1. Basis of Presentation and Significant Accounting Policies

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 8.03 of Regulation S-X for smaller reporting companies. Accordingly, these statements do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, the accompanying balance sheets and related interim statements of operations and comprehensive loss and cash flows include all adjustments, consisting only of normal recurring items necessary for their fair presentation in accordance with U.S. generally accepted accounting principles. All significant intercompany transactions have been eliminated in consolidation.

Interim results are not necessarily indicative of results expected for a full year. For further information regarding Document Security Systems, Inc.'s (the "Company") accounting policies, refer to the audited consolidated financial statements and footnotes thereto included in the Company's Form 10-K for the fiscal year ended December 31, 2012.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States (U.S. GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates and assumptions. In preparing these financial statements, the Company has evaluated events and transactions for potential recognition or disclosure.

Plan of Merger - On October 1, 2012, DSS entered into an Agreement and Plan of Merger (the "Merger Agreement") with Lexington Technology Group, Inc. ("Lexington") pursuant to which a wholly-owned subsidiary of DSS will merge with and into Lexington, with Lexington surviving the merger as a wholly-owned subsidiary of DSS (the "Merger"). Defined terms contained in the descriptions of the Merger which follow shall have the meanings ascribed to them in the Merger Agreement, filed with the Securities and Exchange Commission on October 4, 2012.

If the Merger is completed, the holders of Lexington Common Stock and Lexington Preferred Stock will have the right to receive, for each share of Lexington Common Stock or Lexington Preferred Stock they hold, as applicable, certain DSS securities, the number of which is based on the Common Stock Exchange Ratio, as such ratio is calculated pursuant to the terms of the Merger Agreement. The Common Stock Exchange Ratio was equal to 0.881 as of May 3, 2013.

The exact Common Stock Exchange Ratio, and therefore the actual number of DSS securities to be issued in respect of each share of Lexington capital stock, will not be determined until immediately prior to the completion of the Merger. Assuming the Merger had been completed on May 3, 2013, the following aggregate number of DSS securities would have been issued in the Merger to the holders of Lexington Common Stock and Preferred Stock:

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up to 19,990,559 shares of DSS Common Stock;

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7,100,000 shares of DSS Common Stock to be held in escrow;

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up to 500,000 shares of DSS Common Stock if Lexington's cash balance exceeds $7.25 million to a maximum of $9.0 million at the effective time of the Merger;

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up to 4,859,894 Warrants with an exercise price of $4.80 per share that are exercisable for an aggregate of 4,859,894 shares of DSS Common Stock;

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additional shares of DSS convertible preferred stock, or warrants with an exercise price of $.02 per share if the proposal to authorize DSS Preferred Stock is not approved by DSS stockholders, to any Lexington preferred stockholder that would beneficially own more than 9.99% of DSS Common Stock as a result of this Merger; and

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for Lexington option holders only, 2,000,000 options to purchase DSS Common Stock in exchange for their options to purchase 3,600,000 shares of Lexington Common Stock.

Lexington is a private intellectual property monetization company that recently acquired a patent portfolio of six patents and four pending patent applications relating to technology invented by Thomas Bascom (the "Bascom Portfolio") and invested in VirtualAgility, a developer of user-friendly programming platforms that facilitate the creation of sophisticated business applications without programming or coding. Lexington is focused on the economic benefits of intellectual property assets through acquiring or internally developing patents or other intellectual property assets (or interests therein) and then monetizing such assets through a variety of value enhancing initiatives, including, but not limited to:

licensing

customized technology solutions (such as applications for medical electronic health records),

strategic partnerships, and

litigation

On October 3, 2012, Lexington, through its wholly-owned subsidiary, Bascom Research, initiated patent infringement lawsuits in the United States District Court for the Eastern District of Virginia against five companies, including Facebook, Inc. and LinkedIn Corporation, for unlawfully using systems that incorporate features claimed in patents owned by Bascom Research. The patents-in-suit relate to the data structure used by social and business networking web sites and Web 2.0 corporate intranets. On December 12, 2012, the lawsuits were transferred to the United States District Court for the Northern District of California.

Immediately following the completion of the Merger (without taking into account any shares of DSS Common Stock held by Lexington stockholders prior to the completion of the Merger), the former stockholders of Lexington are expected to own approximately 51% of the outstanding common stock of the combined company and the current stockholders of DSS are expected to own approximately 49% of the outstanding common stock of the combined company. In addition, Lexington stockholders will own 100% of the outstanding DSS preferred stock, if approved.

It is currently expected that the Merger will be treated by DSS as a reverse merger under the acquisition method of accounting in accordance with GAAP. For accounting purposes, Lexington is considered to be acquiring DSS in this transaction. However, certain assumptions made by DSS and certain factors may change from the date of this filing to the date of the Merger that could cause the Merger to not being considered a reverse merger, and if so, then the Merger would be accounted for as a business combination with DSS as the accounting acquirer.

The Company has expended significant efforts and management attention on the proposed Merger transaction. There is no assurance that the transactions contemplated by the Merger Agreement will be consummated. If the Merger transaction is not consummated for any reason, the business and operations, as well as the market price of The Company's stock and warrants may be adversely affected. The Company has filed a Form S-4 Registration Statement with the SEC regarding the proposed Merger. The Merger requires approval by the stockholders of both Lexington and DSS, and if approved, the Company currently estimate that the Merger will close on or about July 1, 2013.

Earnings Per Common Share - The Company presents basic and diluted earnings per share. Basic earnings per share reflect the actual weighted average of shares issued and outstanding during the period. Diluted earnings per share are computed including the number of additional shares that would have been outstanding if dilutive potential shares had been issued. In a loss year, the calculation for basic and diluted earnings per share is considered to be the same, as the impact of potential common shares is anti-dilutive.

As of March 31, 2013 and 2012, there were up to 4,371,534 and 4,293,191, respectively, of shares potentially issuable under convertible debt agreements, options, warrants, restricted stock agreements and employment agreements that could potentially dilute basic earnings per share in the future. These shares were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive to the Company's losses in the respective periods.

Concentration of Credit Risk - The Company maintains its cash in bank deposit accounts, which at times may exceed federally insured limits. The Company believes it is not exposed to any significant credit risk as a result of any non-performance by the financial institutions. During the three months ended March 31, 2013 and 2012, one customer accounted for 16% and 33%, respectively, of the Company's consolidated revenue. As of March 31, 2013 and 2012, this customer accounted for 3% and 29%, respectively, of the Company's trade accounts receivable balance. The risk with respect to trade receivables is mitigated by credit evaluations we perform on our customers, the short duration of our payment terms for the significant majority of our customer contracts and by the diversification of our customer base.

Conventional Convertible Debt -When the convertible feature of the conventional convertible debt provides for a rate of conversion that is below market value, this feature is characterized as a beneficial conversion feature ("BCF"). Prior to the determination of the BCF, the proceeds from the debt instrument are first allocated between the convertible debt and any detachable free standing instruments that are included, such as common stock warrants. The Company records a BCF as a debt discount pursuant to FASB ASC Topic 470-20. In those circumstances, the convertible debt will be recorded net of the discount related to the BCF. The Company amortizes the discount to interest expense over the life of the debt using the effective interest method.

Derivative Instruments - The Company maintains an overall interest rate risk management strategy that incorporates the use of interest rate swap contracts to minimize significant fluctuations in earnings that are caused by interest rate volatility. The Company has two interest rate swaps that change variable rates into fixed rates on a term loan and promissory note with RBS Citizens, N.A. These swaps qualify as Level 2 fair value financial instruments. These swap agreements are not held for trading purposes and the Company does not intend to sell the derivative swap financial instruments. The Company records the interest swap agreements on the balance sheet at fair value because the agreements qualify as cash flow hedges under accounting principles generally accepted in the United States of America. Gains and losses on these instruments are recorded in other comprehensive income (loss) until the underlying transaction is recorded in earnings. When the hedged item is realized, gains or losses are reclassified from accumulated other comprehensive income (loss) (AOCI) to the Consolidated Statement of Operations on the same line item as the underlying transaction. The valuations of the interest rate swaps have been derived from proprietary models of the bank based upon recognized financial principles and reasonable estimates about relevant future market conditions and may reflect certain other financial factors such as anticipated profit or hedging, transactional, and other costs. The notional amounts of the swaps decrease over the life of the agreements. The Company is exposed to a credit loss in the event of non-performance by the counter parties to the interest rate swap agreements. However, the Company does not anticipate non-performance by the counter parties. The fair value of interest rate swap hedging liabilities as of March 31, 2013 amounted to $108,714 ($127,883 - December 31, 2012) and the net gain attributable to this cash flow hedge recorded during the three months ended March 31, 2013 amounted to $19,169 ($22,642- March 31, 2012).

Fair Value of Financial Instruments - Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Fair Value Measurement Topic of the FASB ASC establishes a three-tier fair value hierarchy which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). These tiers include:

Level 1, defined as observable inputs such as quoted prices for identical instruments in active markets;

Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and

Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.

Financial instruments include cash, which is a short term investment and its carrying amount is a reasonable estimate of fair value, interest rate swaps as discussed above, notes payable and a convertible note payable. Notes payable are valued based on rates currently available to financial institutions for debt with similar terms and remaining maturities. The carrying value approximates the fair value of these debt instruments as of March 31, 2013 and December 31, 2012. The convertible note payable is recorded at its face amount, net of an unamortized discount for a beneficial conversion feature and has an estimated fair value of approximately $591,000 ($565,000 - December 31, 2012) based on the underlying shares the note can be converted into at the trading price on March 31, 2013. Since the underlying shares are trading in an active, observable market, the fair value measurement qualifies as a Level 1 input.

Reclassifications - Certain prior year amounts have been reclassified to conform to the current year presentation.