10-Q

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

þ QUARTERLY REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For quarterly period ended September 30, 2005

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 1-13738

PSYCHEMEDICS CORPORATION

(exact name of Issuer as specified in its charter)

Delaware	58-1701987
(State or other jurisdiction of	(I.R.S. Employer
incorporation of organization)	Identification No.)

125 Nagog Park, Acton, MA	01720
(Address of principal executive offices)	(Zip Code)

Issuer’s telephone number, including area code (978) 206-8220

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 þ      No o

Indicate by check mark whether the registrant is an accelerated filer.

YES o      NO þ

Indicate by check mark whether the registrant is a shell company.

YES o      NO þ

Number of shares outstanding of only class of Issuer’s Common Stock as of November 14, 2005: Common Stock $.005 par value (5,167,097 shares).

1

PSYCHEMEDICS CORPORATION

	Page No.
Part I FINANCIAL INFORMATION
Item 1 Financial Statements (Unaudited)
Condensed Balance Sheets as of September 30, 2005 and December 31, 2004		3
Condensed Statements of Income for the three month periods ended September 30, 2005 and 2004		4
Condensed Statements of Income for the nine month periods ended September 30, 2005 and 2004		5
Condensed Statements of Cash Flows for the nine month periods ended September 30, 2005 and 2004		6
Notes to Condensed Financial Statements		7-10
Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations		11-16
Item 3 Quantitative and Qualitative Disclosures about Market Risk		17
Item 4 Controls and Procedures		17
Part II OTHER INFORMATION
Item 6 Exhibits		18
SIGNATURES		18
EXHIBIT INDEX		19
EX-31.1 SECTION 302 CERTIFICATION OF C.E.O.
EX-31.2 SECTION 302 CERTIFICATION OF C.F.O.
EX-32.1 SECTION 906 CERTIFICATION OF C.E.O.
EX-32.2 SECTION 906 CERTIFICATION OF C.F.O.

2

PSYCHEMEDICS CORPORATION

CONDENSED BALANCE SHEETS

	SEPTEMBER 30,			DECEMBER 31,
	2005			2004
	(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	3,201,837		$	3,260,178
Short-term investments		2,000,000			—
Accounts receivable, net of allowance for doubtful accounts of $464,058 in 2005 and $483,230 in 2004		3,601,562			3,289,863
Prepaid expenses and other current assets		431,902			246,372
Deferred tax assets		529,752			529,752
Total current assets		9,765,053			7,326,165
PROPERTY AND EQUIPMENT:
Equipment and leasehold improvements, at cost		9,994,041			9,960,831
Less-accumulated depreciation and amortization		(9,251,847	)		(9,099,472	)
		742,194			861,359
DEFERRED TAX ASSETS		166,583			166,583
OTHER ASSETS, NET		39,829			79,529
	$	10,713,659		$	8,433,636
LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	401,655		$	554,214
Accrued expenses		1,236,196			1,157,740
Deferred revenue		581,440			487,633
Total current liabilities		2,219,291			2,199,587
SHAREHOLDERS’ EQUITY:
Preferred stock, $0.005 par value; 872,521 shares authorized; none issued or outstanding		—			—
Common stock; $0.005 par value; 50,000,000 shares authorized; 5,750,894 shares and 5,710,704 shares issued in 2005 and 2004, respectively		28,754			28,554
Paid-in capital		25,446,781			24,978,039
Accumulated deficit		(7,858,476	)		(9,649,853	)
Less — Treasury stock, at cost; 583,797 shares		(9,122,691	)		(9,122,691	)
Total shareholders’ equity		8,494,368			6,234,049
	$	10,713,659		$	8,433,636

See accompanying notes to financial statements and management’s discussion and
analysis of financial condition and results of operations.

3

PSYCHEMEDICS CORPORATION

CONDENSED STATEMENTS OF INCOME

(UNAUDITED)

	THREE MONTHS
	ENDED SEPTEMBER 30,
	2005		2004
REVENUE	$	5,353,168	$	4,870,218
COST OF REVENUE		2,267,237		2,105,768
Gross profit		3,085,931		2,764,450
EXPENSES:
General and administrative		765,758		803,940
Marketing and selling		703,731		673,724
Research and development		87,090		83,854
		1,556,579		1,561,518
OPERATING INCOME		1,529,352		1,202,932
INTEREST INCOME		34,269		8,476
OTHER INCOME		—		3,750
		34,269		12,226
NET INCOME BEFORE INCOME TAXES		1,563,621		1,215,158
PROVISION FOR INCOME TAXES		581,000		414,000
NET INCOME	$	982,621	$	801,158
BASIC NET INCOME PER SHARE	$	0.19	$	0.16
DILUTED NET INCOME PER SHARE	$	0.19	$	0.16
DIVIDENDS DECLARED PER SHARE	$	0.10	$	0.08
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING, BASIC		5,167,097		5,126,907
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING, DILUTED		5,179,134		5,132,976

See accompanying notes to financial statements and management’s discussion and
analysis of financial condition and results of operations.

4

PSYCHEMEDICS CORPORATION

CONDENSED STATEMENTS OF INCOME

(UNAUDITED)

	NINE MONTHS
	ENDED SEPTEMBER 30,
	2005		2004
REVENUE	$	16,306,247	$	14,373,139
COST OF REVENUE		6,656,516		6,362,714
Gross profit		9,649,731		8,010,425
EXPENSES:
General and administrative		2,394,370		2,416,796
Marketing and selling		2,110,980		1,893,877
Research and development		232,891		234,192
		4,738,241		4,544,865
OPERATING INCOME		4,911,490		3,465,560
INTEREST INCOME		73,867		23,376
OTHER INCOME		1,250		11,250
		75,117		34,626
NET INCOME BEFORE INCOME TAXES		4,986,607		3,500,186
PROVISION FOR INCOME TAXES		1,855,000		1,282,000
NET INCOME	$	3,131,607	$	2,218,186
BASIC NET INCOME PER SHARE	$	0.61	$	0.43
DILUTED NET INCOME PER SHARE	$	0.61	$	0.43
DIVIDENDS DECLARED PER SHARE	$	0.26	$	0.24
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING, BASIC		5,153,178		5,126,907
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING, DILUTED		5,165,060		5,131,946

See accompanying notes to financial statements and management’s discussion and
analysis of financial condition and results of operations.

5

PSYCHEMEDICS CORPORATION

CONDENSED STATEMENTS OF CASH FLOWS

(UNAUDITED)

	NINE MONTHS
	ENDED SEPTEMBER 30,
	2005			2004
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	3,131,607		$	2,218,186
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		318,073			404,491
Tax benefit associated with exercise of options		35,503			—
Changes in operating assets and liabilities:
Accounts receivable		(311,699	)		(885,642	)
Prepaid expenses and other assets		(185,530	)		(52,955	)
Accounts payable		(152,559	)		106,119
Accrued expenses		78,456			315,474
Deferred revenue		93,807			36,356
Net cash provided by operating activities		3,007,658			2,142,029
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of short-term investments		(2,000,000	)		—
Purchases of property and equipment		(163,507	)		(251,674	)
Decrease (Increase) in other assets — net		4,299			(6,180	)
Net cash used in investing activities		(2,159,208	)		(257,854	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Cash dividends paid		(1,340,230	)		(1,230,458	)
Net proceeds from the issuance of common stock		433,439			—
Net cash used in financing activities		(906,791	)		(1,230,458	)
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		(58,341	)		653,717
CASH AND CASH EQUIVALENTS, beginning of period		3,260,178			3,022,467
CASH AND CASH EQUIVALENTS, end of period	$	3,201,837		$	3,676,184

See accompanying notes to financial statements and management’s discussion and
analysis of financial condition and results of operations.

6

PSYCHEMEDICS CORPORATION

NOTES TO CONDENSED FINANCIAL STATEMENTS

(UNAUDITED)

September 30, 2005

1. Interim Financial Statements

The accompanying unaudited interim financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission for reporting on Form 10-Q. Accordingly, certain information and footnote disclosure required for complete financial statements are not included herein. It is recommended that these financial statements be read in conjunction with the financial statements and related notes of Psychemedics Corporation (the “Company”) as reported in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of financial position, results of operations, and cash flows at the dates and for the periods presented have been included. The results of operations for the three months and the nine months ended September 30, 2005 may not be indicative of the results that may be expected for the year ending December 31, 2005, or any other period.

2. Stock-Based Compensation

The Company accounts for its stock compensation arrangements with employees under the provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. The Company has adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure.

Statement of Financial Accounting Standards, (SFAS) No. 123, Accounting for Stock-Based Compensation, requires the measurement of the fair value of stock options or warrants to be included in the statement of income or disclosed in the notes to financial statements. The Company has computed the value of options using the Black-Scholes option pricing model prescribed by SFAS No. 123.

The assumptions used and the weighted average information are as follows:

	Three Months Ended				Nine Months Ended
	September 30, 2005		September 30, 2004		September 30, 2005			September 30, 2004
Risk-free interest rates range		—		—		3.8	%		2.7 – 3.9	%
Expected dividend yield range		—		—		2.3	%		2.7	%
Expected lives		—		—	5 years			5 years
Expected volatility range		—		—		30.09	%		23.99 – 27.94	%

7

PSYCHEMEDICS CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

Consistent with SFAS No. 123, net income and basic and diluted net income per share would have been as follows:

	Three Months Ended						Nine Months Ended
	September 30, 2005			September 30, 2004			September 30, 2005			September 30, 2004
Net income, as reported	$	982,621		$	801,158		$	3,131,607		$	2,218,186
Less: Total stock based compensation cost determined under the fair value based method for all employee awards		(9,558	)		(25,371	)		(938,440	)		(133,307	)
Pro forma net income	$	973,063		$	775,787		$	2,193,167		$	2,084,879
Income per share:
Basic, as reported	$	0.19		$	0.16		$	0.61		$	0.43
Diluted, as reported	$	0.19		$	0.16		$	0.61		$	0.43
Basic, pro forma	$	0.19		$	0.15		$	0.43		$	0.41
Diluted, pro forma	$	0.19		$	0.15		$	0.42		$	0.41

No options were granted for the three months ended September 30, 2005 or 2004. The fair value of options granted for the nine months ended September 30, 2005 and 2004 was $3.76 per share and $2.19 per share, respectively.

3. Basic and Diluted Net Income Per Share

Basic net income per share was computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per share was computed by dividing net income by the weighted average number of common and dilutive common equivalent shares outstanding during the period. The number of dilutive common equivalent shares outstanding during the period has been determined in accordance with the treasury-stock method. Common equivalent shares consist of common stock issuable upon the exercise of outstanding options.

Basic and diluted weighted average common shares outstanding were as follows:

	Three Months Ended				Nine Months Ended
	September 30, 2005		September 30, 2004		September 30, 2005		September 30, 2004
Weighted average common shares		5,167,097		5,126,907		5,153,178		5,126,907
Dilutive common stock options		12,037		6,069		11,882		5,039
Weighted average common shares outstanding, assuming dilution		5,179,134		5,132,976		5,165,060		5,131,946

8

PSYCHEMEDICS CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

For the three months ended September 30, 2005 and 2004, options to purchase 449,207 and 368,912 common shares, respectively, were outstanding but not included in the diluted weighted average common share calculation as the effect would have been antidilutive. For the nine months ended September 30, 2005 and 2004, options to purchase 484,208 and 384,362 common shares, respectively, were outstanding but not included in the diluted weighted average common share calculation as the effect would have been antidilutive.

4. Revenue Recognition

The Company performs drug testing as well as provides training for collection of samples and storage of positive samples for its customers for an agreed-upon fee per unit tested of samples. Revenues are recognized when the predominant deliverable, drug testing, is provided and reported to the customer. The Company also provides expert testimony, when and if necessary, to support the results of the tests, which is generally billed separately and recognized as the services are provided.

In 2003, the Company adopted Emerging Issue Task Force 00-21, Revenue Arrangements with Multiple Deliverables, which was effective for all transactions entered into subsequent to June 15, 2003. The Company applied the consensus reached under EITF 00-21 and concluded that the testing, training and storage elements are considered one unit of accounting for revenue recognition purposes as the training and storage costs do not have stand-alone value to the customer. The Company has concluded that the predominant deliverable in the arrangement is the testing of the units and has recognized revenue as that service is performed and reported to the customer.

At September 30, 2005 and December 31, 2004, the Company had deferred revenue of approximately $581,000 and $488,000, respectively, reflecting sales of its personal drug testing service for which the performance of the related test had not yet occurred.

5. Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. The provisions of SFAS No. 123(R) are effective for all employee equity awards granted and to any unvested awards outstanding as of January 1, 2006. The Company currently does not expect the impact of adopting this new standard to be of a material nature.

9

PSYCHEMEDICS CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

6. Contingencies

The Company is subject to legal proceedings and claims, which arise in the ordinary course of its business. The Company believes that based upon information available to the Company at this time, the expected outcome of these matters would not have a material impact on the Company’s results of operations or financial condition.

7. Subsequent Event — Dividends

On October 26, 2005, the Company declared a quarterly dividend of $.10 per share, which will be paid on December 23, 2005 to shareholders of record on December 9, 2005.

10

Item 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

Psychemedics Corporation was incorporated in 1986. The Company utilizes a patented hair analysis method involving radioimmunoassay technology to analyze human hair to detect abused substances.

Revenue for the third quarter of 2005 was $5.4 million and was 10% above revenue of $4.9 million for the third quarter of 2004. Revenue for the first three quarters of 2005 was $16.3 million and was 13% above revenue of $14.4 million for the first three quarters of 2004. Due to the increase in revenue and gross profit, the Company reported net income of $0.19 per share in the quarter ended September 30, 2005 and net income of $0.61 per share for the nine months ended September 30, 2005. At September 30, 2005, the Company had $5.2 million of cash, cash equivalents and short-term investments. The Company distributed $0.5 million, or $0.10 per share, of cash dividends to its shareholders in the third quarter of 2005, and $0.4 million, or $0.08 per share, of cash dividends in both the first and second quarters of 2005, which represented year to date totals of $1.3 million, or $0.26 per share. As of the date of this Report, the Company has paid thirty-six consecutive quarterly cash dividends.

RESULTS OF OPERATIONS

Revenue was $5,353,168 for the three month period ended September 30, 2005 as compared to $4,870,218 for the comparable period of 2004, representing an increase of 10%. Revenue was $16,306,247 for the nine month period ended September 30, 2005 as compared to $14,373,139 for the comparable period of 2004, representing an increase of 13%. The increase in revenue for the third quarter of 2005 was due to an increase of 11% in testing volume from both new and existing clients, while the average revenue per sample decreased by approximately 1% as compared to the comparable period of 2004. The increase in revenue for the nine months ended September 30, 2005 was due to an increase of 14% in testing volume from both new and existing clients, while the average revenue per sample decreased by 1% as compared to the comparable period of 2004. The Company believes that the growth in testing volume was due to an improvement in the hiring environment at new and existing customers. The Company continued to add approximately the same number of new clients for the nine months ended September 30, 2005 as it did in the comparable period of 2004.

Gross margin was 58% of revenue for the three month period ended September 30, 2005, as compared to 57% for the comparable period of 2004. Gross margin was 59% of revenue for the nine month period ended September 30, 2005, as compared to 56% for the comparable period of 2004. Fixed and semi-variable direct costs were spread over a greater number of tests performed for the three month period and the nine month period ended September 30, 2005, as compared to the same periods of 2004. Also, reduced depreciation and amortization expense contributed to a decline in fixed costs for the three month period and the nine month period ended September 30, 2005 as compared to the year earlier periods.

11

General and administrative (“G&A”) expenses were $765,758 for the three month period ended September 30, 2005 as compared to $803,940 for the comparable period of 2004, representing a decrease of 5%. G&A expenses were $2,394,370 for the nine month period ended September 30, 2005 as compared to $2,416,796 for the comparable period of 2004, representing a decrease of 1%. The decrease in general and administrative expenses for the three month period ended September 30, 2005 as compared to the comparable period of 2004 was due primarily to reduced professional fees related to legal services and a decrease in rent expense pertaining to the Company’s headquarters, partially offset by greater professional fees related to Sarbanes-Oxley compliance. All other general and administrative expenses remained relatively constant. The decrease in general and administrative expenses for the nine month period ended September 30, 2005 as compared to the comparable period of 2004 was due primarily to reduced professional fees related to legal services and a decrease in rent expense pertaining to the Company’s headquarters, partially offset by greater professional fees related to Sarbanes-Oxley compliance along with an increase in personnel expenses. All other general and administrative expenses remained relatively constant. As a percentage of revenue, G&A expenses decreased to 14% for the three month period ended September 30, 2005 from 17% for the comparable period of 2004 and decreased to 15% for the nine months ended September 30, 2005 from 17% for the comparable period of 2004. The Company expects general and administrative expenses to remain relatively flat during the remainder of 2005.

Marketing and selling expenses were $703,731 for the three month period ended September 30, 2005 as compared to $673,724 for the comparable period of 2004, an increase of 4%. Marketing and selling expenses were $2,110,980 for the nine month period ended September 30, 2005 as compared to $1,893,877 for the comparable period of 2004, an increase of 11%. The increase for both the three month and the nine month periods ended September 30, 2005 as compared to the comparable periods of 2004 was due primarily to an increase in personnel expenses pertaining to the Company’s sales and support staff. Total marketing and selling expenses represented 13% of revenue in the third quarter of 2005 and 14% of revenue in the third quarter of 2004. Total marketing and selling expenses represented 13% of revenue for the nine month period ended September 30, 2005 and 13% of revenue for the nine month period ended September 30, 2004. Even though the Company does not anticipate any significant increases in marketing and selling expenses during the remainder of 2005, the Company does expect to continue to aggressively promote its drug testing services in future years in order to expand its client base.

Research and development (“R&D”) expenses for the three month period ended September 30, 2005 increased by $3,236 from the comparable period of the prior year to $87,090, an increase of 4%. This increase was primarily due to increased personnel and consulting costs, partially offset by reduced consumables costs. Research and development (“R&D”) expenses for the nine month period ended September 30, 2005 decreased by $1,301 from the comparable period of the prior year to $232,891, a decrease of 1%. This decrease was primarily due to reduced consumables costs. R&D expenses represented 2% of revenue for both of the three month periods ended September 30, 2005 and September 30, 2004. R&D expenses represented 1% of revenue for the nine month period ended September 30, 2005 and 2% of revenue for the nine month period ended September 30, 2004. The Company does not expect any significant changes in research and development expenses during the remainder of 2005.

12

Interest income for the three month period ended September 30, 2005 increased by $25,793 and increased by $50,491 for the nine month period ended September 30, 2005 as compared to the comparable year periods and represented interest earned on cash equivalents and short-term investments. Higher average investment balances along with an increase in the yield on investment balances in 2005 as compared to 2004 caused the increase in interest income.

During the three month period ended September 30, 2005, the Company recorded a tax provision of $581,000 reflecting an effective tax rate of 37.2% as compared to a tax provision of $414,000 reflecting an effective tax rate of 34.1% for the three month period ended September 30, 2004. During the nine months ended September 30, 2005 and September 30, 2004, the Company recorded tax provisions of $1,855,000 and $1,282,000 representing effective tax rates of 37.2% and 36.6%, respectively. The variation in the effective tax rate resulted from the Company reducing its tax accrual and tax provision by $40,000 during the third quarter of 2004 in order to properly reflect its estimated taxes payable.

LIQUIDITY AND CAPITAL RESOURCES

At September 30, 2005, the Company had approximately $5.2 million of cash, cash equivalents and short-term investments. The Company’s operating activities generated net cash of $3,007,658 in the nine months ended September 30, 2005. Investing activities used $2,159,208 in the nine month period while financing activities used a net amount of $906,791 during the period.

Operating cash flow of $3,007,658 for the nine months ended September 30, 2005 principally reflected net income of $3,131,607 adjusted for depreciation and amortization of $318,073 offset partially by the growth in accounts receivable and prepaid expenses along with the decrease in accounts payable.

Capital expenditures in the first three quarters of 2005 were $163,507. The expenditures primarily consisted of new equipment, including laboratory and computer equipment. The Company currently plans to make additional capital expenditures of approximately $200,000 during the balance of 2005, primarily in connection with the purchase of additional laboratory and computer equipment. The Company believes that within the next two to five years it may be required to expand its existing laboratory or develop a second laboratory, the cost of which is currently believed to range from $2 million to $4 million.

During the nine month period ended September 30, 2005, the Company distributed $1,340,230 in cash dividends to its shareholders. The Company did not repurchase any shares for treasury during the nine month period ended September 30, 2005. The Company has authorized 500,000 shares for repurchase since June of 1998 of which 466,351 shares have been repurchased as of September 30, 2005.

13

Contractual obligations as of September 30, 2005 were as follows:

	Less Than		1-3		4-5		After 5
	One Year		Years		Years		Years		Total
Operating leases	$	487,000	$	909,000	$	885,000	$	681,000	$	2,962,000
Purchase commitment		247,000		—		—		—		247,000
	$	734,000	$	909,000	$	885,000	$	681,000	$	3,209,000

The Company signed a seven year extension in May of 2005 with an option to renew for an additional three years on the space leased for laboratory purposes in Culver City, California. This extension commences on January 1, 2006. The Company also signed a five year lease extension in May of 2005 with an option to renew for an additional two years on the space leased for customer service and information technology purposes in Culver City, California. This extension also commences on January 1, 2006. The lease obligations are reflected in the above table.

     Purchase Commitment

The Company has a supply agreement with a vendor which requires the Company to purchase isotopes used in its drug testing procedures from this sole supplier in exchange for variable annual payments based upon prior year purchases. Purchases amounted to $370,727 for the nine months ended September 30, 2005 as compared to $329,301 for the comparable period of 2004. The Company expects to purchase approximately $124,000 for the remainder of 2005. In exchange for exclusivity, the supplier has provided the Company with the right to purchase the isotope technology at fair market value under certain conditions, including the failure to meet the Company’s purchase commitments. This agreement does not include a fixed termination date; however, it is cancelable upon mutual agreement by both parties or six months after termination notice by the Company of its intent to use a different technology in connection with its drug testing procedures.

At September 30, 2005, the Company’s principal sources of liquidity included an aggregate of approximately $5.2 million of cash, cash equivalents and short-term investments. Management currently believes that such funds, together with cash generated from operations, should be adequate to fund anticipated working capital requirements and capital expenditures in the near term. Depending upon the Company’s results of operations, its future capital needs and available marketing opportunities, the Company may use various financing sources to raise additional funds. Such sources could potentially include joint ventures, issuances of common stock or debt financing, although the Company does not have any such plans at this time. At September 30, 2005, the Company had no long-term debt.

14

CRITICAL ACCOUNTING POLICIES

Management believes the most critical accounting policies include revenue recognition and income taxes.

     Revenue Recognition

The Company is in the business of performing drug testing and reporting the results thereof. The Company performs drug testing which includes training for collection of samples and storage of positive samples for its customers for an agreed-upon fee per unit tested of samples. The revenues are recognized when the predominant deliverable, drug testing, is provided and reported to the customer. The Company also provides expert testimony, when and if necessary, to support the test results, which is generally billed separately and recognized as the services are provided.

In 2003, the Company adopted Emerging Issue Task Force 00-21, Revenue Arrangements with Multiple Deliverables, which was effective for all transactions entered into subsequent to June 15, 2003. The Company applied the consensus reached under EITF 00-21 and concluded that the testing, training and storage elements are considered one unit of accounting for revenue recognition purposes as the training and storage costs do not have stand-alone value to the customer. The Company has concluded that the predominant deliverable in the arrangement is the testing of the units and has recognized revenue as that service is performed and reported to the customer.

Deferred revenue represents payments received in advance of the performance of drug testing procedures. Deferred revenue is reclassified as revenue when the underlying test results are delivered. With respect to a portion of these transactions, there may be instances where the customer ultimately does not require performance (referred to as breakage). Revenue is then recognized (as other income) when the Company can reasonably, reliably and objectively determine the breakage has occurred. Breakage is deemed to occur only at the point it becomes remote that performance will be required. The Company has not recorded any breakage in the first three quarters of 2005 and during 2004. The Company continues to monitor this to determine whether breakage can be reasonably, reliably and objectively determined.

     Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates, including bad debts and income taxes, 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 from those estimates.

     Allowance for Doubtful Accounts

The allowance for doubtful accounts is based on management’s assessment of the collectibility of its customer accounts. Management reviews its accounts receivable aging for doubtful accounts and specifically identifies accounts that may not be collectible. The Company routinely assesses the financial strength of its customers

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and, as a consequence, believes that its accounts receivable credit risk exposure is limited. The Company maintains an allowance for potential credit losses but historically has not experienced any significant losses related to individual customers or groups of customers in any particular industry or geographic area. Bad debt expense and the issuance of credit memos have been within management’s expectations.

     Income Taxes

The Company accounts for income taxes using the liability method, which requires the Company to recognize a current tax liability or asset for current taxes payable or refundable and a deferred tax liability or asset for the estimated future tax effects of temporary differences between the financial statement and tax reporting bases of assets and liabilities to the extent that they are realizable. Deferred tax expense (benefit) results from the net change in deferred tax assets and liabilities during the year. A deferred tax valuation allowance is required if it is more likely than not that all or a portion of the recorded deferred tax assets will not be realized.

The Company operates within multiple taxing jurisdictions and could be subject to audit in these jurisdictions. These audits may involve complex issues, which may require an extended period of time to resolve. The Company has provided for its estimated taxes payable in the accompanying financial statements.

The above listing is not intended to be a comprehensive list of all of the Company’s accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for management’s judgment in their application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result.

FACTORS THAT MAY AFFECT FUTURE RESULTS

From time to time, information provided by the Company or statements made by its employees may contain “forward-looking” information which involves risks and uncertainties. In particular, statements contained in this report which are not historical facts (including, but not limited to, the Company’s expectations regarding revenues, business strategy, anticipated operating results, strategies with respect to governmental agencies and regulations, cash dividends, capital expenditures and anticipated cash requirements) may be “forward-looking” statements. The Company’s actual results may differ from those stated in any “forward-looking” statements. Factors that may cause such differences include, but are not limited to, employee hiring practices of the Company’s principal customers, development of markets for new products and services offered by the Company, the economic health of principal customers of the Company, financial and operational risks associated with possible expansion of testing facilities used by the Company, government regulation (including, but not limited to, Food and Drug Administration regulations), competition and general economic conditions. With respect to the continued payment of cash dividends, factors include, but are not limited to, available surplus, cash flow, capital expenditure reserves required, and other factors that the Board of Directors of the Company may take into account.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Sensitivity. The Company maintains a short-term investment portfolio consisting principally of money market securities and Taxable Auction Rate Preferred, 7 and 28 day Dutch Auction securities that are not sensitive to sudden interest rate changes. The Company does not use derivative financial instruments for speculative or trading purposes.

Item 4. Controls and Procedures

As of September 30, 2005, our Chief Executive Officer and Chief Financial Officer performed an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in ensuring the reporting of material information required to be included in the Company’s periodic filings with the Securities and Exchange Commission. There were no significant changes in the Company’s internal controls over financial reporting or in other factors that could significantly affect these internal controls over financial reporting subsequent to the date of the most recent evaluation.

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PART II OTHER INFORMATION

Item 6. Exhibits

See Exhibit Index included in this Report

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	Psychemedics Corporation
Date: November 14, 2005	By:	/s/ Raymond C. Kubacki, Jr.
	Raymond C. Kubacki, Jr.
	Chairman and Chief Executive Officer
Date: November 14, 2005	By:	/s/ Peter C. Monson
	Peter C. Monson
	Vice President, Treasurer & Chief Financial Officer

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PSYCHEMEDICS CORPORATION
FORM 10-Q
September 30, 2005

EXHIBIT INDEX

		Page No.
31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	20
31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	22
32.1	Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002	24
32.2	Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002	25

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EX-31.1

Exhibit 31.1

CERTIFICATION PURSUANT TO
SECTION 302
OF THE SARBANES-OXLEY ACT OF 2002

     I, Raymond C. Kubacki, Jr., President and Chief Executive Officer of Psychemedics Corporation, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Psychemedics Corporation;

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 quarterly 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 quarterly report;

4. The registrant’s other certifying officer 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)) 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)	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
c)	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 (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting;

5. The registrant’s other certifying officer 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):

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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: November 14, 2005	By: /s/ Raymond C. Kubacki, Jr.
	Raymond C. Kubacki, Jr.
	Chairman and Chief Executive Officer

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EX-31.2

Exhibit 31.2

CERTIFICATION PURSUANT TO
SECTION 302
OF THE SARBANES-OXLEY ACT OF 2002

     I, Peter C. Monson, Vice President, Treasurer and Chief Financial Officer of Psychemedics Corporation, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Psychemedics Corporation;

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 quarterly 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 quarterly report;

4. The registrant’s other certifying officer 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)) 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)	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
c)	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 (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting;

5. The registrant’s other certifying officer 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):

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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: November 14, 2005	By:	/s/ Peter C. Monson
	Peter C. Monson
	Vice President, Treasurer & Chief Financial Officer

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EX-32.1

Exhibit 32.1

CERTIFICATION PURSUANT TO
U.S.C. SECTION 1350
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

I, Raymond C. Kubacki, Jr., President and Chief Executive Officer of Psychemedics Corporation (the “Company”), 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 Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005, as filed with the Securities and Exchange Commission on or about November 14, 2005 (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.

Date: November 14, 2005	By: /s/ Raymond C. Kubacki, Jr.
	Raymond C. Kubacki, Jr.
	Chairman and Chief Executive Officer

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EX-32.2

Exhibit 32.2

CERTIFICATION PURSUANT TO
U.S.C. SECTION 1350
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

I, Peter C. Monson, Vice President, Treasurer and Chief Financial Officer of Psychemedics Corporation (the “Company”), certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(3)	The Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005, as filed with the Securities and Exchange Commission on or about November 14, 2005 (the “Report”), fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and
(4)	The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: November 14, 2005	By:	/s/ Peter C. Monson
	Peter C. Monson
	Vice President, Treasurer & Chief Financial Officer

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