10QSB

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-QSB

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QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED March 31, 2006.

¨

TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ______________ TO ______________.

Commission file number 1-11900

Integrated Security Systems, Inc.

(Exact name of small business issuer as specified in its charter)

Delaware	75-2422983
(State of incorporation)	(IRS Employer Identification No.)

8200 Springwood Drive, Suite 230, Irving, Texas	75063
(Address of principal executive offices)	(Zip Code)

(972) 444-8280

(Issuer’s telephone number)

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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  ¨

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

As of April 30, 2006, 90,221,647 shares of the Registrant’s common stock were outstanding.

Transitional Small Business Disclosure Format:   Yes  ¨     No  x

Page 1 of 21

INTEGRATED SECURITY SYSTEMS, INC.

INDEX

Page

PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

Consolidated Balance Sheets at March 31, 2006 (unaudited) and June 30, 2005

3

Consolidated Statements of Operations (unaudited) for the three and nine months

ended March 31, 2006 and 2005

4

Consolidated Statements of Cash Flows (unaudited) for the nine months ended

March 31, 2006 and 2005

5

Notes to Financial Statements

6

Item 2.  Management’s Discussion and Analysis or Plan of Operation

12

Item 3.  Controls and Procedures

15

PART II.  OTHER INFORMATION

Item 1.  Legal Proceedings

17

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

17

Item 3.  Defaults Upon Senior Securities

17

Item 4.  Submission of Matters to a Vote of Security Holders

17

Item 5.  Other Information

17

Item 6.  Exhibits

17

SIGNATURES

18

Page 2 of 21

PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements.

INTEGRATED SECURITY SYSTEMS, INC.

Consolidated Balance Sheets

	March 31,		June 30,
	2006		2005
		(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	192,220	$	305,495
Accounts receivable, net of allowance
for doubtful accounts of $127,197		3,114,229		2,859,083
Inventories		622,805		688,029
Other current assets		80,727		194,987
Total current assets		4,009,981		4,047,594
Property and equipment, net		511,784		696,939
Goodwill		4,008,042		3,872,676
Other assets		517,300		533,120
Total assets	$	9,047,107	$	9,150,329
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
Current liabilities:
Accounts payable	$	2,135,933	$	2,262,740
Accrued liabilities		1,095,176		1,157,674
Demand note payable		1,778,383		1,160,867
Current portion of long-term debt		3,193,952		627,664
Total current liabilities	$	8,203,444	$	5,208,945
Long-term debt		6,994,033		7,479,323
Minority interest		110,480		3,208
Stockholders’ equity (deficit):
Preferred stock, $.01 par value, 750,000 shares
authorized; 100,750 shares issued and
outstanding (liquidation value of $2,015,000)		1,008		1,008
Common stock, $.01 par value, 150,000,000 shares
authorized; 89,913,108 and 86,271,402 shares
issued, respectively		899,131		862,714
Additional paid in capital		33,666,468		32,842,075
Accumulated deficit		(40,708,707)		(37,128,194)
Treasury stock, at cost - 50,000 common shares		(118,750)		(118,750)
Total stockholders’ equity (deficit)		(6,260,850)		(3,541,147)
Total liabilities and stockholders’ equity (deficit)	$	9,047,107	$	9,150,329

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

Page 3 of 21

INTEGRATED SECURITY SYSTEMS, INC.

Consolidated Statements of Operations

(Unaudited)

	For the Three Months Ended March 31,				For the Nine Months Ended March 31,
	2006		2005		2006		2005
Sales	$	3,186,084	$	3,534,718	$	8,557,874	$	10,065,562
Cost of sales		2,084,122		2,767,775		6,035,192		7,334,115
Gross margin		1,101,962		766,943		2,522,682		2,731,447
Operating expenses:
Selling, general and administrative		1,299,876		1,561,207		4,478,138		4,022,734
Research and product development		82,580		124,288		247,946		376,027
		1,382,456		1,685,495		4,726,084		4,398,761
Loss from operations		(280,494)		(918,552)		(2,203,402)		(1,667,314)
Interest expense		(425,449)		(236,752)		(1,060,805)		(599,604)
Loss before minority interest		(705,943)		(1,155,304)		(3,264,207)		(2,266,918)
Minority interest		(48,439)		--		(131,272)		--
Net loss		(754,382)		(1,155,304)		(3,395,479)		(2,266,918)
Preferred dividends		(40,500)		(40,500)		(123,300)		(123,300)
Net loss allocable to common stockholders	$	(794,882)	$	(1,195,804)	$	(3,518,779)	$	(2,390,218)
Weighted average common shares outstanding – basic and diluted		89,256,589		85,308,916		88,127,332		84,752,964
Net loss per share – basic and diluted	$	(0.01)	$	(0.01)	$	(0.04)	$	(0.03)

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

Page 4 of 21

INTEGRATED SECURITY SYSTEMS, INC.

Consolidated Statements of Cash Flows

(Unaudited)

	For the Nine Months Ended March 31,
	2006		2005
Cash flows from operating activities:
Net loss	$	(3,395,479)	$	(2,266,918)
Adjustments to reconcile net loss to net cash used by operating activities:
Depreciation		112,545		154,725
Gain on sale of assets		(12,490)		--
Amortization		186,548		44,364
Provision for bad debt		57,439		4,749
Provision for warranty reserve		7,673		250,000
Expenses paid with stock, warrants and options		368,673		362,940
Amortization of debt discount		228,559		--
Debt discount on notes receivable sold		84,280		--
Minority interest		131,272		--
Changes in operating assets and liabilities,
net of effects of acquisition:
Accounts receivable		(312,585)		(1,140,176)
Inventories		65,224		(633,411)
Other assets		43,532		(462,339)
Accounts payable		(126,705)		339,330
Accrued liabilities		(70,171)		(359,753)
Net cash used in operating activities		(2,631,685)		(3,706,489)
Cash flows from investing activities:
Purchase of property and equipment		(14,900)		(152,186)
Proceeds from sale of assets		100,000		--
Purchase of business, net of cash acquired		(135,366)		(302,231)
Net cash used in investing activities		(50,266)		(454,417)
Cash flows from financing activities:
Employee stock option exercise		8,125		18,750
Payments on debt and other liabilities		(492,615)		(198,061)
Proceeds from notes payable and long-term debt		3,077,166		4,772,287
Distribution to minority interest		(24,000)		--
Net cash provided by financing activities		2,568,676		4,592,976
Increase (decrease) in cash and cash equivalents		(113,275)		432,070
Cash and cash equivalents at beginning of period		305,495		172,688
Cash and cash equivalents at end of period	$	192,220	$	604,758

Supplemental disclosure of noncash financing activities
Debt payment made directly to lender for debt refinancing	$	1,160,867	$	--
Fair market value of warrants issued regarding credit facility		298,877		--
Issuance of common stock in payment of preferred stock dividends		185,135		--
Issuance of promissory note in exchange of indebtedness		328,386		--

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

Page 5 of 21

INTEGRATED SECURITY SYSTEMS, INC.

Notes to Consolidated Financial Statements (Unaudited)

Nine Months Ended March 31, 2006 and 2005

Note 1 - Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information.  Accordingly, they do not include all of the information and footnotes required for complete financial statements.  In the opinion of management, all adjustments (all of which are normal recurring accruals) considered necessary for a fair presentation have been included.  Operating results for the interim period are not necessarily indicative of the results that may be expected for the fiscal year ending June 30, 2006.

The accompanying financial statements include the accounts of Integrated Security Systems, Inc. (the “Company”) and all of its subsidiaries, with all significant intercompany accounts and transactions eliminated.  For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s fiscal 2005 Annual Report on Form 10-KSB filed on October 13, 2005 with the Securities and Exchange Commission.

Note 2 – Stock Options

The Company accounts for stock-based compensation to employees using the intrinsic value method.  Accordingly, compensation cost for stock options granted to employees is measured as the excess, if any, of the quoted market price of the Company’s common stock at the date of the grant over the amount an employee must pay to acquire the stock.

In December 2004, the Financial Accounting Standards Board (“FASB”) issued a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123R”).  SFAS No. 123R supercedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” and requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award, and recognize that cost over the vesting period.  SFAS No. 123R is effective for the fiscal years beginning after December 15, 2005 and the Company will begin recognizing option expense July 1, 2006.

The following table illustrates the effect on net loss and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123R to stock-based employee compensation:

	For the Three Months Ended March 31,				For the Nine Months Ended March 31,
	2006		2005		2006		2005
Net loss, as reported	$	(754,382)	$	(1,155,304)	$	(3,395,479)	$	(2,266,918)
Deduct:  Total stock-based
employee compensation
expense determined under
fair value based method		(105,503)		(94,697)		(316,508)		(284,091)
Pro forma net loss	$	(859,885)	$	(1,250,001)	$	(3,711,987)	$	(2,551,009)
Earnings per share:
Basic and Diluted-as reported	$	(0.01)	$	(0.01)	$	(0.04)	$	(0.03)
Basic and Diluted-pro forma	$	(0.01)	$	(0.01)	$	(0.04)	$	(0.03)

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The fair value of these options was estimated at the date of grant using the Black-Sholes option pricing model with the following weighted average assumptions used for grants in fiscal 2006 and 2005, respectively:  no dividend yield, expected lives of three and five years with expected volatility and risk-free interest rates as outlined in the following table:

	For the Three Months Ended March 31,			For the Nine Months Ended March 31,
		2006	2005		2006	2005
Expected volatility		99.29% - 99.57%	107.55%		99.29% - 109.96%	107.78%
Risk-free interest rate		4.62% - 4.63%	3.70%		3.80% - 4.63%	3.42%

Note 3 – Accounts Receivable

The majority of the Company's accounts receivable are due from companies in the perimeter security and road and bridge industries.  Credit is extended based on evaluation of a customer’s financial condition and credit history and, generally, collateral is not required.  Accounts receivable are due within 30 days and are stated at amounts due from customers net of an allowance for doubtful accounts.  Accounts outstanding longer than the contractual payment terms are considered past due.  The Company determines its allowance by considering a number of factors, including the length of time trade accounts receivable are past due, the Company’s previous loss history, the customer’s current ability to pay its obligation to the Company, and the condition of the general economy and the industry as a whole.  The Company writes-off accounts receivable when they become uncollectible, and payments subsequently r eceived on such receivables are credited to the allowance for doubtful accounts.  

	March 31,
	2006		2005
Accounts receivable:
Trade receivables	$	3,241,426	$	3,280,884
Less:  allowance for doubtful receivables		(127,197)		(100,007)
	$	3,114,229	$	3,180,877

	For the Nine Months Ended March 31,
	2006		2005
Allowance for doubtful receivables:
Beginning Balance	$	127,197	$	109,527
Bad debt expense		57,439		4,749
Accounts written-off		(57,439)		(14,269)
Ending Balance	$	127,197	$	100,007

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Note 4 – Product Warranties

The Company offers one-year, two-year and five-year warranties on products it manufactures.  The length of the warranty is dictated by competition.  The Company provides for repair or replacement of components and/or products that contain defects of material or workmanship. When the Company uses other manufacturers’ components, the warranties of the other manufacturers are passed to the dealers and end users.

The Company records a liability for an estimate of costs that it expects to incur under its basic limited warranty when product revenue is recognized.  Factors affecting the Company’s warranty liability include the number of units sold and historical and anticipated rates of claims and costs per claim.  The Company periodically assesses the adequacy of its warranty liability based on changes in these factors.

The changes in the Company’s product warranty liability are as follows:

	March 31,
	2006	2005
Liability, beginning of year	$       250,017	$       94,157
Expense for new warranties issued	7,673	250,000
Warranty claims	(127,204)	(327,570)
Liability, end of period	$       130,486	$       16,587

Note 5 – Preferred Stock Dividend Arrearage

At March 31, 2006, the Company had dividends in arrears in the amount of $348,528 related to its outstanding Series A and Series D preferred stock, which consists of the following:

	Shares Outstanding	Dividends In Arrears
Series A $20	9,500	$           --
Series D $20	91,250	348,528
	100,750	$  348,528

Note 6 – Net Loss Per Share

The Company computes basic loss per common share using the weighted average number of common shares. At March 31, 2006 and 2005, there were 3,221,252 and 5,310,955 shares, respectively, of in-the-money potentially dilutive common shares outstanding, which were not included in weighted average shares outstanding because their effect is antidilutive due to the Company’s reported net loss.  

At March 31, 2006 and 2005, the Company had approximately 144,394,822 and 111,457,616 shares, respectively, of common stock and common stock equivalents outstanding, which comprises all of the Company’s outstanding equity instruments.  

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Note 7 – Debt

As of March 31, 2006, the Company’s current and long-term debt consisted of the following:

	Total
Demand notes payable:
Secured convertible minimum borrowing note and secured revolving note with a financial institution; interest at Wall Street Journal (7.75% as of March 31, 2006) plus 1.5%; principal and accrued unpaid interest due July 29, 2008; convertible at the option of the financial institution at $0.25 per share (net of debt discount of $166,909)	$	1,778,383
	$	1,778,383
Long-term debt:
Notes payable to stockholders; interest at 8% due in monthly installments of $11,333; principal and accrued unpaid interest due September 30, 2006	$	2,400,000
Convertible note payable to stockholder; interest at 8% due in monthly installments of $10,000 principal and accrued unpaid interest due December 31, 2008; convertible at the option of the shareholder at $0.25 per share; Company may call the note at $0.60 per share (based on certain restrictions)		1,500,000
Notes payable to stockholders; interest at 8% due in monthly installments of $4,833; principal and accrued unpaid interest due November 11, 2007 (net of debt discount of $375,609)		349,391
Convertible note payable to stockholder; interest at 8% due in monthly installments of $3,333; principal and accrued unpaid interest due July 29, 2008; convertible at the option of the shareholder at $0.25 per share; Company may call the note at $0.60 per share (based on certain restrictions); (net of debt discount of $69,406)		430,594
Convertible note payable to stockholder; interest at 7% due in monthly installments of $2,917; principal and accrued unpaid interest due September 5, 2008; convertible at the option of the shareholder at $0.40 per share; Company may call the note at $0.60 per share (based on certain restrictions)		500,000
Term note payable to a bank; due in monthly principal and interest installments of $10,500; interest at 8.25% at March 31, 2006; secured by first mortgage on real estate and equipment; maturity date of July 21, 2006		380,562
Note payable to Chief Executive Officer; interest at 10% due in monthly installments of $2,737; principal and accrued unpaid interest due September 30, 2006; the Company is currently in the process of renewing this letter of credit		328,386
Note payable; interest at 6%; interest and principal payments of $8,607 due monthly through February 2007		91,893
Convertible notes payable; interest at 10% due in semi-annual installments of $205,900; principal and accrued unpaid interest due November 30, 2009; convertible at the option of the shareholder at $0.25 per share; Company may call the notes at $0.60 per share (based on certain restrictions)		4,118,000
Line of credit with a bank; maximum borrowing amount of $300,000; interest at Wall Street Journal prime rate (7.75% as of March 31, 2006) plus 2%; principal and accrued unpaid interest due on March 14, 2007		25,000
Other		64,159
		10,187,985
Less current portion		(3,193,952)
	$	6,994,033

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Note 8 – Business Segments

Information for the Company’s reportable segments for the three and nine months ended March 31, 2006 and 2005 is as follows:

	For the Three Months Ended		For the Nine Months Ended
	March 31,		March 31,
	2006	2005	2006	2005
Sales
B&B ARMR Corporation	$   1,721,780	$   3,237,079	$   4,462,503	$   9,360,130
B&B Roadway	1,112,239	11,530	3,072,506	11,530
Intelli-Site, Inc.	192,832	97,657	551,310	473,996
DoorTek Corporation	159,233	188,452	471,555	219,906
	$   3,186,084	$   3,534,718	$   8,557,874	$ 10,065,562
Income (loss) from operations
B&B ARMR Corporation	$    (227,182)	$    (572,617)	$  (1,998,960)	$  (1,165,815)
B&B Roadway	147,095	(1,055)	396,632	(1,055)
Intelli-Site, Inc.	18,954	(74,260)	42,975	(109,718)
DoorTek Corporation	(13,839)	2,415	(26,011)	3,425
Corporate	(205,522)	(273,035)	(618,038)	(394,151)
	$    (280,494)	$    (918,552)	$  (2,203,402)	$  (1,667,314)

Note 9 – Acquisition

On December 15, 2004, the Company acquired all of the issued and outstanding shares of common stock of DoorTek Corporation, a manufacturer of access control systems and other physical security system products.  The following unaudited pro forma consolidated statements of operations have been prepared as if the acquisition discussed above had occurred at July 1, 2004.

The following unaudited pro forma consolidated statement of operations information has been prepared as if the acquisition discussed above had occurred at the beginning of the period presented.

	For the Nine Months Ended March 31, 2005
Sales	$     10,490,526
Net loss allocable to common stockholders	$    (2,237,923)
Net loss per share allocable to common stockholders, basic and diluted	$            (0.03)
Weighted average shares outstanding, basic and diluted	84,981,536

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Note 10 – Closure of Manufacturing Facility

Effective August 19, 2005, we have ceased all manufacturing operations at our location in Norwood, Louisiana.  This action, consistent with our overall business plan, was undertaken in order to increase our profitability by outsourcing our manufacturing operations to third party subcontractors and focus our efforts on the marketing and sales efforts of our anti-terrorist crash barriers and related products.

As a result of the closure of this manufacturing facility, we reduced our staff by approximately 45 employees, recognized expense of approximately $633,000 in inventory reserves, sold our manufacturing equipment and have placed the building on the open market for sale.  In addition, we have incurred approximately $720,000 in costs related to the manufacturing plant closure, including employee severance costs and overall company organization expenses.

We plan to complete the aforementioned transactions by the end of 2006.

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Item 2.  Management’s Discussion and Analysis or Plan of Operation.

Forward Looking Statements

This quarterly report on Form 10-QSB includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.  Forward-looking statements can be identified by the use of forward-looking terminology such as “may,” “believe,” “expect,” “intend,” “plan,” “seek,” “anticipate,” “estimate,” or “continue” or the negative of those words or other variations or comparable terminology.  

All statements other than statements of historical fact included in this quarterly report on Form 10-QSB, including the statements under “Part I. —Item 2.  Management’s Discussion and Analysis or Plan of Operation” and located elsewhere in this quarterly report on Form 10-QSB regarding the financial position and liquidity of the Company are forward-looking statements.  Although the Company believes that the expectations reflected in the forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct.  Important factors regarding forward-looking statements, including certain risks and uncertainties that could cause actual results to differ materially from the Company’s expectations, are disclosed in this quarterly report on Form 10-QSB. The Company does not undertake any obligation to publicly revise its forward-looking statements to reflect e vents or circumstances that arise after the date of this quarterly report on Form 10-QSB.

Important factors that could cause actual results to differ materially from those in the forward-looking statements in this quarterly report on Form 10-QSB include changes from anticipated levels of operations, customer acceptance of existing and new products, anticipated development schedules of new products, anticipated levels of sales, future national or regional economic and competitive conditions, changes in relationships with customers, access to capital, casualty to or other disruption of the Company’s production facility and equipment, delays and disruptions in the shipment of the Company’s products, government regulations and the ability of the Company to meet its stated business goals.  All subsequent written and oral forward-looking statements attributable to the Company or persons acting on its behalf are expressly qualified in their entirety by the Company's cautionary statements.

Results of Operations

Three Months Ended March 31, 2006 Compared to Three Months Ended March 31, 2005

Sales.  Our total sales decreased by $0.3 million, or 10%, to $3.2 million during the quarter ended March 31, 2006 from $3.5 million during the quarter ended March 31, 2005.   Sales at our B&B ARMR Corporation (“B&B ARMR”) subsidiary decreased approximately $1.5 million due to a reduction in product manufacturing resulting from the closure of B&B ARMR’s Norwood, Louisiana manufacturing facility, coupled with productivity reductions associated with the ongoing restructuring of the operations at B&B ARMR.  This decrease was offset by the inclusion of sales at our B&B Roadway, LLC (“B&B Roadway”) joint venture partnership of approximately $1.1 million and by the increase in sales at our Intelli-Site, Inc. (“Intelli-Site”) subsidiary of approximately $0.1 million.  Sales decreased slightly at our DoorTek Corporation (“DoorTek”) subsidiary.

Gross Margin.  Gross profit increased by approximately $0.3 million during the quarter ended March 31, 2006 to $1.1 million.  This increase is due to the contribution of gross profit of $0.3 million of B&B Roadway and $0.1 million of Intelli-Site, but was offset by a decline of approximately $0.1 million in gross margin at B&B ARMR due to the manufacturing plant closure and operations restructuring.  

Selling, General and Administrative.  Selling, general and administrative expenses decreased by $0.3 million or 17% during the quarter ended March 31, 2006 compared to the quarter ended March 31, 2005.  B&B ARMR experienced a reduction in expenses of $0.4 million, but was offset by the inclusion of $0.2

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million in expenses of B&B Roadway.  Corporate office expenses declined by approximately $0.1 million.

Research and Product Development.  Research and product development expenses decreased by approximately $42,000 or 34%, during the quarter ended March 31, 2006 compared to the quarter ended March 31, 2005.  This decrease is primarily due a reduction in research and development expenditures at B&B ARMR, which the Company expects will continue through fiscal 2006.

Interest Expense.  Interest expense increased by approximately $0.2 million, or 80%, during the quarter ended March 31, 2006 compared to the quarter ended March 31, 2005.  This increase is due to the Company accreting to interest expense the value of warrants issued in conjunction with securing additional debt, coupled with the Company’s debt issuance of $2.0 million during the quarter ending December 31, 2005.

Nine Months Ended March 31, 2006 Compared to Nine Months Ended March 31, 2005

Sales.  Our total sales decreased by $1.5 million, or 15%, to $8.6 million during the nine months ended March 31, 2006 from $10.1 million during the nine months ended March 31, 2005.   Sales at our B&B ARMR decreased approximately $4.9 million due to a reduction in product manufacturing resulting from the closure of B&B ARMR’s Norwood, Louisiana manufacturing facility, coupled with productivity reductions associated with the restructuring of the operations at B&B ARMR.  This decrease was offset by the inclusion of an increase in sales at both B&B Roadway of approximately $3.1 million and DoorTek of approximately $0.2 million.  Sales increased by $0.1 million at Intelli-Site.

Gross Margin.  Gross profit decreased by approximately $0.2 million during the nine months ended March 31, 2006 to $2.5 million.  B&B ARMR experienced a decline of approximately $1.4 million in gross margin due to the manufacturing plant closure and operations restructuring.  This decrease was offset by the contribution of gross profit increase of $0.9 million of B&B Roadway, $0.1 million of DoorTek and $0.2 million at Intelli-Site.

Selling, General and Administrative.  Selling, general and administrative expenses increased by approximately $0.4 million, or 11%, during the nine months ended March 31, 2006 compared to the nine months ended March 31, 2005.  This increase is due to the inclusion of an increase of $0.5 million of B&B Roadway, $0.1 million at DoorTek and of $0.2 million at the corporate office.  B&B ARMR experienced a reduction of $0.4 million in expenses as a result of overall cost cutting measures of $1.1 million which was offset by expenses incurred of approximately $0.7 million related to the manufacturing plant closure and operations restructuring at B&B ARMR.

Research and Product Development.  Research and product development expenses decreased by approximately $128,000, or 34%, during the nine months ended March 31, 2006 compared to the nine months ended March 31, 2005.  This decrease is primarily due a reduction in research and development expenditures at B&B ARMR, which the Company expects will continue through fiscal 2006.

Interest Expense.  Interest expense increased by approximately $0.5 million, or 77%, during the nine months ended March 31, 2006 compared to the nine months ended March 31, 2005.  This increase is due to the Company accreting to interest expense the value of warrants issued in conjunction with securing additional debt, coupled with the Company’s debt issuance of $2.0 million during the quarter ending December 31, 2005.

Liquidity and Capital Resources

Our cash position decreased by $113,275 during the nine months ended March 31, 2006.  At March 31, 2006, we had $192,220 in cash and cash equivalents and had approximately $1.9 million outstanding

Page 13 of 21

under our asset based lending facility.  This revolving credit facility, which is secured by substantially all of our assets, permits us to borrow up to $3.0 million, subject to availability under our borrowing base.

For the nine months ended March 31, 2006, our operating activities used $2.6 million of cash compared to $3.7 million of cash used in operations during the nine months ended March 31, 2005.

We used $14,900 for the purchase of property and equipment during the nine months ended March 31, 2006, compared to $152,186 for the nine months ended March 31, 2005.  We anticipate no significant capital expenditures for the remainder of fiscal 2006. We also incurred an additional $135,000 during the nine months ended March 31, 2006 related to earn-out agreements executed as a part of the B&B ARMR and DoorTek acquisitions.

During the nine months ended March 31, 2006, we financed our operations with cash flows from borrowings of $3.1 million, compared to $4.8 million during the nine months ended March 31, 2005.  We made payments on debt of $492,615 for the nine months ending March 31, 2006, compared to $198,061 during the nine months ending March 31, 2005.

The cash that we receive from our revolving credit facility is utilized to support Company-wide operations.  Our working capital requirements will depend upon many factors, including future sales of our products, our operating results, the status of competitive products, and actual profits compared to the our business plan. We are currently experiencing declining liquidity, which makes it difficult for us to meet our current cash requirements and may jeopardize our ability to continue as a going concern.  Our auditor issued a going concern modification in their auditors’ report for the fiscal year ended June 30, 2005.  We intend to address our liquidity problems by controlling costs, seeking additional funding and maintaining focus on revenues and collections.  In the foreseeable future, we will need to obtain additional financing either through equity placement or additional debt.  There can be no assurance t hat we will be able to secure such financing.  If our liquidity does not improve by the end of fiscal 2006, we may have to seek a merger partner, limit or discontinue our operations or seek protection under the federal bankruptcy laws. Any of the foregoing options may be on terms that are unfavorable to us or disadvantageous to our stockholders.

Principal payments required under demand note payable and long-term debt outstanding at March 31, 2006 are as follows:

Year Ending June 30,
2006	$      2,721,361
2007	2,077,193
2008	556,079
2009	2,493,735
2010	4,118,000
	$    11,966,368

The Company’s backlog is calculated as the aggregate sales prices of firm orders received from customers less revenue recognized.  At April 30, 2006, the Company’s backlog was approximately $7.4 million.  The Company expects that it will fill the majority of this backlog by June 30, 2007.

Page 14 of 21

Item 3.  Controls and Procedures.

(a)

Evaluation of Disclosure Controls and Procedures.  As of the end of the period covered by this report, an evaluation was carried out under the supervision and with the participation of our senior management, including our Chief Executive Officer (CEO) (our principal financial officer) and Chief Accounting Officer (CAO), of the effectiveness and the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)).  This evaluation included consideration of the various processes carried out under the direction of our CEO and CAO in an effort to ensure that information required to be disclosed in our SEC reports is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms and that information is accumulated and communicated to management, including the CEO and CAO, to allow timely decisions regarding required disclosures.

Based upon this evaluation, our CEO and CAO concluded that, as of the end of the period covered by this report, as a result of the material weakness discussed below, our disclosure controls and procedures were not effective to provide reasonable assurance that information required to be disclosed in the reports we file and submit under the Exchange Act is recorded, processed, summarized and reported as and when required.  Due to this material weakness as discussed below, in preparing our financial statements as of and for the three and nine month periods ending March 31, 2006, we performed compensating additional procedures and processes designed to ensure that such financial statements were fairly presented in all material respects in accordance with generally accepted accounting principles.

Material Weakness

There exists a material weakness in our processes, procedures and controls related to the preparation of our quarterly and annual financial statements.  In connection with the preparation of our quarterly report on Form 10-QSB for the quarter ended September 30, 2005, we discovered that, due to our decentralized, predominately manual control processes, and our significant turnover and lack of qualified personnel at senior management positions at our B&B ARMR Corporation subsidiary, our control environment is reliant on the review function to prevent or detect material misstatement from reaching the financial statements. This environment also requires effective entity-level controls to ensure accuracy and consistency in the performance of control activities. Our CEO and CAO identified the following:

·

significant turnover, and resulting lack of qualified personnel, at senior management and financial reporting positions (including the chief executive officer, chief financial officer, president and controller positions) at our B&B ARMR Corporation subsidiary during the quarter and six months ending December 31, 2005;

·

lack of timeliness and precision of the preparation and review of detailed account reconciliations;

·

lack of a clear organization and accountability structure within the accounting function, including insufficient review and supervision, combined with financial reporting systems that are not integrated and which require extensive manual interventions;

·

lack of sufficient awareness of, and timely and appropriate remediation of, internal control issues by company personnel; and

·

lack of sufficient awareness and formal communication of accounting policies and procedures, resulting in the inconsistent application of and adherence to corporate policies.

The ineffectiveness of these controls represent material weaknesses that resulted in adjustments to revenue, inventory and cost of sales, accrued liabilities, and other current assets and liabilities in the

Page 15 of 21

consolidated financial statements as of and for the three month period ended September 30, 2005.  These material weaknesses could result in the reporting of financial information and disclosures in future consolidated annual and interim financial statements that are not in accordance with generally accepted accounting principles.

While we believe that we are taking the steps necessary to remediate this material weakness in our processes, procedures and controls related to the preparation of our quarterly and annual financial statements, we are still in the process of evaluating these controls.  Accordingly, we will continue to monitor vigorously the effectiveness of these processes, procedures and controls and will make any further changes management determines appropriate.

(b)

Changes in Internal Controls. There were no changes to our internal controls over financial reporting during our last completed fiscal quarter that have materially affected or are reasonably likely to materially affect, our internal controls over financial reporting, except as described above.  Additionally, we have and will continue to improve both the quality and the quantity of staffing in order to effect significant improvements in our internal control structure.

Page 16 of 21

PART II.  OTHER INFORMATION

Item 1. Legal Proceedings.

None.

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds.

None.

Item 3.  Defaults Upon Senior Securities.

None.

Item 4.  Submission of Matters to a Vote of Security Holders.

None.

Item 5.  Other Information.

None.

Item 6.  Exhibits.

31.1+

Officer’s Certificate Pursuant to Section 302

32.1+

Officer’s Certificate Pursuant to Section 906

________________

+

Filed herewith.

Page 17 of 21

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.

		Integrated Security Systems, Inc.
		(Registrant)
Date:	May 12, 2006	/s/ VERNON H. FOERSTERLING, JR.
		Vernon H. Foersterling, Jr.
		President and Chief Executive Officer (Principal Executive and Financial Officer)
Date:	May 12, 2006	/s/ RICHARD B. POWELL
		Richard B. Powell
		Vice President and Chief Accounting Officer (Principal Accounting Officer)

Page 18 of 21

EXHIBIT INDEX

31.1+

Officer’s Certificate Pursuant to Section 302

32.1+

Officer’s Certificate Pursuant to Section 906

________________

+

Filed herewith.

Page 19 of 21

EX-31

Exhibit 31.1

CERTIFICATION

I, Vernon H. Foersterling, Jr., certify that:

1.  

I have reviewed this quarterly report on Form 10-QSB of Integrated Security Systems, 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 small business issuer as of, and for, the periods presented in this report;

4.  

I am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the small business issuer and have:

(a)

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

(b)

Evaluated the effectiveness of the small business issuer’s disclosure controls and procedures and presented in this report my 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

(c)

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

5.  

I have disclosed, based on my most recent evaluation of internal control over financial reporting, to the small business issuer’s auditors and the audit committee of the small business issuer’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 small business issuer’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 small business issuer’s internal control over financial reporting.

Date:  May 12, 2006

/s/ VERNON H. FOERSTERLING, JR.

Vernon H. Foersterling, Jr.,

President and Chief Executive Officer

Principal Executive and Financial Officer

EX-32

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

Pursuant to Section 906 of the Sarbanes-Oxley of 2002 (subsections (a) and (b) of Section 1350, Chapter 63 of Title 18, United States Code), each of the undersigned officers of Integrated Security Systems, Inc. (the “Company”), does hereby certify, to such officer’s knowledge, that:

The Quarterly Report on Form 10-QSB for the quarter ended March 31, 2006 (the “Form 10-QSB”) of the Company fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and the information contained in the Form 10-QSB fairly presents, in all material respects, the financial condition and results of operations of the Company as of, and for, the periods presented in the Form 10-QSB.

May 12, 2006

/s/ VERNON H. FOERSTERLING, JR.

Vernon H. Foersterling, Jr.,

President and Chief Executive Officer

Principal Executive and Financial Officer

May 12, 2006

/s/ RICHARD B. POWELL

Richard B. Powell

Vice President, Chief Accounting Officer

Principal Accounting Officer

A signed original of this written statement required by section 906 has been provided to Integrated Security Systems, Inc. and will be retained by Integrated Security Systems, Inc. and furnished to the Securities and Exchange Commission or its staff upon request.

The foregoing certification is being furnished as an exhibit to Form 10-QSB pursuant to Item 601(b)(32) of Regulation S-B and Section 906 of the Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of Section 1350, Chapter 63 of Title 18, United States Code) and, accordingly, is not being filed as part of the Form 10-QSB for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and is not incorporated by reference into any filing of the Company, whether made before or after the date hereof, regardless of any general incorporation language in such filing.