10-Q 1 a10q.txt QUARTERLY REPORT ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended SEPTEMBER 30, 2009 or [ ] 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 000-51859 ELECTRONIC SENSOR TECHNOLOGY, INC. (Exact name of registrant as specified in its charter) NEVADA 98-0372780 (State or other jurisdiction (I.R.S. Employer Identification No.) of incorporation or organization) 1077 Business Center Drive Newbury Park, California 91320 (Address of principal executive offices) (805) 480-1994 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [ ] No [ ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [ ] Smaller reporting company [X] (Do not check if a smaller reporting company) Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. 161,918,543 shares of common stock as of November 4, 2009 ================================================================================ Certain statements in this quarterly report on Form 10-Q, including those relating to the company's plans regarding business and product development; product sales and distribution; market demands and developments in the homeland security, the future state of the homeland security market, analytical instrumentation/quality control and environmental monitoring markets; and the sufficiency of the company's resources to satisfy operation cash requirements are 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. These forward-looking statements may contain the words "believe," "anticipate," "expect," "predict," "estimate," "project," "will be," "will continue," "will likely result," or other similar words and phrases. Risks and uncertainties exist that may cause results to differ materially from those set forth in these forward-looking statements. Factors that could cause the anticipated results to differ from those described in the forward-looking statements include: risks related to changes in technology, our dependence on key personnel, our ability to protect our intellectual property rights, emergence of future competitors, changes in our largest customer's business and government regulation of homeland security companies. The forward-looking statements speak only as of the date they are made. We do not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made. PART I. FINANCIAL INFORMATION Item 1. Financial Statements. INDEX TO FINANCIAL STATEMENTS Consolidated Balance Sheets as of September 30, 2009 (unaudited) and December 31, 2008 (audited) F-1 Consolidated Statements of Operations (unaudited) for the Three and Nine Months Ended September 30, 2009 and 2008 F-2 Consolidated Statements of Cash Flows (unaudited) for the Three and Nine Months Ended September 30, 2009 and 2008 F-3 Notes to Consolidated Financial Statements (unaudited) F-4 1 ELECTRONIC SENSOR TECHNOLOGY, INC. CONSOLIDATED BALANCE SHEETS ASSETS

See unaudited notes to consolidated financial statements F-1 ELECTRONIC SENSOR TECHNOLOGY, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

See unaudited notes to consolidated financial statements F-2 ELECTRONIC SENSOR TECHNOLOGY, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

See unaudited notes to consolidated financial statements. F-3 ELECTRONIC SENSOR TECHNOLOGY, INC. Notes to Consolidated Financial Statements (Unaudited) September 30, 2009 1) Basis of Presentation The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial statements and with the instructions to Form 10-Q and Item 10 of Regulation S-K. Accordingly, they do not include all the information and disclosures required for annual financial statements. These financial statements should be read in conjunction with the consolidated financial statements and related footnotes for the year ended December 31, 2008, included in the Annual Report filed on Form 10-K for the year then ended. In the opinion of the management of Electronic Sensor Technology, Inc. (the "Company"), all adjustments (consisting of normal recurring accruals) necessary to present fairly the Company's financial position as of September 30, 2009, and the results of operations and cash flows for the nine month period ending September 30, 2009 have been included. The results of operations for the nine month period ended September 30, 2009 are not necessarily indicative of the results to be expected for the full year. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report filed on Form 10-K as filed with the Securities and Exchange Commission for the year ended December 31, 2008. 2) Basis of Consolidation The accompanying financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. 3) Nature of Business and Summary of Significant Accounting Policies a) Nature of Business The Company develops and manufactures electronic devices used for vapor analysis. It markets its products primarily to government agencies, higher education institutions, and multi-national corporations. The company sells its products directly to domestic customers who are end-users and, sells internationally to distributors who, in turn, sell to end-users. Distributors are used for their capability to provide local after-sales support to end-users. b) Cash and Cash Equivalents The Company considers highly liquid financial instruments with maturities of three months or less at the time of purchase to be cash equivalents. c) Certificate of Deposit - Restricted The Company had two certificates of deposit in place at September 30, 2009. One, in the amount of $12,000, was used to secure and collateralize the Company's credit card liability. The other certificate of deposit in the amount of $3,500 was used to provide a performance guarantee for a sale to an overseas customer. d) Allowance for Doubtful Accounts The allowance for doubtful accounts is based on the Company's assessment of the collectibility of customer accounts and the aging of the accounts receivable. If there is a deterioration of a major customer's credit worthiness or actual defaults are higher than the Company's historical experience, the Company's estimates of the recoverability of amounts due it could be adversely F-4 affected. The Company regularly reviews the adequacy of the Company's allowance for doubtful accounts through identification of specific receivables where it is expected that payments will not be received. The Company also establishes an unallocated reserve that is applied to all amounts that are not specifically identified. In determining specific receivables where collections may not be received, the Company reviews past due receivables and gives consideration to prior collection history and changes in the customer's overall business condition. The allowance for doubtful accounts reflects the Company's best estimate as of the reporting dates. Changes may occur in the future, which may require the Company to reassess the collectibility of amounts and at which time the Company may need to provide additional allowances in excess of that currently provided. The allowance for doubtful accounts balance at September 30, 2009 was increased to $105,000 due to uncertainty in collection from a customer who has encountered financial difficulties. e) Revenue Recognition The Company sells directly to domestic customers who are end-users. The Company sells internationally to distributors who, in turn, sell to end-users. Sales to distributors are not contingent on the sale by the distributor to an end-user. As such, the distributor is the owner of the products it purchases from the Company. The Company records revenue from sales of products to customers when the products are shipped, collection of the purchase price is probable and the Company has no significant further obligations to the customer. Costs of remaining insignificant Company obligations, if any, are accrued as costs of revenue at the time of revenue recognition. Cash payments received in advance of product shipment or service revenue are recorded as deferred revenue. f) Shipping and Handling The Company accounts for shipping and handling costs as a component of "Cost of Sales". g) Inventories Inventories are comprised of raw materials, work in process, and finished goods. Inventories are stated at the lower of cost or market and are determined using the first-in, first-out method. h) Property and Equipment Property and equipment are stated at cost, net of accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of five years. i) Research and Development Research and development costs are charged to operations as incurred and consists primarily of salaries and related benefits, raw materials and supplies. j) Use of Estimates The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the recorded amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. F-5 k) Fair Value of Financial Instruments The fair value of certain financial instruments, including accounts receivable, accounts payable and accrued liabilities, approximate their carrying values due to the short maturity of these instruments. The fair value as of September 30, 2009 of the 9% convertible debentures issued by the Company on March 28, 2008 and the 9% note payable issued by the Company on April 10, 2009 amounts to $2,000,000 and $1,000,000, respectively, based on the Company's incremental borrowing rate. l) Long-lived Assets The Company reviews long-lived assets, such as property and equipment, to be held and used or disposed of, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If the sum of the expected cash flows, undiscounted and without interest, is less than the carrying amount of the asset, an impairment loss is recognized as the amount by which the carrying amount of the asset exceeds its fair value. At September 30, 2009 no assets were impaired. m) Capital Lease On June 28, 2007, the Company entered into a capital lease under which the present value of the minimum lease payments amounted to $59,200. The present value of the minimum lease payments was calculated using a discount rate of 11.41%. The principal balance of the capital lease obligation amounted to approximately $21,800 at September 30, 2009. The capital lease matures on September 8, 2010. n) Basic and Diluted Earnings Per Share Basic earnings per share are calculated by dividing income available to stockholders by the weighted-average number of common shares outstanding during each period. Diluted earnings per share are computed by dividing income available to stockholders, adjusted for interest savings on the convertible debenture and changes in income or loss associated with the derivative contract that would result if the contract had been recorded as an equity instrument for accounting purposes during the period, by the weighted average number of common shares outstanding during the period plus the net effect of stock options and warrants, effect of the convertible debentures, and embedded conversion features. The outstanding options, warrants and shares equivalent issuable pursuant to embedded conversion features and warrants at September 30, 2009 and 2008 are excluded from the loss per share computation for that period due to their antidilutive effect. The following sets forth the computation of basic and diluted earnings per share at September 30: F-6 2009 2008 ------------- -------------- Numerator: Net (loss) $ (1,656,618) $ (835,606) Net other (income)/expense associated with derivative contracts - (323,210) ------------- -------------- Net (loss) for diluted earnings per share purposes $ (1,656,618) $ (1,158,816) ============= ============== Denominator: Denominator for basic earnings per share-Weighted average shares outstanding 157,994,029 125,209,050 Effect of dilutive stock options and warrants, determined under the treasury stock method - - Assume issued common shares for convertible debentures, determined under the if-converted method - - ------------- -------------- Denominator for diluted earnings per share-Weighted average shares outstanding 157,994,029 125,209,050 ============= ============== Basic earnings (loss) per share $ (0.01) $ (0.01) ============= ============== Diluted earnings (loss) per share $ (0.01) $ (0.01) ============= ============== o) Stock Based Compensation The Company adopted guidance for "Share Based Payments." The guidance requires companies to expense the value of employee stock options and similar awards and applies to all outstanding and vested stock-based awards. In computing the impact, the fair value of each option is estimated on the date of grant based on the Black-Scholes options-pricing model utilizing certain assumptions for a risk free interest rate; volatility; and expected remaining lives of the awards. The assumptions used in calculating the fair value of share-based payment awards represent management's best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and the Company uses different assumptions, the Company's stock-based compensation expense could be materially different in the future. In addition, the Company is required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. In estimating the Company's forfeiture rate, the Company analyzed its historical forfeiture rate, the remaining lives of unvested options, and the amount of vested options as a percentage of total options outstanding. If the Company's actual forfeiture rate is materially different from its estimate, or if the Company reevaluates the forfeiture rate in the future, the stock-based compensation expense could be significantly different from what we have recorded in the current period. The impact of applying this guidance approximated $14,300 in additional compensation expense during for the nine month period ended September 30, 2009. Such amount is included in general and administrative expenses on the statement of operations. p) Risk Factors Recently, the credit markets and the financial services industry have been experiencing a period of unprecedented turmoil and upheaval characterized by the bankruptcy, failure, collapse or sale of various financial institutions and an unprecedented level of intervention from the United States federal government. While the ultimate outcome of these events cannot be predicted, they may have a material adverse effect on the Company's liquidity and financial condition if its ability to borrow money to finance its operations from its existing lenders or from other sources, or obtain credit from trade creditors were to be impaired. In addition, the recent economic crisis could also adversely impact our customers' ability to finance the purchase of electronic instruments from us or our suppliers' ability to provide us with product, either of which may negatively impact the Company's business and results of operations. F-7 Concentration of Credit Risks The Company is subject to concentrations of credit risk primarily from cash and cash equivalents. The Company's cash and cash equivalents accounts are held at financial institutions and are insured by the Federal Deposit Insurance Corporation ("FDIC") up to $250,000 at September 30, 2009. During the nine-month periods ended September 30, 2009 and 2008, the Company has reached bank balances exceeding the FDIC insurance limit. While the Company periodically evaluates the credit quality of the financial institutions in which it holds deposits, it cannot reasonably alleviate the risk associated with the sudden failure of such financial institutions. Customer Concentration The Company's largest customer accounted for approximately 15% and 26% of its revenues during the nine-month periods ended September 30, 2009 and 2008, respectively. The customer accounted for approximately 39% and 53% of the gross accounts receivable balance at September 30, 2009 and 2008, respectively. Product Concentration All of the Company's revenues were derived from the sale of electronic devices, related accessories and support services used for vapor analysis. Geographic Concentration The Company sells its products internationally in 20 countries. Sales to these countries were approximately 44% and 43% of net revenues during the nine-month periods ended September 30, 2009 and 2008, respectively. q) Recently Issued Accounting Pronouncements In April 2009, the FASB issued guidance in the Financial Instruments Topic of the Codification on interim disclosures about fair value of financial instruments. The guidance requires disclosures about the fair value of financial instruments for both interim reporting periods, as well as annual reporting periods. The guidance is effective for all interim and annual reporting periods ending after June 15, 2009 and shall be applied prospectively. The adoption of this guidance had no impact on our financial statements as of September 30, 2009. In May 2009, the FASB issued guidance in the Subsequent Events Topic of the Codification . The guidance is intended to establish general standards of accounting for, and disclosure of, events that occur after the balance sheet date but before financial statements are issued. It requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date. The guidance is effective for interim or annual financial periods ending after June 15, 2009 and is required to be adopted prospectively. We adopted this guidance effective for the quarter ending June 30, 2009. The adoption of this guidance had no impact on our financial statements as of September 30, 2009. In June 2009, the FASB issued guidance which will amend the Consolidation Topic of the Codification. The guidance addresses the effects of eliminating the qualifying special-purpose entity (QSPE) concept and responds to concerns over the transparency of enterprises' involvement with variable interest entities (VIEs). The guidance is effective beginning on January 1, 2010. We do not expect the adoption of this guidance to have an impact on our financial statements. In August 2009, the FASB issued Accounting Standards Update No. 2009-05, "Measuring Liabilities at Fair Value" (ASU 2009-05). ASU 2009-05 amends the Fair Value Measurements and Disclosures Topic of the FASB Accounting Standards Codification by providing additional guidance clarifying the measurement of liabilities at fair value. ASU 2009-05 is effective for us F-8 for the reporting period ending December 31, 2009. We do not expect the adoption of ASU 2009-05 to have an impact on our financial statements. 4) Convertible Debentures Issued To Related Parties 9% Debenture Payable On April 10, 2009, the Company received $1 million from Halfmoon Bay Capital Ltd., the Company's largest shareholder, in exchange for a debenture bearing an interest rate of 9% with a maturity of one year. The debenture grants the investor a security interest in all of the intellectual property of the Company. 9% Convertible Debentures On March 28, 2008, we received $2,000,000 from Halfmoon Bay Capital Ltd., the Company's largest shareholder, in exchange for a convertible debenture bearing an interest rate of 9%, payable semi-annually in cash. The convertible debenture has a five (5)-year term, and the conversion rate of the debenture is $0.0486 (equal to 41,152,263 common shares). The difference between the conversion rate of the debenture and the closing price of the Company's common stock on the date of issuance resulted in a note discount of approximately $58,000. The note discount will be amortized over the term of the convertible debenture. On October 5, 2009, Halfmoon Bay Capital Ltd agreed to defer a $90,000 interest payment owed to it on September 28, 2009 until December 31, 2009. 5) Stockholders' Equity Common Stock On June 12, 2009, the Company filed Amended and Restated Articles of Incorporation with the Nevada Secretary of State. The Articles of Incorporation of the Company were amended and restated to give effect to the following amendments: (i) to increase the number of authorized shares of common stock from 200,000,000 shares to 250,000,000 shares, (ii) to vest authority in the Board of Directors to prescribe the classes, series and the number of each class or series of preferred stock and the voting powers, designations, preferences, limitations, restrictions and relative rights granted to or imposed upon any wholly unissued series of preferred stock and (iii) to clarify and restate that the purpose of the business of the Company is to engage in any lawful act or activity for which corporations may be organized under the General Corporation Law of the State of Nevada. Options In 2005, the Board of Directors adopted the Electronic Sensor Technology, Inc. 2005 Stock Incentive Plan. The purpose of the Stock Incentive Plan is to attract and retain the services of experienced and knowledgeable individuals to serve as our employees, consultants and directors. On the date the Stock Incentive Plan was adopted, the total number of shares of common stock subject to it was 5,000,000. The Stock Incentive Plan is currently administered by the Board of Directors, and may be administered by any Committee authorized by the Board of Directors, so long as any such Committee is made up of Non-Employee Directors, as that term is defined in Rule 16(b)-3(b) of the Securities Exchange Act of 1934. The Stock Incentive Plan is divided into two separate equity programs: the Discretionary Option Grant Program and the Stock Issuance Program. Under the Discretionary Option Grant Program, eligible persons may, at the discretion of the administrator, be granted options to purchase shares of common stock and stock appreciation rights. Under the Stock Issuance Program, eligible persons may, at the discretion of the administrator, be issued shares of common stock directly, either through the immediate purchase of such shares or as a bonus for services rendered for Electronic Sensor Technology (or a parent or subsidiary of Electronic Sensor Technology). Pursuant to the terms of the Discretionary Option Grant Program, the exercise price per share is fixed by the administrator, but may not be less than 85% of the fair market value of the common stock on the date of F-9 grant, unless the recipient of a grant owns 10% or more of Electronic Sensor Technology's common stock, in which case the exercise price of the option must not be less than 110% of the fair market value. An option grant may be subject to vesting conditions. Options may be exercised in cash, with shares of the common stock of Electronic Sensor Technology already owned by the person or through a special sale and remittance procedure, provided that all applicable laws relating to the regulation and sale of securities have been complied with. This special sale and remittance procedure involves the optionee concurrently providing irrevocable written instructions to: (i) a designated brokerage firm to effect the immediate sale of the purchased shares and remit to Electronic Sensor Technology, out of the sale proceeds available on the settlement date, sufficient funds to cover the aggregate exercise price payable for the purchased shares plus all applicable federal, state and local income and employment taxes required to be withheld by Electronic Sensor Technology by reason of such exercise and (ii) Electronic Sensor Technology to deliver the certificates for the purchased shares directly to such brokerage firm in order to complete the sale. The term of an option granted pursuant to the Discretionary Option Grant Program may not be more than 10 years. The Discretionary Option Grant Program also allows for the granting of Incentive Options to purchase common stock, which may only be granted to employees, and are subject to certain dollar limitations. Any options granted under the Discretionary Option Grant Program that are not Incentive Options are considered Non-Statutory Options and are governed by the aforementioned terms. The exercise price of an Incentive Option must be no less than 100% of the fair market value of the common stock on the date of grant, unless the recipient of an award owns 10% or more of Electronic Sensor Technology's common stock, in which case the exercise price of an incentive stock option must not be less than 110% of the fair market value. The term of an Incentive Option granted may not be more than five years if the option is granted to a recipient who owns 10% or more of Electronic Sensor Technology's common stock, or 10 years for all other recipients of Incentive Options. Incentive Options are otherwise governed by the general terms of the Discretionary Option Grant Program. Pursuant to the terms of the Stock Issuance Program, the purchase price per share of common stock issued is fixed by the administrator, but may not be less than 85% of the fair market value of the common stock on the issuance date, unless the recipient of a such common stock owns 10% or more of Electronic Sensor Technology's common stock, in which case the purchase price must not be less than 100% of the fair market value. Common stock may be issued in exchange for cash or past services rendered to Electronic Sensor Technology (or any parent or subsidiary of Electronic Sensor Technology). Common stock issued may be fully and immediately vested upon issuance or may vest in one or more installments, at the discretion of the administrator. Management used Black Scholes methodology to determine the fair value of the options on the date of issue based on the following assumptions. The expected volatility was based on the average historical volatility of comparable publicly-traded companies. 2009 2008 ------------- -------------- Exercise price $0.02 - $0.24 $0.03 - $0.24 Market value $0.02 - $0.24 $0.03 - $0.24 Expected dividend yield 0% 0% Expected volatility 36% - 47% 36% - 39% Risk free interest rate 3.81% - 4.54% 4.01% - 4.54% Expected life of option 5 years 5 years The fair value of the granted stock options shares was approximately $0.02 per share. Approximately $30,600 and $14,300 were charged to compensation expense for the nine month period ended September 30, 2008 and 2009, respectively. The remaining amount will be amortized to compensation expense over future periods based on the vesting schedule of the respective stock option shares. The total compensation cost related to nonvested awards not yet recognized amounted to approximately $22,100 at September 30, 2009. This compensation cost will be recognized over the weighted average period 2.3 years, unless the options are terminated sooner. F-10 The following tables summarize all stock option grants to employees and non-employees as of September 30, 2009: Weighted Number of Average Stock Options Options Exercise Price ------------------------------------------ ------------- -------------- Balance at December 31, 2007 3,437,950 $ 0.41 Granted 2,000,000 $ 0.03 Exercised - $ - Forfeited (2,291,050) $ 0.37 ------------- -------------- Balance at December 31, 2008 3,146,900 $ 0.19 Granted - $ - Exercised - $ - Forfeited (642,500) $ 0.48 ------------- -------------- Balance at September 30, 2009 2,504,400 $ 0.12 ============= ============== Options exercisable at September 30, 2009 635,700 $ 0.38 ============= ============== Weighted average fair value of options granted during 2009 - $ - ============= ============== A summary of the status of the Company's nonvested shares as of September 30, 2009, and changes during the fiscal period then ended as presented below. Weighted Average Grant Date Nonvested Shares Shares Fair Value ------------------------------------------ ------------- -------------- Nonvested at December 31, 2007 1,598,200 $ 0.09 Granted 2,000,000 $ 0.03 Vested (191,850) $ 0.24 Cancelled (1,158,300) $ 0.21 ------------- -------------- Nonvested at December 31, 2008 2,248,050 $ 0.09 Granted - $ - Vested (316,850) $ 0.07 Cancelled (62,500) $ 0.24 ------------- -------------- Nonvested at September 30, 2009 1,868,700 $ 0.04 ============= ==============

F-11 Warrants On May 29, 2009, the Company entered into an agreement with Montgomery 2006-1 Partnership ("Montgomery"), pursuant to which Montgomery agreed to terminate and cancel the warrants issued by the Company on December 7, 2005 which entitled Montgomery to purchase up to 485,213 shares of common stock of the Company. In consideration for the termination and cancellation of the warrants, the Company paid $2,500 to Montgomery. On June 29, 2009, the Company entered into an agreement with Midsummer Investment, Ltd. ("Midsummer") and Islandia, L.P. ("Islandia"), pursuant to which, the Company agreed to issue 3,899,030 shares of common stock to Midsummer and 2,166,128 shares of common stock to Islandia in exchange for the termination and cancellation of the warrants issued by the Company to each of Midsummer and Islandia on December 7, 2005. The agreement also provided for the termination of all existing agreements among the Company, Midsummer and Islandia. The following table summarizes the warrants outstanding at September 30, 2009:

F-12 Item 2. Management's Discussion and Analysis or Plan of Operation. You should read the following discussion and analysis of our financial condition and results of operations together with our interim financial statements and the related notes appearing at the beginning of this report. The interim financial statements and this Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2008 and the related Management's Discussion and Analysis of Financial Condition and Results of Operations, both of which are contained in our Annual Report on Form 10-K filed with the Securities and Exchange Commission. -------------------------------------------------------------------------------- Overview The company is engaged in the development, manufacturing, and sales of a patented product called zNose(R); a device designed to detect and analyze chemical odors and vapors, or, in other words, an electronic "nose." We believe the zNose(R) is superior to other electronic "noses" because of its speed, specificity and sensitivity. The zNose(R) is capable of measuring and quantifying the chemistry of any compound, fragrance, vapor or odor with parts per trillion sensitivity in 10 seconds. We also believe the zNose(R) has the unique ability to quantify and speciate the subject chemical vapor by creating visual olfactory images. This enables the measured odor or vapor to be easily identified by the user. We believe that our products will have broad applications in the homeland security, analytical instrumentation/quality control, and environmental monitoring and detection markets. The company is involved in ongoing product research and development efforts in that regard. The company has also concentrated its efforts on further product development, testing and proving and continuing to expand our sales and support organization. The company was originally incorporated under the laws of the state of Nevada as "Bluestone Ventures, Inc." on July 12, 2000. From inception until February 1, 2005, we engaged in the business of acquiring, exploring and developing certain mining properties in Ontario, Canada. Upon acquisition of Electronic Sensor Technology, L.P. ("ELP"), we abandoned our mining business and adopted ELP's business of developing, manufacturing and selling the vapor analysis device. On January 26, 2005, we changed our name to "Electronic Sensor Technology, Inc." Our executive offices are located at 1077 Business Center Circle, Newbury Park, California 91320 and our telephone number is (805) 480-1994. Critical Accounting Policies The company sells directly to domestic customers who are end-users. The company sells internationally to distributors who, in turn, sell to end-users. Sales to distributors are not contingent on the sale by the distributor to an end-user. The distributor is the owner whether or not it sells the product to an end-user. The company records revenue from sales of products to customers when the products are shipped, collection of the purchase price is probable and the company has no significant further obligations to the customer. Costs of remaining insignificant company obligations, if any, are accrued as costs of revenue at the time of revenue recognition. Cash payments received in advance of product shipment or service revenue are recorded as deferred revenue. The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the recorded amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The company reviews long-lived assets, such as property and equipment, to be held and used or disposed of, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If the sum of the expected cash flows, undiscounted and without interest, is less than the carrying amount of the asset, an impairment loss is recognized as the amount by which the carrying amount of the asset exceeds its fair value. At September 30, 2009 no assets were impaired. 2 Plan of Operations Over the course of the next 12 months, we intend to execute our business plan and focus our business development efforts in the following key areas: o By diversifying our product offerings to enhance the usefulness of our solutions for customers who will have already adopted one or more products; o By enhancing our product lines and developing new products to attract new customers; and o By developing partnering relationships with wide-ranging sales and distribution channel leaders already serving our vertical market space in a way that assists them in developing new revenue streams and opportunities through improved technical and sales support and customer services. Results of Operations The following table sets forth, as a percentage of revenues, certain items included in the company's Income Statements (see Financial Statements and Notes) for the periods indicated: Nine Months Ended Three Months Ended September 30 September 30 ------------------- ------------------- Statement of Operations Data: 2009 2008 2009 2008 ----------------------------------- -------- -------- -------- -------- Revenues......................... 100% 100% 100% 100% Cost of Sales.................... 59% 64% 67% 68% Gross Profit..................... 41% 36% 33% 32% Operating Expenses............... 229% 158% 298% 105% (Loss) From Operations........... (188%) (122%) (265%) (73%) Other Income (Expense)........... (25%) 57% (37%) (9%) Net (Loss)....................... (213%) (65%) (302%) (82%) Nine Months Ended September 30, 2009 Compared to Nine Months Ended September 30, 2008 Revenues are derived from product sales and product support services. For the three and nine month periods ended September 30, 2009, revenues were $194,700 and $778,100, compared to $543,900 and $1,303,600 in 2008. The decrease in revenues for both the quarter and year-to-date results from: (1) a price reduction averaging 24% on all of our instruments instituted at the beginning of the year to make our products more price competitive and, (2) current global economic conditions which have had a significant negative impact on the durable equipment market. Potential customers are taking a "wait and see" approach to capital equipment purchase decisions and are delaying such decisions until economic conditions improve. This is reflected in the shipments for the quarter and year-to-date which were 7 and 30 units, respectively, compared to 20 and 42 units shipped for the same periods in 2008. The decrease in shipments has also impacted product support revenues which for the three and nine periods ended September 30, 2009 were 16% and 50% less than for the same periods in 2008. The decrease in product support revenues for the quarter was offset somewhat by an increase in revenues from equipment rentals. Finally, revenues from the company's license agreement with a customer ended in October 2008 when the agreement was concluded and not renewed. The license agreement provided $12,500 in quarterly royalty income in 2008 for the company. The company anticipates the stresses of current global economic conditions on the commercial durable equipment market to continue for the rest of the year and into 2010. These conditions have caused many of our customers (and potential customers) to postpone their purchases of capital equipment. Until global economic conditions improve, we expect the commercial durable equipment market to remain depressed. During the third quarter, we continued with the global rollout of our latest product, the Model 4500, to mostly homeland security customers. Although the upside potential of this market is vast, the homeland security market is characterized by its long sales cycle where the time between product introduction to product sale may be 3 considerable. Initial market reaction to the Model 4500 has been positive and we are confident in the product's capabilities to meet the requirements of our homeland security customers. We are, however, still in the early stages of the sales cycle with many of these customers and, as such, anticipate only modest sales performance for the Model 4500 for the remainder of 2009. Cost of Sales consist of product costs and expenses associated with product support services. For the three and nine month periods ended September 30, 2009, cost of sales were $130,300 and $459,100, compared to $367,800 and $828,500 in 2008. For the same periods, cost of sales, as a percentage of revenues, were 67% and 59%, versus 68% and 64% in 2008. Cost of sales were improved by favorable price economics on purchased materials which offset production variances resulting from under-absorption of overhead expenses caused by reduction in production levels due to business conditions and to work-off on-hand inventories. Gross profits were 33% and 41% of sales for the three and nine month periods ended September 30, compared to 32% and 36% of sales for the same periods in 2008. Gross margins were aided by cost improvements, primarily price economics achieved on purchased materials, on our products which offset an averaged 24% across-the-board price reduction on our entire instrument product line instituted at the beginning of the year. Research and Development costs for the three and nine month periods ended September 30, 2009 were $95,000 and $293,100 versus $163,900 and $512,900 for the same periods in 2008. The improvement of $68,900 for the quarter is attributed to lower personnel expenses due to reduction of census ($59,800), lower operating expenses ($16,200), offset by an increase in facilities expenses ($7,100). For the nine month period, expenses were improved by $219,800 due to reductions in personnel expenses ($206,500), lower operating expenses ($43,500), offset by higher facilities expenses ($21,200) and increase in use of outsider services ($9,000). Selling, General and Administrative expenses for the three and nine month periods ended September 30, 2009 were $485,400 and $1,490,800, compared to $405,000 and $1,545,700 for the same periods in 2008. For the quarter, expenses were $80,400 higher than in 2008 due to recognition of bad debts expense ($105,000), higher outside services expenses ($27,100), higher facilities costs ($3,900), offset by savings from reductions in personnel expenses ($26,500) and operating costs ($29,100). For the nine month period, selling, general and administrative expenses were $54,900 improved over the same period in 2008 due to lower operating ($154,900) and personnel ($200,000) expenses, offset by increase in bad debts expense ($105,000), higher outside services ($83,200) and facilities ($111,800) costs, Interest expense for the nine months ending September 30, 2009 was $4,400, as compared to $740,400 for the same period in 2008. Interest expense for the first nine months of 2008 consisted of: (1) interest accrued on the $7.0 million 8% convertible debentures which were retired on March 28, 2008; and, (2) amortization of the debt discount on the same retired 8% convertible debentures. Interest expense - related party for the three and nine month periods ended September 30, 2009 were $70,400 and $186,300, compared to $47,800 and $96,800 for the same periods in 2008. Current year's interest consists of interest accrued on the $2.0 million 9% convertible debenture issued to Halfmoon Bay Capital Ltd on March 28, 2008 and on the $1.0 million 9% debenture also issued to Halfmoon Bay Capital Ltd on April 10, 2009. Interest expense for 2008 pertained only to the $2.0 million 9% convertible debenture issued on March 28, 2008. Other income-derivatives. There was no income from derivatives in 2009. Such income from derivatives in 2008 resulted primarily from the decrease in the fair value of derivative liabilities between the measurement dates which are the balance sheet dates. On March 31, 2008, we satisfied our obligations under the 8% convertible debentures and as a result, the company asserted that it has a sufficient amount of authorized and unissued shares to settle its obligations which can be settled in shares. Accordingly, the company reclassified all contracts, warrants, and other convertible instruments outstanding at March 31, 2008 from liability to equity. Gain on extinguishment of debt. In 2008, a gain was realized from the early retirement of the 8% convertible debentures on March 31, 2008. There have been no debt retirements in 2009. 4 Liquidity and Capital Resources For the nine months ending September 30, net cash used by the company for operating activities were $1,165,600 and $1,510,600 for 2009 and 2008 respectively. Cash used for the nine months ending September 30, 2009 was comprised of the net loss for the period of $1,656,600, plus net non-cash items (including depreciation and amortization expenses of $32,400, increase in allowance for doubtful accounts of $105,000, stock based compensation of $14,300, issuance of common shares for services of $109,200 and amortization of debt discount of $8,600) of $269,500, and plus the net change in operating assets and liabilities of $221,500. Cash used in operations during the same nine months of 2008 was comprised of the net loss for the period of $835,600, less net non-cash expenses (including depreciation and amortization expenses of $36,200, stock based compensation of $30,600, issuance of common shares for payment of interest of $280,000, amortization of debt discount of $589,100, amortization of deferred financing costs of $45,400, less decrease in fair value of derivative liability of $323,200, and gain on early retirement of debt of $1,261,900) of $603,800, and less the net change in operating assets and liabilities of $71,200. Investing activities used cash of 23,200 in the first nine months of 2009 and provided cash of $6,300 during the same period in 2008. For the period, cash of $4,800 was provided from the sale of property and equipment, and $28,000 was used to purchase capital equipment. In 2008, cash of $9,900 was provided from the sales of property and equipment and $3,600 was used to purchase capital equipment. Financing activities for the first nine months of 2009 provided cash of $985,200 which resulted from the issuance of a 9% debenture payable to an investor for $1,000,000 and a decrease in capital lease obligation of $14,800. For the same period in 2008, financing activities provided cash of $1,985,200 which included $2,000,000 received from the issuance of 9% convertible debentures to a related party investor, $3,500,000 from the issuance of equity to the same investor, less $3,500,000 used to retire the 8% convertible debentures and a decrease in capital lease obligation of $14,800. On September 30, 2009 the company's cash (including cash equivalents) was $208,400, compared to $484,000 on September 30, 2008. The company had working deficit of $503,500 on September 30, 2009, compared to a working capital of $1,414,000 on September 30, 2008. The Company's current cash balance is not expected to be adequate to fund operations beyond the fourth quarter of 2009. As such, the Company is actively seeking additional funding to provide necessary working capital for operations and implementation of its business strategy of creating a sales and marketing staff for the marketing, advertising and selling of the zNose(R) family of chemical detection products, increasing distribution channels both in the U.S. and foreign countries, introducing new products, improving existing product lines and development of a strong corporate infrastructure. There can be no assurance that any financing will be available through any bank borrowings, debt, or equity offerings, or otherwise, on acceptable terms. If future financing requirements are satisfied through the issuance of equity securities, investors may experience significant dilution in the net book value per share of common stock and there is no guarantee that a market will exist for the sale of the Company's shares. Seasonality and Quarterly Results We have not experienced and do not foresee any seasonality to our revenues or our results of operations. Inflation Although we currently use a limited number of sources for most of the supplies and services that we use in the manufacturing of our vapor detection and analysis technology, our raw materials and finished products are sourced from cost-competitive industries. While prices for our raw materials may vary significantly based on market trends, we have not experienced and do not foresee any material inflationary trends for our product sources. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements. 5 Item 3. Quantitative and Qualitative Disclosures About Market Risk. This Item is not applicable to smaller reporting companies. Item 4T. Controls and Procedures. The company's Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of the company's disclosure controls and procedures (as defined in Rules 13a-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this quarterly report on Form 10-Q, have concluded that, based on such evaluation, the company's disclosure controls and procedures were effective to ensure that material information relating to the company is recorded, processed, summarized, and reported in a timely matter. In designing and evaluating the disclosure controls and procedures, the company's management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and the company's management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. There were no changes in the company's internal control over financial reporting that occurred during the period covered by this quarterly report that have materially affected, or are reasonably likely to materially affect, the company's internal control over financial reporting. 6 PART II. OTHER INFORMATION Item 1. Legal Proceedings. We are not a party to any pending material legal proceedings and are not aware of any threatened or contemplated proceeding by any governmental authority against us. Item 1A. Risk Factors. This Item is not applicable to smaller reporting companies. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. We did not sell any unregistered equity securities or repurchase any of our equity securities during the three months ended September 30, 2009. Item 3. Defaults Upon Senior Securities. During the three months ended September 30, 2009, there were no material defaults upon senior securities. Item 4. Submission of Matters to a Vote of Security Holders. None. Item 5. Other Information. On August 25, 2009, the Company received a comment letter from the United States Securities and Exchange Commission ("SEC") seeking additional information related to Form 10-K for the fiscal year ended December 31, 2008 filed on April 15, 2009. The Company provided the requested information in a letter to the SEC on September 8, 2009. Based on the Company's responses, the SEC in a letter dated September 10, 2009 accepted our responses and indicated that it had no further comments. Item 6. Exhibits. Exhibit No. Description ------------ ----------------------------------------------------------------- 31.1 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act. 31.2 Certification of Principal Financial and Accounting Officer Pursuant to Section 302 of the Sarbanes-Oxley Act. 32.1 Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act. 32.2 Certification of Principal Financial and Accounting Officer Pursuant to Section 906 of the Sarbanes-Oxley Act. 7 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. ELECTRONIC SENSOR TECHNOLOGY, INC. Dated: November 12, 2009 By: /s/ Teong Lim ---------------------------------------- Name: Teong Lim Title: President and Chief Executive Officer (Principal Executive Officer) Dated: November 12, 2009 By: /s/ Philip Yee ---------------------------------------- Name: Philip Yee Title: Secretary, Treasurer and Chief Financial Officer (Principal Financial and Accounting Officer)

Electronic Sensor Technology, Inc 10-Q