrid networking technologies enable us to provide innovative clean technology solutions and have helped position Telkonet as a leading Clean Technology provider.

Our Telkonet SmartEnergy, Networked Telkonet SmartEnergy and EcoSmart energy efficiency products incorporate our patented Recovery Time™ technology, providing continuous monitoring of climate and environmental conditions to dynamically adjust a room’s temperature, accounting for the occupancy of the room.  Our SmartEnergy and EcoSmart platforms maximize energy savings while at the same time ensuring occupant comfort and extending equipment life expectancy.  This technology is particularly attractive to customers in the hospitality industry, as well as the education, healthcare and government/military markets, who are continually seeking ways to reduce costs and meet federal and state mandates without impacting building occupant comfort.  By reducing energy consumption automatically when a space is unoccupied, our customers can realize significant cost savings without diminishing occupant comfort.  This technology may also be integrated with property management systems and building automation systems and used in load shedding initiatives.  This feature provides management companies and utilities enhanced opportunity for cost savings, environmental awareness and energy management.  Telkonet’s energy management systems are lowering heating, ventilation and air conditioning, or HVAC, costs in hundreds of thousands of rooms worldwide and qualify for state and federal energy efficiency and rebate programs.

The Series 5 SmartGrid networking technology allows commercial, industrial and consumer users to connect computers to a communications network using the existing low voltage electrical grid. The Series 5 SmartGrid networking technology uses powerline communications, or PLC, technology to transform existing electrical infrastructure into a communications backbone.  Operating at 200 Mbps, the PLC platform offers a secure alternative in grid communications, transforming a traditional electrical distribution system into a “smart grid” that delivers electricity in a manner that can save energy, reduce cost and increase reliability.

On March 4, 2011, the Company sold its Series 5 Power Line Carrier product line and related business assets to Dynamic Ratings (“Dynamic Ratings”).  The purchase price was $1,000,000 in cash.  In connection with the sale, Dynamic Ratings lent the Company an additional $700,000 in the form of a 6% promissory note dated March 4, 2011.  Concurrently with the sale, the Company entered into a Distributorship Agreement and a Consulting Agreement with Dynamic Ratings.  Under the Distributorship Agreement, the Company was designated as a distributor of the Series 5 product to the non-utility sector and will receive preferred pricing for purchases of Series 5 product.  Under the Consulting Agreement, the Company agreed to provide Dynamic Ratings with ongoing transition assistance and consulting services for the Series 5 product.  The Distributorship Agreement and the Consulting Agreement have initial terms that expire on March 31, 2014 and March 31, 2013, respectively.  Proceeds payable to the Company under the Distributorship Agreement and the Consulting Agreement will be applied to pay the balance of the Promissory Note. 

Telkonet’s EthoStream Hospitality Network is now one of the largest high speed internet access (HSIA) solution providers in the world, with a customer base of more than 2,314 properties representing approximately 215,000 hotel rooms.  This network provides Telkonet with the opportunity to market our energy efficiency solutions.  In addition, more than 3.9 million users access the Internet monthly via the EthoStream Hospitality Network providing Telkonet with a growing captive audience for promotional relationships.  The EthoStream Hospitality Network is backed by a 24/7 U.S.-based in-house support center that uses integrated, web-based management tools enabling proactive customer support.

We utilize direct and indirect sales channels in all areas of our business.  With a growing Value-Added Reseller (VAR) network, we continue to broaden our reach throughout the industry.  Utilizing key integrators and strategic partners, we’ve been able to increase penetration in each of our targeted markets.  The impact of this effort is a growing percentage of Telkonet’s business is driven by our indirect sales channels.

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Our direct sales efforts target the hospitality, education, commercial, utility and government/military markets.  Taking advantage of legislation, including the Energy Independence and Security Act of 2007, or EISA, and the Energy Policy Act of 2005, we’ve focused our sales efforts in areas with available public funding and incentives, such as rebate programs offered by utilities for efficiency upgrades.  Through our proprietary platform, technology and partnerships with energy efficiency providers, we intend to position our company as a leading provider of energy management solutions. 

Forward Looking Statements

In accordance with the Private Securities Litigation Reform Act of 1995, we can obtain a “safe-harbor” for forward-looking statements by identifying those statements and by accompanying those statements with cautionary statements which identify factors that could cause actual results to differ materially from those in the forward-looking statements.  Accordingly, the following “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Quantitative and Qualitative Disclosures about Market Risk” may contain certain forward-looking statements regarding strategic growth initiatives, growth opportunities and management’s expectations regarding orders and financial results for 2011 and future periods.  These forward-looking statements are based on current expectations and current assumptions which management believes are reasonable.  However, these statements involve risks and uncertainties that could cause actual results to differ materially from any future results encompassed within the forward-looking statements.  Factors that could cause or contribute to such differences include those risks affecting the Company’s business as described in the Company’s filings with the SEC, including the Company’s 2010 Annual Report on Form 10-K and later filed quarterly reports on Form 10-Q and Current Reports on Form 8-K, which factors are incorporated herein by reference.  The Company expressly disclaims a duty to provide updates to forward-looking statements, whether as a result of new information, future events or other occurrences.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes.  On an ongoing basis, we evaluate significant estimates used in preparing our condensed consolidated financial statements including those related to revenue recognition, guarantees and product warranties, stock based compensation and business combinations.  We base our estimates on historical experience, underlying run rates and various other assumptions that we believe to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities.  Actual results could differ from these estimates. The following are critical judgments, assumptions, and estimates used in the preparation of the consolidated financial statements.

Revenue Recognition

For revenue from product sales, we recognize revenue in accordance with ASC 605-10, and ASC Topic 13 guidelines that require that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the selling price is fixed and determinable; and (4) collectability is reasonably assured.  Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the selling prices of the products delivered and the collectability of those amounts.  Provisions for discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period the related sales are recorded.  We defer any revenue for which the product has not been delivered or is subject to refund until such time that we and the customer jointly determine that the product has been delivered or no refund will be required.  The guidelines also address the accounting for arrangements that may involve the delivery or performance of multiple products, services and/or rights to use assets.

Fair Value of Financial Instruments

The company accounts for the fair value of financial instruments in accordance with ASC 820, which defines fair value for accounting purposes, established a framework for measuring fair value and expand disclosure requirements regarding fair value measurements.  Fair value is defined as an exit price, which is the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date.  The degree of judgment utilized in measuring the fair value of assets and liabilities generally correlates to the level of pricing observability.  Financial assets and liabilities with readily available, actively quoted prices or for which fair value can be measured from actively quoted prices in active markets generally have more pricing observability and require less judgment in measuring fair value.  Conversely, financial assets and liabilities that are rarely traded or not quoted have less price observability and are generally measured at fair value using valuation models that require more judgment.  These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency of the asset, liability or market and the nature of the asset or liability.  We have categorized our financial assets and liabilities that are recurring, at fair value into a three-level hierarchy in accordance with these provisions.

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New Accounting Pronouncements

During December 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2010-28, “Intangibles—Goodwill and Other (Topic 350):  When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts—a consensus of the FASB Emerging Issues Task Force.”  ASU No. 2010-28 requires entities with reporting units with zero or negative carrying amounts to perform step 2 of the goodwill impairment test if qualitative factors indicate that it is more likely than not that a goodwill impairment exists.  Any goodwill impairment recorded upon the adoption of ASU No. 2010-28 is required to be recorded as a cumulative-effect adjustment to beginning retained earnings.  ASU No. 2010-28 is effective for fiscal years beginning after December 15, 2010. The company is currently assessing the effect that ASU No. 2010-28 will have on its results of operations, financial position and cash flows.

Revenues

The table below outlines product versus recurring revenues for comparable periods:

	Three Months Ended
	June 30, 2011			June 30, 2010			Variance
Product	$	1,776,888	61%	$	1,970,286	62%	$	(193,398	)	-10%
Recurring		1,151,048	39%		1,213,115	38%		(62,067	)	-5%
Total	$	2,927,936	100%	$	3,183,401	100%	$	(255,465	)	-8%

	Six Months Ended
	June 30, 2011			June 30, 2010			Variance
Product	$	3,127,960	58%	$	3,536,737	61%	$	(408,777	)	-12%
Recurring		2,282,675	42%		2,230,704	39%		51,971		2%
Total	$	5,410,635	100%	$	5,767,441	100%	$	(356,806	)	-6%

Product revenue

Product revenue principally arises from the sale and installation of SmartEnergy, SmartGrid and High Speed Internet Access   equipment.  These include TSE, Telkonet Series 5, Telkonet iWire, and wireless networking products.  We market and sell to the hospitality, education, healthcare and government/military markets.  The Telkonet Series 5 and the Telkonet iWire products consist of the Telkonet Gateways, Telkonet Extenders, the patented Telkonet Coupler, and Telkonet iBridges.  The SmartEnergy product suite consists of thermostats, sensors, controllers, wireless networking products and a control platform.  The HSIA product suite consists of gateway servers, switches and access points.  Despite selling the Series 5 PLC product line and related business assets, the Company believes this will have an immaterial impact on revenue and profitability, since it represented less than 5% of its revenue base in 2010.

For the three and six months ended June 30, 2011, product revenue decreased by 10% and 12% respectively, when compared to the prior year periods.  Product revenue in 2011 includes approximately $1.8 million attributed to the sale and installation of energy management products, and approximately $1.2 million for the sale and installation of HSIA products, and approximately $0.1 million attributable to the Telkonet Series 5 products.   Since our sales of energy management and HSIA products are concentrated in the hospitality market, we have been impacted by a market reluctance to incur capital expenditures in the present economy. However, we believe the economy continues to demonstrate gradual signs of recovery and anticipate it will continue, albeit at a modest, uneven pace.

Recurring Revenue

The recurring revenue consists primarily of HSIA support services and advertising revenue.  The Company recognizes revenue over the term of the service period.  Advertising revenue is based on impression-based statistics for a given period from customer site visits to the Company’s under the terms of advertising agreements entered into with third-parties.

Recurring revenue includes approximately 2,314 hotels in our broadband network portfolio.  We currently support over 215,000 HSIA rooms, with over 3.9 million monthly users.  For the three and six months ended June 30, 2011, recurring revenue decreased by 5% and increased by 2% respectively when compared to the same periods of the prior year.  The year to date increase in recurring revenue was primarily attributed to a new advertising program started in the first quarter of 2011.

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Cost of Sales

	Three Months Ended
	June 30, 2011			June 30, 2010			Variance
Product	$	1,017,894	57%	$	1,012,124	51%	$	5,770		1%
Recurring		291,247	25%		326,062	27%		(34,815	)	-11%
Total	$	1,309,141	45%	$	1,338,186	42%	$	(29,045	)	-2%

	Six Months Ended
	June 30, 2011			June 30, 2010			Variance
Product	$	1,726,164	55%	$	1,911,907	54%	$	(185,743	)	-10%
Recurring		555,116	24%		631,907	28%		(76,791	)	-12%
Total	$	2,281,280	42%	$	2,543,814	44%	$	(262,534	)	-10%

Product Costs update

Product costs include equipment and installation labor related to the sale of Telkonet SmartEnergy™ products, Telkonet Series 5™ products and the Telkonet iWire System™.  For the three months ended June 30, 2011, product costs increased by 1% when compared to the prior year period, as a result of increased distribution costs.   Product costs for the six months ended June 30, 2011, decreased by 10% when compared to the prior year period, a direct correlation to the decrease in product revenues.

Recurring Costs update

For the three and six months ended June 30, 2011, recurring costs decreased by 11% and 12% respectively when compared to the prior year periods, due to increased efficiencies in providing support services to our EthoStream Hospitality Network.  As we continue to add new HSIA customers to our portfolio, we may need to hire additional support center staff which may affect our recurring product costs and margins.

Gross Profit

	Three Months Ended
	June 30, 2011			June 30, 2010			Variance
Product	$	758,994	43%	$	958,162	49%	$	(199,168	)	-21%
Recurring		859,801	75%		887,053	73%		(27,252	)	-3%
Total	$	1,618,795	55%	$	1,845,215	58%	$	(226,420	)	-12%

	Six Months Ended
	June 30, 2011			June 30, 2010			Variance
Product	$	1,401,796	45%	$	1,624,830	46%	$	(223,034	)	-14%
Recurring		1,727,559	76%		1,598,797	72%		128,762		8%
Total	$	3,129,355	58%	$	3,223,627	56%	$	(94,272	)	-3%

Product Gross Profit

The gross profit on product revenue for the three and six months ended June 30, 2011 decreased by 21% and 14%, respectively, compared to the prior year periods as a result of decreased product sales and installations on energy management and HSIA sales.

Recurring Gross Profit

Our gross profit percentage associated with recurring revenue decreased by 3% and increased by 8% for the three and six months ended June 30, 2011.  The increase was due to the growth in advertising revenue which yields greater margins.

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Operating Expenses

	Three Months Ended
	June 30, 2011		June 30, 2010		Variance
Total	$	1,494,620	$	1,646,684	$	(152,064	)	-9%

	Six Months Ended
	June 30, 2011		June 30, 2010		Variance
Total	$	2,847,220	$	3,683,684	$	(836,464	)	-23%

During the three and six months ended June 30, 2011, operating expenses decreased by 9% and 23%, respectively, when compared to the prior year periods.  These decreases are primarily the result of cost reduction efforts in areas of staffing, professional fees, financing fees and debt forgiveness plans.  We do not anticipate any significant changes to operating expenses for the remainder of 2011, except as necessary to meet future growth opportunities.

Research and Development

	Three Months Ended
	June 30, 2011		June 30, 2010		Variance
Total	$	184,207	$	264,049	$	(79,842	)	-30%

	Six Months Ended
	June 30, 2011		June 30, 2010		Variance
Total	$	371,318	$	529,900	$	(158,582	)	-30%

Our research and development costs related to both present and future products are expensed in the period incurred.  Current research and development costs are associated with product development and integration. The Company anticipates a continued decrease in research and development costs in the remainder of 2011compared to 2010.

Selling, General and Administrative Expenses

	Three Months Ended
	June 30, 2011		June 30, 2010		Variance
Total	$	1,224,178	$	1,304,845	$	(80,667	)	-6%

	Six Months Ended
	June 30, 2011		June 30, 2010		Variance
Total	$	2,310,722	$	2,995,584	$	(684,862	)	-23%

During the three and six months ended June 30, 2011, selling, general and administrative expenses decreased over the comparable prior year periods by approximately 6% and 23%, respectively.   These decreases are primarily the result of cost reduction efforts in areas of staffing, professional fees, financing fees and debt forgiveness plans. We do not expect to see a significant increase in selling, general and administrative expenses for the remainder of 2011, except as necessary to meet future growth opportunities.

Liquidity and Capital Resources

We have financed our operations since inception primarily through private and public offerings of our equity securities, the issuance of various debt instruments and asset based lending.

Working Capital

Our working capital deficit decreased by $3,944,844 during the six months ended June 30, 2011 from a working capital deficit (current liabilities in excess of current assets) of $4,162,420 at December 31, 2010 to a working capital deficit of $167,576 at June 30, 2011. The decrease in working capital deficit for the six months ended June 30, 2011 is due to the retirement of a convertible debenture, the associated derivative liability and the retirement of two related party notes.

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Business Loan

On September 11, 2009, we entered into a Loan Agreement to borrow an aggregate principal amount of $300,000 from the Wisconsin Department of Commerce (“Department”).  The outstanding principal balance on the loan bears interest at the annual rate of two percent (2.0%).  Payment of interest and principal is to be made in the following manner:  (a) payment of any and all interest that accrues from the date of disbursement commences on January 1, 2010 and continues on the first day of each consecutive month thereafter through and including December 31, 2010; (b) commencing on January 1, 2011 and continuing on the first day of each consecutive month thereafter through and including November 1, 2016, we are obligated to pay equal monthly installments of $4,426 each; followed by a final installment on December 1, 2016 which will include all remaining principal, accrued interest and other amounts owed by us to the Department under the Loan Agreement.  We may prepay amounts outstanding under the loan in whole or in part at any time without penalty.  The loan is secured by substantially all of our assets and the proceeds from this loan were used for our working capital requirements.  The outstanding borrowing under the agreement at June 30, 2011 was $276,346.

On March 4, 2011, the Company sold its Series 5 Power Line Carrier product line and related business assets to Dynamic Ratings Inc., (“Dynamic Ratings”).  The purchase price was $1,000,000 in cash.  In connection with the sale Dynamic Ratings lent $700,000 in the form of a 6% promissory note (Promissory Note# 1) dated March 4, 2011. The Company used the proceeds received to retire substantially all of its obligations under its $1.6 million senior convertible debenture due May 29, 2011 and to cancel the related warrants covering 11.7 million shares of the Company’s common stock.  In exchange for the early retirement of debt and cancellation of warrants, the Company provided the lender with an unsecured one-year promissory note for $50,000 (Promissory Note# 2).

Promissory Note #1

On March 4, 2011, the Company sold all its Series 5 PLC product line assets to Wisconsin-based Dynamic Ratings, Inc. (“Purchaser”) under an Asset Purchase Agreement (“APA”).  Per the APA, the Company signed a Promissory Note (“Note #1”) due to Purchaser in the aggregate principal amount of $700,000. The outstanding principal balance bears interest at the annual rate of six (6) percent and is due on March 31, 2014.   Note #1 may be prepaid in whole or in part, without penalty at any time, however scheduled payments are due on June 30, 2012 and June 30, 2013.  Payments shall be applied first to accrued but unpaid interest and then to principal.Note #1 contains certain earn-out provisions that encompass both the Company’s and Purchaser’s revenue volumes.  Provided these provisions are met, the Company could potentially retire Note #1 prior to its expiration date.  Payments not made when due, by maturity acceleration or otherwise, shall bear interest at the rate of 12% per annum from the date due until fully paid.

Promissory Note #2

From the sale of its Series 5 PLC product line assets, the Company used the proceeds received to retire substantially all of its obligations under its $1.6 million senior convertible debenture due May 29, 2011 and to cancel the related warrants covering 11.7 million shares of the Company’s common stock.  In exchange for the early retirement of debt and cancellation of warrants, the Company provided the lender with an unsecured one-year promissory note (“Note #2”) for $50,000.  The outstanding principal balance bears interest at the annual rate of five and one-quarter percent (5.25) percent and is due on March 4, 2012.  However  Note #2 is due immediately if the Company (a) receives three million ($3,000,000) dollars in aggregate in new debt or equity financing, (b) attains one million ($1,000,000) dollars in EBITDA for any reporting quarter or (3) becomes insolvent.  The Note may be prepaid in whole or in part, without penalty at any time.  Payments shall be applied first to accrued but unpaid interest and then to principal.

Proceeds from the issuance of  Series B Preferred Stock

On April 8, 2011, the Company sold 271 shares of series B Preferred Stock with attached warrants to purchase 5,211,538 shares of common stock at $0.13 per share.

Cashflow analysis

Cash used in continuing operations was $648,143 and $113,016 during the periods ending June 30, 2011 and 2010, respectively. As of June 30, 2011, our primary capital needs included business strategy execution, inventory procurement and managing current liabilities.

We utilized cash for investing activities from continuing operations of $1,006,644 and $0 during the periods ended June 30, 2011 and 2010, respectively.

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Cash provided from financing activities was $387,953 during the period ending June 30, 2011, compared to cash used in financing activities of $288,417 during the period ending June 30, 2010. The Company issued Series B preferred stock, sold the Series 5 PLC product line and repaid convertible debentures during 2011. The Company made repayments on our working capital line of credit used for inventory purchases of $288,417 in 2010.

We have eased cash required for operations by trimming operating costs and reducing staff levels.  In addition, we are working to manage our current liabilities while we continue to make changes in operations to improve our cash flow and liquidity position.

Concurrent with the first quarter debenture retirement, the second quarter equity raise and our year to date operating results, the Company believes anticipated revenues and its’ continued operational efficiencies will be sufficient to satisfy its ongoing capital and cash flow requirements for the remainder of fiscal 2011.  However, the Company also believes there remains sufficient uncertainty, both in the economic environment and our current deficit position, that the Company cannot make any representations for fiscal 2012.

Our prior independent registered public accountants stated in their report dated March 29, 2011 for the period ended December 31, 2010 that we have incurred operating losses in the past years, and that we are dependent upon management’s ability to develop profitable operations and/or obtain necessary funding from outside sources, including by the sale of our securities, or obtaining loans from financial institutions, where possible.  These factors, among others, may raise substantial doubt about our ability to continue as a going concern. This may also affect our ability to obtain financing in the future.

Off-Balance sheet Arrangements

The Company has no other off-balance sheet arrangements other than it’s facility leases.

Acquisition or Disposition of Property and Equipment

During the six months ended June 30, 2011, there were no expenditures on fixed assets and costs of equipment under operating leases.  The Company does not anticipate the sale or purchase of any significant property, plant or equipment during the next twelve months, other than computer equipment and peripherals to be used in the Company’s day-to-day operations.

We presently lease two commercial office spaces in Germantown, MD totaling, in the aggregate, 16,400 square feet.  Both leases expire in December 2015.  On July 15, 2011, Telkonet executed a sublease agreement for 11,626 square feet of its’ former corporate headquarters located in Germantown, MD.  The sublease term will expire on January 31, 2013.  The Subtenant received a one (1) month rent abatement and has the option to extend the sublease from January 31, 2013 to December 31, 2015.

Item 4.  Controls and Procedures.

As of June 30, 2011, the Company performed an evaluation, under the supervision and with the participation of management, including the Chief Executive Officer and Acting Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures. Based on that evaluation and due to the lack of segregation of duties and failure to implement accounting controls, the Chief Executive Officer and Acting Chief Financial Officer concluded that our disclosure controls and procedures were ineffective as of the end of the period covered by this report.  During the six months ended June 30, 2011, there was no change in the Company’s internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1.  Legal Proceedings.

Litigation

The Company is subject to legal proceedings and claims which arise in the ordinary course of its business.  Although occasional adverse decisions or settlements may occur, the Company believes that the final disposition of such matters should not have a material adverse effect on its financial position, results of operations or liquidity.

Robert P. Crabb v. Telkonet Inc.

On November 9, 2010, a former executive, Robert P. Crabb, served Telkonet, Inc. and Telkonet Communications, Inc. ("Telkonet") with a Complaint in the Circuit Court for Montgomery County, MD alleging  (1) violation of Maryland’s Wage Payment and Collection Act  (2) Breach of Contract and  (3) Promissory Estoppel/Detrimental Reliance.  The claims in his Complaint arise out of his retirement in September 2007.  On December 6, 2010, Telkonet filed an Answer and Counterclaim, alleging “Recoupment.” Mr. Crabb filed an Answer to the Counterclaim on January 10, 2011.  In terms of relief, Mr. Crabb is seeking "severance compensation" in the amount of $156,000, treble damages, interest, and attorneys’ fees.  Treble damages and attorneys’ fees are only available under the Maryland Wage Payment and Collection Act.  Mr. Crabb's Complaint provides no specific accounting for the relief sought.  A pre-trial conference was held on July 28, 2011, during which time the Court scheduled a four day jury trial beginning on December 12, 2011.  On July 28, Plaintiff also filed a Motion for Partial Summary Judgment on his claims and Defendants' Counterclaim.  Defendants' Opposition is due on August 12, 2011.  Although discovery in this matter has closed, there are two discovery motions pending before the Court.  

Stephen L. Sadle v. Telkonet, Inc

On April 15, 2011, a former executive, Stephen L. Sadle, served Telkonet, Inc. and Telkonet Communications, Inc. ("Telkonet") with a Complaint in the Circuit Court for Montgomery County, MD alleging (1) Breach of Contract, (2) Promissory Estoppel/Detrimental Reliance and (3) violation of Maryland's Wage Payment and Collection Act.  The three claims in his Complaint each arise out of his retirement in 2007.  On May 27, 2011 Defendants filed a motion to dismiss Mr. Sadle's claims.  A hearing on Defendants' motion to dismiss will be held on August 10, 2011.   In terms of relief, Mr. Sadle is seeking "severance compensation" in the amount of $195,000, treble damages, interest, and attorneys’ fees.  Treble damages and attorneys’ fees are only available under the Maryland Wage Payment and Collection Act.  Mr. Sadle's Complaint provides no specific accounting for the relief sought. The trial in this case will likely be scheduled between February and June 2012.

Item 1A. Risk Factors.

There have been no material changes to risk factors previously disclosed in our 2010 Annual Report in response to Item 1A of Form 10-K.

Item 2. Unregistered Sales of Equity Securities.

On June 30, 2011, the Company issued in aggregate, 198,200 shares to its independent directors, William H. Davis and Anthony J. Paoni in payment for their services as such during April, May and June of 2011. The shares were issued under the Company’s 2010 Stock Option and Incentive Plan prior to the Company’s filing of a registration statement on Form S-8 in connection with such plan. In addition, the Company issued 177,083 shares of common stock to Mr. Davis in connection with consulting services rendered  by Mr. Davis prior to his election to the Company’s Board of Directors. The Company believes that each of these sales were a non public offering exempt from registration requirements pursuant to Section 4(2) of the Securities Act of 1933, as amended, based on among other factors, the limited number of offerees and their status as affiliates of the Company.

Item 6.  Exhibits.

Exhibit Number	Description Of Document
10.1	Securities Purchase Agreement, dated April 8, 2011, by and among Telkonet, Inc. and the parties listed therein (incorporated by reference to the Company’s Form 8-K filed on April 13, 2011).
10.2	Registration Rights Agreement, dated April 8, 2011, by and among Telkonet, Inc. and the parties listed therein (incorporated by reference to the Company’s Form 8-K filed on April 13, 2011).
10.3	Employment Agreement, dated April 11, 2011 by and between Telkonet, Inc. and Jason L. Tienor (incorporated by reference to the Company’s Form 8-K filed on April 14, 2011).
10.4	Employment Agreement, dated April 11, 2011 by and between Telkonet, Inc. and Jeffrey J. Sobieski (incorporated by reference to the Company’s Form 8-K filed on April 14, 2011).
31.1	Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Jason L. Tienor
31.2	Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Richard E. Mushrush
32.1	Certification of Jason L. Tienor pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification of Richard E. Mushrush pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101.INS	XBRL Instance Document
101.SCH	XBRL Schema Document
101.CAL	XBRL Calculation Linkbase Document
101.LAB	XBRL Label Linkbase Document
101.PRE	XBRL Presentation Linkbase Document
101.DEF	XBRL Definition Linkbase Document

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.

	Telkonet, Inc. Registrant
Date: August 8, 2011	By:	/s/ Jason L. Tienor
		Jason L. Tienor
		Chief Executive Officer
		(principal executive officer)

Date: August 8, 2011	By:	/s/ Richard E. Mushrush
		Richard E. Mushrush
		Controller and Acting Chief Financial Officer
		(principal financial officer)

28

EX-31.1

 

EXHIBIT 31.1

CERTIFICATIONS

I, Jason L. Tienor, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Telkonet, Inc.;

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

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

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

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

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

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

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

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

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

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

Date:  August 8,, 2011

By: /s/ Jason L. Tienor

       Jason L. Tienor

       Chief Executive Officer

EX-31.2

EXHIBIT 31.2

CERTIFICATIONS

I, Richard E. Mushrush certify that:

1. I have reviewed this quarterly report on Form 10-Q of Telkonet, Inc.;

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

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

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

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

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

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

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

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

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

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

Date:  August 8, 2011

By: /s/ Richard E. Mushrush

       Richard E. Mushrush

       Acting Chief Financial Officer

EX-32.1

EXHIBIT 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of Telkonet Inc. (the "Company") on Form 10-Q for the period ending June 30, 2011 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Jason L. Tienor, Chief Executive Officer of Telkonet, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

This certification is being provided pursuant to 18 U.S.C. section 1350 and is not to be deemed a part of the Report, nor is it to be deemed to be “filed” for any purpose whatsoever.

/s/ Jason L. Tienor

Jason L. Tienor

Chief Executive Officer

August 8, 2011

EX-32.2

EXHIBIT 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of Telkonet Inc. (the "Company") on Form 10-Q for the period ending June 30, 2011 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Richard E. Mushrush, Acting Chief Financial  Officer of Telkonet, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

This certification is being provided pursuant to 18 U.S.C. section 1350 and is not to be deemed a part of the Report, nor is it to be deemed to be “filed” for any purpose whatsoever.

/s/ Richard E. Mushrush

Richard E. Mushrush

Acting Chief Financial Officer

August 8, 2011

XML



Condensed Consolidated Balance Sheets (Parentheticals) (USD $)	Jun. 30, 2011	Dec. 31, 2010
Discounts on convertible debentures (in Dollars)	$ 0	$ 134,625
Preferred stock par value (in Dollars per share)	$ 0.001	$ 0.001
Preferred stock shares authorized	15,000,000	15,000,000
Preferred stock shares issued	748	482
Preferred stock shares outstanding	748	482
Common stock, par value (in Dollars per share)	$ 0.001	$ 0.001
Common stock, shares authorized	190,000,000	190,000,000
Common stock, shares outstanding	101,469,581	101,258,725
Common stock, shares issued	102,037,171	101,258,725
Redeemable Convertible Preferred Stock [Member]
Preferred stock par value (in Dollars per share)	$ 0.001	$ 0.001
Preferred stock shares authorized	215	215
Preferred stock shares issued	215	215
Preferred stock shares outstanding	215	215
Redeemable Preferred Stock SeriesB [Member]
Preferred stock par value (in Dollars per share)	$ 0.001	$ 0.001
Preferred stock shares authorized	538	267
Preferred stock shares issued	538	267
Preferred stock shares outstanding	533	267

XML



Condensed Consolidated Statements of Operations (USD $)	3 Months Ended		6 Months Ended
	Jun. 30, 2011	Jun. 30, 2010	Jun. 30, 2011	Jun. 30, 2010
Product	$ 1,776,888	$ 1,970,286	$ 3,127,960	$ 3,536,737
Recurring	1,151,048	1,213,115	2,282,675	2,230,704
Total Revenue	2,927,936	3,183,401	5,410,635	5,767,441
Product	1,017,894	1,012,124	1,726,164	1,911,907
Recurring	291,247	326,062	555,116	631,907
Total Cost of Sales	1,309,141	1,338,186	2,281,280	2,543,814
Gross Profit	1,618,795	1,845,215	3,129,355	3,223,627
Research and development	184,207	264,049	371,318	529,900
Selling, general and administrative	1,224,178	1,304,845	2,310,722	2,995,584
Depreciation and amortization	86,235	77,790	165,180	158,200
Total Operating Expenses	1,494,620	1,646,684	2,847,220	3,683,684
Income (Loss) from Operations	124,175	198,531	282,135	(460,057)
Financing expense, net	(10,986)	(155,547)	(190,406)	(324,293)
Gain on derivative liability		541,326	172,477	696,793
Gain on sale of asset			829,296
Gain (loss) on disposal of fixed asset		(100,744)	2,165	(100,744)
Total Other Income (Expense)	(10,986)	285,035	813,532	271,756
Income (Loss) Before Provision for Income Taxes	113,189	483,566	1,095,667	(188,301)
Provision for Income Taxes	0	0	0	0
Net Income (Loss)	113,189	483,566	1,095,667	(188,301)
Accretion of preferred dividends and discount	(170,800)	(39,347)	(313,867)	(78,460)
Net income (loss) attributable to common shareholders	$ (57,611)	$ 444,219	$ 781,800	$ (266,761)
Income per share from continuing operations - basic (in Dollars per share)	$ 0.00	$ 0.00	$ 0.01	$ 0.00
Income per share from continuing operations - diluted (in Dollars per share)	$ 0.00	$ 0.00	$ 0.01	$ 0.00
Weighted Average Common Shares Outstanding - basic (in Shares)	102,878,097	96,916,357	101,475,906	96,714,804
Weighted Average Common Shares Outstanding - diluted (in Shares)	104,404,580	97,140,595	103,002,389	96,714,804

XML



Document And Entity Information (USD $)	6 Months Ended
	Jun. 30, 2011	Aug. 04, 2011
Document and Entity Information [Abstract]
Entity Registrant Name	TELKONET INC
Document Type	10-Q
Current Fiscal Year End Date	--12-31
Entity Common Stock, Shares Outstanding		102,037,171
Entity Public Float	$ 9,093,824
Amendment Flag	false
Entity Central Index Key	0001094084
Entity Current Reporting Status	Yes
Entity Voluntary Filers	No
Entity Filer Category	Smaller Reporting Company
Entity Well-known Seasoned Issuer	No
Document Period End Date	Jun. 30, 2011
Document Fiscal Year Focus	2011
Document Fiscal Period Focus	Q2

XML



NOTE F - LONG TERM DEBT

6 Months Ended

Jun. 30, 2011

Debt Disclosure [Text Block]

NOTE F - LONG TERM DEBT

Senior Convertible Debenture

A summary of convertible debentures payable at June 30, 2011 and December 31, 2010 is as follows:

	June 30, 2011		December 31, 2010
Senior Convertible Debentures, accrue interest at 13% per annum and mature on May 29, 2011	$	-	$	1,606,023
Debt Discount - beneficial conversion feature, net of accumulated amortization of $733,756 at December 31, 2010.		-		(73,208	)
Debt Discount - value attributable to warrants attached to notes, net of accumulated amortization of $616,593 at December 31, 2010.		-		(61,417	)
Total	$	-	$	1,471,398
Less: current portion		-		(1,471,398	)
Total Long Term Portion	$	-	$	-

On March 4, 2011, the Company sold its Series 5 Power Line Carrier product line and related business assets to Dynamic Ratings, Inc. (“Dynamic Ratings”).  The purchase price was $1,000,000 in cash.  In connection with the sale, Dynamic Ratings lent the Company an additional $700,000 in the form of a 6% promissory note dated March 4, 2011. The Company used the proceeds to retire substantially all of its obligations under its $1.6 million senior convertible debenture due May 29, 2011 and to cancel the related warrants covering 11.7 million shares of the Company’s common stock.  In exchange for the early retirement of debt and cancellation of warrants, the Company provided the lender with an unsecured one-year promissory note for $50,000 (Promissory Note#2).

Business Loan

On September 11, 2009, the Company entered into a Loan Agreement in the aggregate principal amount of $300,000 with the Wisconsin Department of Commerce (the “Department”).  The outstanding principal balance bears interest at the annual rate of two (2.00) percent. Payment of interest and principal is to be made in the following manner:   (a) payment of any and all interest that accrues from the date of disbursement commenced on January 1, 2010 and continued on the first day of each consecutive month thereafter through and including December 31, 2010; (b) commencing on January 1, 2011 and continuing on the first day of each consecutive month thereafter through and including November 1, 2016, the Company shall pay equal monthly installments of $4,426 each; followed by a final installment on December 1, 2016 which shall include all remaining principal, accrued interest and other amounts owed by the Company to the Department under the Loan Agreement.  The Company may prepay amounts outstanding under the credit facility in whole or in part at any time without penalty.  The credit facility is secured by substantially all of the Company’s assets and the proceeds from this loan were used for the working capital requirements of the Company.  The outstanding borrowing under the agreement at June 30, 2011 was $276,346.

Promissory Note #1

On March 4, 2011, the Company sold all its Series 5 PLC product line assets to Wisconsin-based Dynamic Ratings, Inc. (“Purchaser”) under an Asset Purchase Agreement (“APA”).  Per the APA, the Company signed a Promissory Note (“Note #1”) due to Purchaser in the aggregate principal amount of $700,000. The outstanding principal balance bears interest at the annual rate of six (6) percent and is due on March 31, 2014.   Note #1 may be prepaid in whole or in part, without penalty at any time, however scheduled payments are due on June 30, 2012 and June 30, 2013.  Payments shall be applied first to accrued but unpaid interest and then to principal.Note #1 contains certain earn-out provisions that encompass both the Company’s and Purchaser’s revenue volumes.  Provided these provisions are met, the Company could potentially retire Note #1 prior to its expiration date.  Payments not made when due, by maturity acceleration or otherwise, shall bear interest at the rate of 12% per annum from the date due until fully paid

Promissory Note #2

From the sale of its Series 5 PLC product line assets, the Company used the proceeds received to retire substantially all of its obligations under its $1.6 million senior convertible debenture due May 29, 2011 and to cancel the related warrants covering 11.7 million shares of the Company’s common stock.  In exchange for the early retirement of debt and cancellation of warrants, the Company provided the lender with an unsecured one-year promissory note (“Note #2”) for $50,000.  The outstanding principal balance bears interest at the annual rate of five and one-quarter (5.25) percent and is due on March 4, 2012. The monthly payment of principal and interest is $4,385.  However Note #2 is due immediately if the Company (a) receives three million ($3,000,000) dollars in aggregate in new debt or equity financing, (b) attains one million ($1,000,000) dollars in EBITDA for any reporting quarter or (3) becomes insolvent.  The Note may be prepaid in whole or in part, without penalty at any time.  Payments shall be applied first to accrued but unpaid interest and then to principal.

Aggregate maturities of long-term debt as of June 30, 2011 are as follows:

As of June 30,	Amount
2011 (Remainder of)	$	48,890
2012		61,253
2013		49,485
2014		750,483
2015 and thereafter		103,979
	$	1,014,090
Less: Current portion		(85,768	)
Total Long term portion	$	928,322

XML



NOTE K - COMMITMENTS AND CONTINGENCIES

6 Months Ended

Jun. 30, 2011

Commitments and Contingencies Disclosure [Text Block]

NOTE K - COMMITMENTS AND CONTINGENCIES

Office Leases Obligations

The Company presently leases approximately 14,000 square feet of office space in Milwaukee, WI for its corporate headquarters.  The Milwaukee lease expires in March 2020.  

The Company presently leases 16,416 square feet of commercial office space in Germantown, MD.  The lease commitments expire in December 2015.  On July 15, 2011, Telkonet executed a sublease agreement for 11,626 square feet of its former corporate headquarters located in Germantown, MD.  The sublease term will expire on January 31, 2013.  The subtenant received a one month rent abatement and has the option to extend the sublease from January 31, 2013 to December 31, 2015.

Commitments for minimum rentals under non cancelable leases at June 30, 2011 are as follows:

2011 (Remainder of)	$	180,264
2012		384,651
2013		402,951
2014		414,267
2015 and thereafter		1,179.837
Total	$	2,561,970

Rental expenses charged to operations for the six months ended June 30, 2011 and 2010 are $405,637 and $325,116, respectively.

Employment and Consulting Agreements

The Company has employment agreements with certain of its key employees which include non-disclosure and confidentiality provisions for protection of the Company’s proprietary information.

Jason Tienor, President and Chief Executive Officer, is employed pursuant to an employment agreement dated April 11, 2011.  Mr. Tienor’s employment agreement is for a term expiring on April 10, 2012, is renewable at the agreement of the parties and provides for a base salary of $200,000 per year.

Jeff Sobieski, Chief Operating Officer, is employed pursuant to an employment agreement, dated April 11, 2011. Mr. Sobieski’s employment agreement is for a term expiring on April 10, 2012, is renewable at the agreement of the parties and provides for a base salary of $190,000 per year. 

Litigation

The Company is subject to legal proceedings and claims which arise in the ordinary course of its business.  Although occasional adverse decisions or settlements may occur, the Company believes that the final disposition of such matters should not have a material adverse effect on its financial position, results of operations or liquidity.

Linksmart Wireless Technology, LLC v. T-Mobile USA, Inc.

On July 1, 2008, Linksmart Wireless Technology, LLC, or Linksmart, filed a civil lawsuit in the Eastern District of Texas against EthoStream, LLC, our wholly-owned subsidiary and 22 other defendants (Linksmart Wireless Technology, LLC v. T-Mobile USA, Inc., et al, U.S. District Court, for the Eastern District of Texas, Marshall Division, No.2:08-cv-00264-TJW-CE).  This lawsuit alleges that the defendants’ services infringe a wireless network security patent held by Linksmart. Linksmart seeks a permanent injunction enjoining the defendants from infringing, inducing the infringement of, or contributing to the infringement of its patent, an award of damages and attorney’s fees.

On August 1, 2008, we timely filed an answer to the complaint denying the allegations. On February 27, 2009, the USPTO granted a reexamination request with respect to the patent in issue in this lawsuit.  Based upon four highly relevant and material prior art references that had not been considered by the USPTO in its initial examination, it found a “substantial new question of patentability” affecting all claims of the patent in suit.  On August 2, 2010, the USPTO issued a Final Office Action rejecting every claim of the patent in suit.  If this action is upheld on appeal it will result in the elimination of all of the issues in the pending litigation. There is a possibility that the claims of the patent will be reinstated on appeal either in their original form or as amended.  

Defendant Ramada Worldwide, Inc. provided us with notice of the suit and demanded that we defend and indemnify it pursuant to a vendor direct supplier agreement between EthoStream and WWC Supplier Services, Inc., a Ramada affiliate (wherein we agreed to indemnify, defend and hold Ramada harmless from and against claims of infringement).  After a review of that agreement, it was determined that EthoStream owes the duty to defend and indemnify with respect to services provided by Telkonet to Ramada and it has assumed Ramada’s defense.  An answer on Ramada’s behalf was filed in U.S. District Court, for the Eastern District of Texas, Marshall Division on September 19, 2008.

On September 1, 2010, the court entered a 60 day stay at the plaintiff’s request. On September 15, 2010 we, along with other defendants, filed a motion seeking a stay of the litigation pending the conclusion of the reexamination proceeding. Subject to certain conditions, Linksmart agreed to entry of a stay. The court granted the defendants’ motion on October 26, 2010 and, subject to the agreed upon conditions, the matter is now stayed pending conclusion of the reexamination, including all appeals. A mandatory mediation was held in October, 2010 which did not achieve any results.  As of June 30, 2011, the case continued to be in stay pending a dismissal or appeal.  Because of the above, the Company is unable to estimate potential damages.

Robert P. Crabb v. Telkonet Inc.

On November 9, 2010, a former executive, Robert P. Crabb, served Telkonet, Inc. and Telkonet Communications, Inc. ("Telkonet") with a Complaint in the Circuit Court for Montgomery County, MD alleging  (1) violation of Maryland’s Wage Payment and Collection Act  (2) Breach of Contract and  (3) Promissory Estoppel/Detrimental Reliance.  The claims in his Complaint arise out of his retirement in September 2007.  On December 6, 2010, Telkonet filed an Answer and Counterclaim, alleging “Recoupment.” Mr. Crabb filed an Answer to the Counterclaim on January 10, 2011.  In terms of relief, Mr. Crabb is seeking "severance compensation" in the amount of $156,000, treble damages, interest, and attorneys’ fees.  Treble damages and attorneys’ fees are only available under the Maryland Wage Payment and Collection Act.  Mr. Crabb's Complaint provides no specific accounting for the relief sought.  A pre-trial conference was held on July 28, 2011, during which time the Court scheduled a four day jury trial beginning on December 12, 2011.  On July 28, Plaintiff also filed a Motion for Partial Summary Judgment on his claims and Defendants' Counterclaim.  Defendants' Opposition is due on August 12, 2011.  Although discovery in this matter has closed, there are two discovery motions pending before the Court.  

Stephen L. Sadle v. Telkonet, Inc

On April 15, 2011, a former executive, Stephen L. Sadle, served Telkonet, Inc. and Telkonet Communications, Inc. ("Telkonet") with a Complaint in the Circuit Court for Montgomery County, MD alleging (1) Breach of Contract, (2) Promissory Estoppel/Detrimental Reliance and (3) violation of Maryland's Wage Payment and Collection Act.  The three claims in his Complaint each arise out of his retirement in 2007.  On May 27, 2011 Defendants filed a motion to dismiss Mr. Sadle's claims.  A hearing on Defendants' motion to dismiss will be held on August 10, 2011.   In terms of relief, Mr. Sadle is seeking "severance compensation" in the amount of $195,000, treble damages, interest, and attorneys’ fees.  Treble damages and attorneys’ fees are only available under the Maryland Wage Payment and Collection Act.  Mr. Sadle's Complaint provides no specific accounting for the relief sought. The trial in this case will likely be scheduled between February and June 2012.

Sales Tax

The Company believes there exists the possibility of sales tax exposure in multiple states covering multiple years. At the quarter ended June 30, 2011, the Company has approximately $225,000 accrued for any potential sales tax exposure. However the Company is unable to estimate if there will be any additional sales tax exposure in excess of this accrual.

XML



NOTE B - NEW ACCOUNTING PRONOUNCEMENTS

6 Months Ended

Jun. 30, 2011

Schedule of New Accounting Pronouncements and Changes in Accounting Principles [Table Text Block]

NOTE B - NEW ACCOUNTING PRONOUNCEMENTS

During December 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2010-28, “Intangibles—Goodwill and Other (Topic 350):  When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts—a consensus of the FASB Emerging Issues Task Force.”  ASU No. 2010-28 requires entities with reporting units with zero or negative carrying amounts to perform step 2 of the goodwill impairment test if qualitative factors indicate that it is more likely than not that a goodwill impairment exists.  Any goodwill impairment recorded upon the adoption of ASU No. 2010-28 is required to be recorded as a cumulative-effect adjustment to beginning retained earnings.  ASU No. 2010-28 is effective for fiscal years beginning after December 15, 2010. The company is currently assessing the effect that ASU No. 2010-28 will have on its results of operations, financial position and cash flows.

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NOTE H - CAPITAL STOCK

6 Months Ended

Jun. 30, 2011

Disclosure of Compensation Related Costs, Share-based Payments [Text Block]

NOTE H - CAPITAL STOCK

The Company has authorized 15,000,000 shares of preferred stock, with a par value of $.001 per share. As of June 30, 2011, the Company has 215 shares of Series A preferred stock issued and outstanding and 538 shares of Series B preferred stock issued and 533 shares outstanding.  The Company has authorized 190,000,000 shares of common stock, with a par value of $.001 per share. As of June 30, 2011 and December 31, 2010, the Company has 102,037,171 and 101,258,725, respectively, shares of common stock issued and outstanding.

During the six months ended June 30, 2011, the Company issued 409,056 shares of common stock to directors and management for services performed through June 30, 2011.  These shares were valued at $55,500, which approximated the fair value of the shares when they were issued.   In addition, 177,083 shares were issued to a current member of the Company’s Board of Directors for consulting fees incurred prior to, but not paid until after, his election to Board of Directors.  These shares were valued at $25,000.

During the three months ended June 30, 2011, five shares of Series B redeemable preferred stock were converted to 192,307 shares of common stock.

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NOTE M - FAIR VALUE MEASUREMENTS

6 Months Ended

Jun. 30, 2011

Fair Value Disclosures [Text Block]

NOTE M - FAIR VALUE MEASUREMENTS

The financial assets of the Company measured at fair value on a recurring basis are cash equivalents and long-term marketable securities. The Company’s long term marketable securities are generally classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency. The Company’s long-term investments are classified within Level 3 of the fair value hierarchy because they are valued using unobservable inputs, due to the fact that observable inputs are not available, or situations in which there is little, if any, market activity for the asset or liability at the measurement date.  The Company’s derivative liabilities and convertible debentures are classified within Level 3 of the fair value hierarchy because they are valued using inputs which are not actively observable, either directly or indirectly.

● Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

● Level 2: Quoted prices in markets that are not active, or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability; or

● Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and are unobservable.

The following table sets forth the Company’s short and long-term investments as of December 31, 2010 which are measured at fair value on a recurring basis by level within the fair value hierarchy. These are classified based on the lowest level of input that is significant to the fair value measurement:

	Level 1		Level 2		Level 3		Total
Derivative liabilities		-		-		1,901,775		1,901,775
Total	$	-	$	-	$	1,901,775	$	1,901,775

The table below sets forth a summary of changes in the fair value of the Company’s Level 3 financial liabilities (derivative liability) for the six months ended June 30, 2011.

	2011
Balance at beginning of year	$	1,901,775
Repayment of debt, cancellation of warrants and related derivative liability		(1,158,729	)
Change in fair value of derivative liability		(172,477	)
Retirement of derivative liability related to warrant obligation		(570,569	)
Balance at end of period	$	-

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NOTE I - STOCK OPTIONS AND WARRANTS

6 Months Ended

Jun. 30, 2011

Share-based Compensation, Option and Incentive Plans Policy [Policy Text Block]

NOTE I - STOCK OPTIONS AND WARRANTS

Employee Stock Options

The Company maintains two stock option plans. The first plan initiated in the year 2000 and was established as a long term incentive plan for employees and consultants, including board of director members. The second plan was established in 2010 also as an incentive plan for officers, employees, non employee directors, prospective employees and other key persons. It is anticipated that providing such persons with a direct stake in the Company’s welfare will assure a better alignment of their interests with those of the Company and its’ stockholders.

The following table summarizes the changes in options outstanding and the related prices for the shares of the Company’s common stock issued to employees of the Company under a non-qualified employee stock option plan.

Options Outstanding								Options Exercisable
Exercise Prices		Number Outstanding		Weighted Average Remaining Contractual Life  (Years)		Weighted Average Exercise Price		Number Exercisable		Weighted Average Exercise Price
$	1.00 - $1.99		1,783,800		2.17	$	1.04		1,600,858	$	1.04
$	2.00 - $2.99		145,000		3.82	$	2.47		126,665	$	2.46
$	3.00 - $3.99		40,000		4.71	$	3.09		40,000	$	3.09
$	4.00 - $4.99		35,000		4.24	$	4.27		35,000	$	4.27
$	5.00 - $5.99		30,000		3.89	$	5.43		30,000	$	5.43
			2,033,800		2.40	$	1.31		1,832,523	$	1.31

Transactions involving stock options issued to employees are summarized as follows:

	Number of Shares			Weighted Average Price Per Share
Outstanding at January 1, 2010		6,120,883		$	1.56
Granted		-			-
Exercised		-			-
Cancelled or expired		(3,572,083	)		1.62
Outstanding at December 31, 2010		2,548,800		$	1.57
Granted		-			-
Exercised		-			-
Cancelled or expired		(515,000	)		2.69
Outstanding at June 30, 2011		2,033,800		$	1.31

The expected life of awards granted represents the period of time that they are expected to be outstanding.  We determine the expected life based on historical experience with similar awards, giving consideration to the contractual terms, vesting schedules, exercise patterns and pre-vesting and post-vesting forfeitures.  We estimate the volatility of our common stock based on the calculated historical volatility of our own common stock using the trailing 24 months of share price data prior to the date of the award.  We base the risk-free interest rate used in the Black-Scholes-Merton option valuation model on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term equal to the expected life of the award.  We have not paid any cash dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future.  Consequently, we use an expected dividend yield of zero in the Black-Scholes-Merton option valuation model. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation for those awards that are expected to vest. In accordance with ASC 718-10, we adjust share-based compensation for changes to the estimate of expected equity award forfeitures based on actual forfeiture experience.

There were no options granted or exercised during the six months ended June 30, 2011 and 2010.  

Total stock-based compensation expense in connection with options granted to employees recognized in the condensed consolidated statement of operations for the three and six months ended June 30, 2011 and 2010 was $7,994 and $41,401, and $15,988 and $88,181, respectively.

Non-Employee Stock Options

The following table summarizes the changes in options outstanding and the related prices for the shares of the Company’s common stock issued to the Company consultants.  These options were granted in lieu of cash compensation for services performed.

Options Outstanding								Options Exercisable
Exercise Prices		Number Outstanding		Weighted Average Remaining Contractual Life (Years)		Weighted Average Exercise Price		Number Exercisable		Weighted Average Exercise Price
$	1.00		425,000		.62	$	1.00		425,000	$	1.00

Transactions involving options issued to non-employees are summarized as follows:

	Number of Shares			Weighted Average Price Per Share
Outstanding at January 1, 2010		675,000		$	1.00
Granted		-			-
Exercised		-			-
Canceled or expired		(250,000	)		1.00
Outstanding at December 31, 2010		425,000		$	1.00
Granted		-			-
Exercised		-			-
Canceled or expired					-
Outstanding at June 30, 2011		425,000		$	1.00

There were no non-employee stock options vested during the periods ended June 30, 2011 and 2010.

Warrants

The following table summarizes the changes in warrants outstanding and the related prices for the shares of the Company’s common stock issued to non-employees of the Company.  These warrants were granted in lieu of cash compensation for services performed or financing expenses and in connection with placement of convertible debentures.

		Warrants Outstanding						Warrants Exercisable
Exercise Prices		Number Outstanding		Weighted Average Remaining Contractual Life (Years)		Weighed Average Exercise Price		Number Exercisable		Weighted Average Exercise Price
$	0.13		10,346,168		4.46	$	0.13		10,346,168	$	0.13
$	0.33		1,705,539		3.26	$	0.33		1,705,539	$	0.33
$	0.60		800,000		1.85	$	0.60		800,000	$	0.60
$	1.00		500,000		.53	$	1.00		500,000	$	1.00
$	2.59		431,226		.12	$	2.59		431,226	$	2.59
$	3.05		1,135,140		2.52	$	3.05		1,135,140	$	3.05
$	4.17		359,712		1.06	$	4.17		359,712	$	4.17
			15,277,785		3.72	$	.59		15,277,785	$	.59

Transactions involving warrants are summarized as follows:

	Number of Shares			Weighted Average Price Per Share
Outstanding at January 1, 2010		12,158,941		$	1.60
Issued		12,819,897			0.28
Exercised		-			-
Canceled or expired		(2,874,096	)		3.29
Outstanding at December 31, 2010		22,104,742		$	.51
Issued		5,322,847			.13
Exercised		-			-
Canceled or expired		(12,149,804	)		.23
Outstanding at June 30, 2011		15,277,785		$	.59

On April 8, 2011, the Company issued 271 shares of Series B Preferred Stock (“Series B”) with attached warrants to purchase 5,211,538 shares of the Company’s common stock at $0.13 per share.  

The Company did not issue any warrants during the period ended June 30, 2010.

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NOTE G - REDEEMABLE PREFERRED STOCK

6 Months Ended

Jun. 30, 2011

Equity Method Investments Disclosure [Text Block]

NOTE G - REDEEMABLE PREFERRED STOCK

Series A

The Company has designated 215 shares of preferred stock as Series A Preferred Stock (“Series A”). Each share of Series A shall be convertible, at the option of the holder thereof, at any time, into shares of our Common Stock at an initial conversion price of $0.363 per share, subject to adjustments for anti-dilution provisions.  In the event of a change of control (as defined in the purchase agreement with respect to the Series A), or at the holder’s option, on November 19, 2014 and for a period of 180 days thereafter, provided that at least fifty percent (50%) of the shares of Series A issued on the Series A Original Issue Date remain outstanding as of November 19, 2014, and the holders of at least a majority of the then outstanding shares of Series A provide written notice requesting redemption of all shares of Series A, we are required to redeem the Series A for the purchase price plus any accrued but unpaid dividends. The Series A accrues dividends at an annual rate of 8% of the original purchase price, and shall be payable only when, as, and if declared by our Board of Directors.

On November 16, 2009, the Company sold 215 shares of Series A with attached warrants to purchase an aggregate of 1,628,800 shares of the Company’s common stock at $0.33 per share.  The Series A shares were sold at a price per share of $5,000 and each Series A share is convertible into approximately 13,774 shares of common stock at a conversion price of $0.363 per share. The Company received $1,075,000 from the sale of the Series A shares.  Since the Series A may ultimately be redeemable at the option of the holder, the carrying value of the preferred stock, net of discount and accumulated dividends, has been classified as Commitments and Contingencies on the balance sheet at June 30, 2011 and December 31, 2010.

In accordance with ASC 470 Topic “Debt”, a portion of the proceeds were allocated to the warrants based on their relative fair value, which totaled $287,106 using the Black Scholes option pricing model. Further, the Company attributed a beneficial conversion feature of $70,922 to the Series A preferred shares based upon the difference between the effective conversion price of those shares and the closing price of the Company’s common stock on the date of issuance. The assumptions used in the Black-Scholes model are as follows:  (1) dividend yield of 0%; (2) expected volatility of 123%, (3) weighted average risk-free interest rate of 2.2%, (4) expected life of 5 years, and (5) estimated fair value of Telkonet common stock of $0.24 per share. The expected term of the warrants represents the estimated period of time until exercise and is based on historical experience of similar awards and giving consideration to the contractual terms. The amounts attributable to the warrants and beneficial conversion feature, aggregating $358,028, have been recorded as a discount and deducted from the face value of the preferred stock. Since the preferred stock is classified as temporary equity, the discount will be amortized over the period from issuance to November 19, 2014 (the initial redemption date) as a charge to additional paid-in capital (since there is a deficit in retained earnings).

The charge to additional paid in capital for amortization of Series A discount and costs for the period ended June 30, 2011 was $35,802.  

For the six months ended June 30, 2011 we have accrued dividends in the amount of $42,424 and cumulative accrued dividends of $138,356. The accrued dividends have been charged to additional paid-in capital (since there is a deficit in retained earnings) and the net unpaid accrued dividends have been added to the carrying value of the Series A shares.

Series B

The Company has designated 567 shares of preferred stock as Series B Preferred Stock (“Series B”). Each share of Series B shall be convertible, at the option of the holder thereof, at any time, into shares of our Common Stock at an initial conversion price of $0.13 per share, subject to adjustments for anti-dilution provisions.  In the event of a change of control (as defined in the purchase agreement with respect to the Series B), or at the holder’s option, on November 19, 2014 and for a period of 180 days thereafter, provided that at least fifty percent (50%) of the shares of Series B issued on the Series B Original Issue Date remain outstanding as of November 19, 2014, and the holders of at least a majority of the then outstanding shares of Series B provide written notice requesting redemption of all shares of Series B, we are required to redeem the Series B for the purchase price plus any accrued but unpaid dividends. The Series B accrues dividends at an annual rate of 8% of the original purchase price, and shall be payable only when, as, and if declared by our Board of Directors.

On August 4, 2010, the Company sold 267 shares of Series B with attached warrants to purchase an aggregate of 10,269,219 shares of the Company’s common stock at $0.13 per share.  The Series B shares were sold at a price per share of $5,000 and each Series B share is convertible into approximately 38,461 shares of common stock at a conversion price of $0.13 per share. The Company received $1,335,000 from the sale of the Series B shares.  Since the Series B shares may ultimately be redeemable at the option of the holder, the carrying value of the Series B shares, net of discount and accumulated dividends, has been classified as temporary equity on the balance sheet at June 30, 2011 and December 31, 2010.

In accordance with ASC 470 Topic “Debt”, a portion of the proceeds were allocated to the warrants based on their relative fair value, which totaled $394,350 using the Black Scholes option pricing model. Further, the Company attributed a beneficial conversion feature of $394,350 to the Series B shares based upon the difference between the effective conversion price of those shares and the closing price of the Company’s common stock on the date of issuance. The assumptions used in the Black-Scholes model are as follows:  (1) dividend yield of 0%; (2) expected volatility of 123%, (3) weighted average risk-free interest rate of 1.76%, (4) expected life of 5 years, and (5) estimated fair value of Telkonet common stock of $0.109 per share. The expected term of the warrants represents the estimated period of time until exercise and is based on historical experience of similar awards and giving consideration to the contractual terms. The amounts attributable to the warrants and beneficial conversion feature, aggregating $788,700, have been recorded as a discount and deducted from the face value of the Series B shares. Since the Series B is classified as temporary equity, the discount will be amortized over the period from issuance to November 19, 2014 (the initial redemption date) as a charge to additional paid-in capital (since there is a deficit in retained earnings).

On April 8, 2011, the Company sold 271 additional shares of Series B with attached warrants to purchase an aggregate of 10,423,067 shares of the Company’s common stock at $0.13 per share.  The Series B shares were sold at a price per share of $5,000 and each Series B share is convertible into approximately 38,461 shares of common stock at a conversion price of $0.13 per share. The Company received $1,355,000 from the sale of the Series B shares.  Since the Series B shares may ultimately be redeemable at the option of the holder, the carrying value of the Series B shares, net of discount and accumulated dividends, has been classified as temporary equity on the balance sheet at June 30, 2011.

In accordance with ASC 470 Topic “Debt”, a portion of the proceeds were allocated to the warrants based on their relative fair value, which totaled $427,895 using the Black Scholes option pricing model. Further, the Company attributed a beneficial conversion feature of $427,895 to the Series B shares based upon the difference between the effective conversion price of those shares and the closing price of the Company’s common stock on the date of issuance. The assumptions used in the Black-Scholes model are as follows:  (1) dividend yield of 0%; (2) expected volatility of 129%, (3) weighted average risk-free interest rate of 0.26%, (4) expected life of 5 years, and (5) estimated fair value of Telkonet common stock of $0.12 per share. The expected term of the warrants represents the estimated period of time until exercise and is based on historical experience of similar awards and giving consideration to the contractual terms. The amounts attributable to the warrants and beneficial conversion feature, aggregating $855,790, have been recorded as a discount and deducted from the face value of the Series B shares. Since the Series B is classified as temporary equity, the discount will be amortized over the period from issuance to November 19, 2014 (the initial redemption date) as a charge to additional paid-in capital (since there is a deficit in retained earnings).

The charge to additional paid in capital for amortization of Series B discount and costs for the period ended June 30, 2011 was $157,995.

For the six months ended June 30, 2011, we have accrued dividends for Series B in the amount of $77,646 and cumulative accrued dividends of $120,683. The accrued dividends have been charged to additional paid-in capital (since there is a deficit in retained earnings) and the net unpaid accrued dividends been added to the carrying value of the preferred stock.

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Condensed Consolidated Statements of Cash Flows (USD $)	6 Months Ended
	Jun. 30, 2011	Jun. 30, 2010
Net income (loss)	$ 1,095,667	$ (188,301)
Amortization of debt discounts and financing costs	191,357	254,120
Gain on sale of asset	(829,296)
Gain on derivative liability	(172,477)	(696,793)
(Gain) loss on disposal of fixed assets	(2,165)	100,744
Stock based compensation	96,488	88,181
Depreciation and amortization	165,180	158,200
Bad debt expense (recoveries)	(56,620)	31,879
Accounts receivable, trade and other	(389,250)	(762,451)
Inventories	(117,270)	219,051
Other current assets	(67,910)	(187,713)
Other current liabilities	(80,970)	42,212
Accounts payable, accrued liabilities & expenses, net	(579,096)	827,855
Deferred lease liability	98,218
Net Cash Used In Operating Activities	(648,144)	(113,016)
Proceeds on disposal of asset	6,645
Proceeds from sale of assets	1,000,000
Net Cash Provided by Investing Activities	1,006,645
Repayment on line of credit		(288,417)
Proceeds from issuance of note payable	700,000
Payments on long term note payable	(35,910)
Payments on note payable – related party	(25,114)
Proceeds from issuance of preferred stock	1,355,000
Repayment of Convertible Debentures	(1,606,023)
Net Cash Provided By (Used In) Financing Activities	387,953	(288,417)
Net increase (decrease) in cash and cash equivalents	746,454	(401,433)
Cash and cash equivalents at the beginning of the period	136,030	503,870
Cash and cash equivalents at the end of the period	882,484	102,437
Cash paid during the period for financing expenses	203,174	301,351
Income taxes paid	0	0
Common stock issuance to pay off accounts payable		62,957
Issuance of note payable in conjunction with warrant cancellation	50,000
Beneficial conversion feature of redeemable convertible preferred stock	427,895
Value of warrants issued with redeemable convertible preferred stock	427,895
Accretion of discount on redeemable preferred stock	193,797	35,802
Accretion of dividend on redeemable preferred stock	$ 120,070	$ 42,658

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NOTE C - INTANGIBLE ASSETS AND GOODWILL

6 Months Ended

Jun. 30, 2011

Goodwill and Intangible Assets Disclosure [Text Block]

NOTE C - INTANGIBLE ASSETS AND GOODWILL

Total identifiable intangible assets acquired and their carrying values at June 30, 2011 are:

	Cost		Accumulated Amortization			Net Book Value		Residual Value		Weighted Average Amortization Period (Years)
Amortized Identifiable Intangible Assets:
Subscriber lists – EthoStream	$	2,900,000	$	(1,037,183	)	$	1,862,817	$	-		12.0
Total Amortized Identifiable Intangible Assets		2,900,000		(1,037,183	)		1,862,817		-
Goodwill – EthoStream	5,796,430			-			5,796,430		-
Goodwill – SSI	5,874,016			-			5,874,016		-
Total	$	14,570,446	$	(1,037,183	)	$	13,533,263	$	-

Total identifiable intangible assets acquired and their carrying values at December 31, 2010 are:

	Cost		Accumulated Amortization			Net Book Value		Residual Value		Weighted Average Amortization Period (Years)
Amortized Identifiable Intangible Assets:
Subscriber lists – EthoStream	$	2,900,000	$	(916,343	)	$	1,983,657	$	-		12.0
Total Amortized Identifiable Intangible Assets		2,900,000		(916,343	)		1,983,657		-
Goodwill – EthoStream	5,796,430			-			5,796,430		-
Goodwill – SSI	5,874,016			-			5,874,016		-
Total	$	14,570,446	$	(916,343	)	$	13,654,103	$	-

Total amortization expense charged to operations for both the three and six months ended June 30, 2011 and 2010 was $60,420 and $120,840, respectively.

Estimated amortization expense as of June 30, 2011 is as follows:

Remainder of 2011	$	120,840
2012		241,680
2013		241,680
2014		241,680
2015 and after		1,016,937
Total	$	1,862,817

The Company does not amortize goodwill. The Company recorded goodwill in the amount of $14,670,455 as a result of the acquisitions of EthoStream and SSI during the year ended December 31, 2007.   The Company evaluates goodwill for impairment based on the fair value of the operating business units to which this goodwill relates at least once a year. The Company generally determines the fair value of a reporting unit using a combination of the income approach, which is based on the present value of estimated future cash flows, and the market approach, which compares the business unit's multiples to its competitors.  

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NOTE D - ACCOUNTS RECEIVABLE

6 Months Ended

Jun. 30, 2011

Loans, Notes, Trade and Other Receivables Disclosure [Text Block]

NOTE D - ACCOUNTS RECEIVABLE

Components of accounts receivable as of June 30, 2011 and December 31, 2010 are as follows:

	June 30, 2011			December 31, 2010
Accounts receivable	$	1,370,055		$	974,185
Allowance for doubtful accounts		(125,000	)		(175,000	)
Total	$	1,245,055		$	799,185

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NOTE L - BUSINESS CONCENTRATION

6 Months Ended

Jun. 30, 2011

Segment Reporting Disclosure [Text Block]

NOTE L - BUSINESS CONCENTRATION

Revenue from one (1) major customer approximated $658,109 or 11% of total revenues for the period ended June 30, 2010. Total accounts receivable of $532,190 or 29% of total accounts receivable, was due from this customer as of June 30, 2010. For the period ended June 30, 2011, the Company did not have a customer with revenue greater to 10% of total revenues.

Purchases from two (2) major suppliers approximated $1,254,804, or 35%, of purchases, and two (2) major suppliers approximated $1,028,314, or 33%, of purchases, for the six months ended June 30, 2011 and 2010, respectively. Total accounts payable of approximately $149,055, or 7%, of total accounts payable, was due to these suppliers as of June 30, 2011, and $543,572, or 15%, of total accounts payable, was due to these suppliers as of June 30, 2010.

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NOTE E - INVENTORY

6 Months Ended

Jun. 30, 2011

Public Utilities Disclosure [Text Block]

NOTE E - INVENTORY

Inventories as of June 30, 2011 and December 31, 2010 are as follows:

	June 30, 2011			December 31, 2010
Inventory, gross	$	735,968		$	799,402
Reserve for obsolescence		(140,000	)		(200,000	)
Inventory, Net	$	595,968		$	599,402

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Condensed Consolidated Statement of Stockholders' Equity (unaudited) (USD $)	Total	Common Stock [Member]	Additional Paid-in Capital [Member]	Retained Earnings [Member]
Balance at Jan. 01, 2011
Shares issued to director and management at approximately $0.125 per share	$ 55,500	$ 409	$ 55,091
Shares issued to director and management at approximately $0.125 per share (in Shares)		409,056
Shares issued to director for consulting fees at approximately $0.15 per share (1)	25,000	177	24,823
Shares issued to director for consulting fees at approximately $0.15 per share (1) (in Shares)		177,083
Shares issued on conversion of preferred stock at approximately $0.18 per share	25,000	192	24,808
Shares issued on conversion of preferred stock at approximately $0.18 per share (in Shares)		192,307
Stock-based compensation expense related to employee stock options	15,988		15,988
Warrants issued with redeemable convertible preferred stock	427,895		427,895
Beneficial conversion feature of redeemable convertible preferred stock	427,895		427,895
Retirement of secured convertible debentures	1,158,729		1,158,729
Retirement of derivative liability related to warrant obligation	570,569		570,569
Accretion of preferred stock discount	(193,797)		(193,797)
Accretion of preferred stock dividend	(120,070)		(120,070)
Net Income	1,095,667			1,095,667
Balance at Jun. 30, 2011	$ 10,071,401	$ 102,039	$ 124,387,048	$ (114,417,686)
Balance (in Shares) at Jun. 30, 2011		102,037,171

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NOTE A - SUMMARY OF ACCOUNTING POLICIES

6 Months Ended

Jun. 30, 2011

Significant Accounting Policies [Text Block]

NOTE A - SUMMARY OF ACCOUNTING POLICIES

A summary of the significant accounting policies applied in the preparation of the accompanying consolidated financial statements follows.

General

The accompanying unaudited condensed consolidated financial statements of Telkonet, Inc. (the “Company”) have been prepared in accordance with Rule S-X of the Securities and Exchange Commission (the “SEC”) and with the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  However, the results from operations for the three and six month periods ended June 30, 2011, are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.  The unaudited condensed consolidated financial statements should be read in conjunction with the consolidated December 31, 2010 financial statements and footnotes thereto included in the Company's Form 10-K filed with the SEC.

Business and Basis of Presentation

Telkonet, Inc., formed in 1999 and incorporated under the laws of the state of Utah, has evolved into a Clean Technology company that develops, manufactures and sells proprietary energy efficiency and SmartGrid networking technology. Prior to January 1, 2007, the Company was primarily engaged in the business of developing, producing and marketing proprietary equipment enabling the transmission of voice and data communications over a building’s internal electrical wiring.

In March 2007, the Company acquired substantially all of the assets of Smart Systems International (SSI), a leading provider of energy management products and solutions to customers in the United States and Canada.

In March 2007, the Company acquired 100% of the outstanding membership units of EthoStream, LLC, a network solutions integration company that offers installation, sales and service to the hospitality industry. The EthoStream acquisition enabled Telkonet to provide installation and support for PLC products and third party applications to customers across North America.

In March 2011, the Company sold all its Series 5 PLC product line assets to Wisconsin-based Dynamic Ratings, Inc. under an Asset Purchase Agreement.

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Telkonet Communications, Inc., and EthoStream, LLC. Significant intercompany transactions have been eliminated in consolidation.

Going Concern

The accompanying condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplate continuation of the Company as a going concern. The Company has reported net income from continuing operations of $1,095,667 for the six month period ended June 30, 2011, accumulated deficit of $114,417,686 and total current liabilities in excess of current assets of $167,576 as of June 30, 2011.

Concurrent with the first quarter debenture retirement, the second quarter equity raise and our year to date operating results, the Company believes anticipated revenues and its’ continued operational efficiencies will be sufficient to satisfy its ongoing capital and cash flow requirements for the remainder of fiscal 2011.  However, the Company also believes there remains sufficient uncertainty, both in the economic environment and our current deficit position, that the Company cannot make any representations for fiscal 2012.   

Fair Value of Financial Instruments

The company accounts for the fair value of financial instruments in accordance with ASC 820, which defines fair value for accounting purposes, established a framework for measuring fair value and expand disclosure requirements regarding fair value measurements.  Fair value is defined as an exit price, which is the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date.  The degree of judgment utilized in measuring the fair value of assets and liabilities generally correlates to the level of pricing observability.  Financial assets and liabilities with readily available, actively quoted prices or for which fair value can be measured from actively quoted prices in active markets generally have more pricing observability and require less judgment in measuring fair value.  Conversely, financial assets and liabilities that are rarely traded or not quoted have less price observability and are generally measured at fair value using valuation models that require more judgment.  These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency of the asset, liability or market and the nature of the asset or liability.  We have categorized our financial assets and liabilities that are recurring, at fair value into a three-level hierarchy in accordance with these provisions.

Goodwill and Other Intangibles

Goodwill represents the excess of the cost of businesses acquired over fair value or net identifiable assets at the date of acquisition.  Goodwill is subject to a periodic impairment assessment by applying a fair value test based upon a two-step method.  The first step of the process compares the fair value of the reporting unit with the carrying value of the reporting unit, including any goodwill.  We utilize a discounted cash flow valuation methodology to determine the fair value of the reporting unit.  If the fair value of the reporting unit exceeds the carrying amount of the reporting unit, goodwill is deemed not to be impaired in which case the second step in the process is unnecessary.  If the carrying amount exceeds fair value, we perform the second step to measure the amount of impairment loss.  Any impairment loss is measured by comparing the implied fair value of goodwill with the carrying amount of goodwill at the reporting unit, with the excess of the carrying amount over the fair value recognized as an impairment loss.

Long-Lived Assets

We review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable in accordance with ASC 360-10. Recoverability is measured by comparison of the carrying amount to the future net cash flows which the assets are expected to generate.  If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the projected discounted future cash flows arising from the asset using a discount rate determined by management to be commensurate with the risk inherent to our current business model.

Income per Common Share

The Company computes earnings per share under ASC 260-10, Earnings Per Share.  Basic net income per common share is computed by dividing net income (loss) by the weighted average number of shares of common stock.  Diluted earnings per share is computed using the weighted average number of common and common stock equivalent shares outstanding during the period. There is no effect on diluted income per share since the common stock equivalents are anti-dilutive. Dilutive common stock equivalents consist of shares issuable the exercise of the Company's stock options and warrants.

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect certain reported amounts and disclosures.  Accordingly, actual results could differ from those estimates.

Income Taxes

The Company accounts for income taxes in accordance with ASC 740-10 “Income Taxes.” Under this method, deferred taxes (when required) are provided based on the difference between the financial reporting and income tax bases of assets and liabilities and net operating losses at the statutory rates enacted for future periods. The Company has a policy of establishing a valuation allowance when it is more likely than not that the Company will not realize the benefits of its deferred tax assets in the future.

The Company has adopted the Financial Accounting Standards Board (“FASB”) issued ASC 740-10-25, which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC 740-10-25 also provides guidance on derecognition, classification, treatment of interest and penalties, and disclosure of such positions. 

Revenue Recognition

For revenue from product sales, we recognize revenue in accordance with ASC 605-10, and ASC Topic 13 guidelines that require that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the selling price is fixed and determinable; and (4) collectability is reasonably assured.  Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the selling prices of the products delivered and the collectability of those amounts.  Provisions for discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period the related sales are recorded.  We defer any revenue for which the product has not been delivered or is subject to refund until such time that we and the customer jointly determine that the product has been delivered or no refund will be required.  The guidelines also address the accounting for arrangements that may involve the delivery or performance of multiple products, services and/or rights to use assets.

Stock Based Compensation

We account for our stock based awards in accordance with ASC 718-10, Compensation, which requires a fair value measurement and recognition of compensation expense for all share-based payment awards made to our employees and directors, including employee stock options and restricted stock awards. We estimate the fair value of stock options granted using the Black-Scholes valuation model. This model requires us to make estimates and assumptions including, among other things, estimates regarding the length of time an employee will retain vested stock options before exercising them, the estimated volatility of our common stock price and the number of options that will be forfeited prior to vesting. The fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. Changes in these estimates and assumptions can materially affect the determination of the fair value of stock-based compensation and consequently, the related amount recognized in our consolidated statements of operations.

The expected term of the options represents the estimated period of time until exercise and is based on historical experience of similar awards, giving consideration to the contractual terms, vesting schedules and expectations of future employee behavior. For 2011 and prior years, expected stock price volatility is based on the historical volatility of the Company’s stock for the related vesting periods.

Stock-based compensation expense in connection with options granted to employees for the six months ended June 30, 2011 and 2010 was $15,988 and $88,181, respectively.

Deferred Lease Liability

Rent expense is recorded on a straight-line basis over the term of the lease. Rent escalations and rent abatement periods during the term of the lease create a deferred lease liability which represents the excess of cumulative rent expense recorded to date over the actual rent paid to date.

Reclassifications

Certain reclassifications have been made in prior year's financial statements to conform to classifications used in the current year.

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NOTE J - RELATED PARTY TRANSACTIONS

6 Months Ended

Jun. 30, 2011

Related Party Transactions Disclosure [Text Block]

NOTE J - RELATED PARTIES

In connection with the Series A Preferred Stock private placement transaction, on November 16, 2009, the Company entered into an Executive Officer Reimbursement Agreement with each of (i) Jason L. Tienor, the Company’s President and Chief Executive Officer, (ii) Richard J. Leimbach, the Company’s then Chief Financial Officer, and (iii) Jeffrey J. Sobieski, the Company’s Chief Operating Officer (collectively, the “Executive Officers”), pursuant to which the Executive Officers agreed to convert a portion of outstanding indebtedness of the Company owed to such Executive Officers into Series A shares and Warrants pursuant to the Securities Purchase Agreement.  Mr. Tienor converted $20,000 of outstanding indebtedness into 4 Series A shares and Warrants to purchase 30,304 shares of Common Stock. Mr. Leimbach converted $10,000 of outstanding indebtedness into 2 Series A shares and Warrants to purchase 15,152 shares of Common Stock. Mr. Sobieski converted $20,000 of outstanding indebtedness into 4 Series A shares and Warrants to purchase 30,304 shares of Common Stock.

Anthony Paoni, Chairman of the Company’s Board of Directors, participated in the private placement of Series A Preferred Stock, purchasing five shares of Series A convertible redeemable preferred stock (convertible into 68,870 shares of common stock) and warrants to purchase 37,880 shares of common stock, for an aggregate purchase price of $25,000.

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NOTE N - SUBSEQUENT EVENTS

6 Months Ended

Jun. 30, 2011

Property, Plant and Equipment Disclosure [Text Block]

NOTE N - SUBSEQUENT EVENTS

On July 15, 2011, Telkonet executed a sublease agreement for 11,626 square feet of its’ former corporate headquarters located in Germantown, MD.  The sublease term will expire on January 31, 2013.  The subtenant received a one month rent abatement and has the option to extend the sublease from January 31, 2013 to December 31, 2015.

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Condensed Consolidated Balance Sheets (USD $)	Jun. 30, 2011	Dec. 31, 2010
ASSETS
Cash and cash equivalents	$ 882,484	$ 136,030
Accounts receivable, net	1,245,055	799,185
Inventories	595,968	599,402
Other current assets	265,475	197,565
Total current assets	2,988,982	1,732,182
Property and equipment, net	64,177	112,997
Deferred financing costs, net		56,732
Goodwill	11,670,446	11,670,446
Intangible assets, net	1,862,817	1,983,657
Total other assets	13,533,263	13,710,835
Total Assets	16,586,422	15,556,014
LIABILITIES AND STOCKHOLDERS’ EQUITY
Accounts payable	1,871,198	2,402,950
Accrued liabilities and expenses	1,110,529	1,157,873
Note payable – current	85,768	47,536
Note payable – related party		25,114
Convertible debentures, net of debt discounts of $134,625		1,471,398
Derivative liability - current		619,698
Other current liabilities	89,063	170,033
Total current liabilities	3,156,558	5,894,602
Derivative liability – long term		1,282,077
Deferred lease liability	98,218
Note payable – long term	928,322	252,464
Total long-term liabilities	1,026,540	1,534,541
Preferred stock, undesignated, par value $.001 per share; 15,000,000 shares authorized; 748 issued and outstanding at June 30, 2011; 482 issued and outstanding at December 31, 2010	0	0
Common stock, par value $.001 per share; 190,000,000 shares authorized; 102,037,171 and 101,258,725 shares issued and outstanding at June 30, 2011 and December 31, 2010, respectively	102,039	101,261
Additional paid-in-capital	124,387,048	121,995,117
Accumulated deficit	(114,417,686)	(115,513,353)
Total stockholders’ equity	10,071,401	6,583,025
Total Liabilities and Stockholders’ Equity	16,586,422	15,556,014
Redeemable Convertible Preferred Stock [Member]
LIABILITIES AND STOCKHOLDERS’ EQUITY
Redeemable preferred stock	968,701	890,475
Redeemable Preferred Stock SeriesB [Member]
LIABILITIES AND STOCKHOLDERS’ EQUITY
Redeemable preferred stock	$ 1,363,222	$ 653,371