NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the nine months ended June 30, 2013 and 2012 respectively.

(Unaudited)

Note 1. 

Organization and Description of Business

Neah Power Systems, Inc. (“the Company”, “we”. “us” or “our”) is engaged in the development and sale of renewable energy solutions using proprietary fuel cell technology. Our fuel cells are designed to replace existing rechargeable and non-rechargeable battery technology in a variety of applications. We have developed solutions specifically targeted for the military, transportation, and portable electronics applications, and are continuing to pursue additional applications for our technology. Our long-lasting, efficient and safe power solutions include devices such as notebook PCs, military radios, and other power-hungry computer, entertainment and communications products.

We are developing two classes of fuel cells, one referred to as the PowerChip™ and the other as the PowerPlay™ product. The PowerChip™ is a silicon based fuel cell that uses traditional computer chip manufacturing to build the fuel cell. The PowerPlay™ product was developed during the last two years using some processing steps of the PowerChip™ technology and using polymeric materials for a lower cost, consumer oriented product. The PowerChip™ is targeted for applications (anaerobic) where the quality of the surrounding air is unpredictable or not available such as diesel-fumes contaminated environments or underwater applications. The PowerPlay™ product uses air from the surrounding environment and is targeted for consumer-oriented and less aggressive applications and typically for lower power ranges. Our technology and its application have been validated both by our own research and customer results. We believe our fuel cells would outperform lithium ion batteries and other similar power sources, with longer run time, shorter recharge time, portability, and other measures of performance. We anticipate that our fuel cell solution will be particularly beneficial in applications requiring the use of more than one battery because the user will only need to use a single fuel cell with a supply of smaller fuel cartridges, resulting in reduced overall size and weight.

We have an intellectual property portfolio consisting of 12 issued patents, 3 patents pending, and various trade secrets for our proprietary technology.  We use a unique, patented and award winning, silicon-based design for our Powerchip™ micro fuel cells that enable higher power densities, lower cost and compact form-factors. The PowerChip™ technology has been recognized for both its innovativeness and its application potential from noted sources including the 2012 ZINO Green finalist, the 2010 WTIA finalist, 2010 Best of What’s New Popular Science and other awards. Our website is www.neahpower.com .

Neah Power continues its aggressive efforts to accelerate the commercialization of our proprietary and patented fuel cell technologies that we passionately believe has the potential to revolutionize the energy storage marketplace. The shipment of our PowerChip™ system in the second half of 2012, and PowerPlay™ system in spring of 2013 were milestone events at the Company and we continue to see the fruits of the $50+ million that have gone into the Company with concrete progress of commercialization. We now have an increasing array of committed customers and customer prospects. Our capital constraints have severely limited our ability to execute on our business plan, the funding for which we consistently devote major attention, recent illustrative achievements are listed below.

·

We launched PowerPlay™ with a paid shipment to a Fortune 110 consumer company. This company is now expanding its interest and by evaluating the PowerChip™ technology for a range of different applications.

·

We entered into a mutually exclusive development contract with Ion Geophysical Corporation to develop a customer-specific product.  The customer has committed to purchase a minimum number of units over a period of time.

·

We intend to update on an ongoing basis high levels of interest from a range of other defense, aerospace and automotive customers for the PowerChip™ products, as well as the large India Defense entity.

·

 We continue to grow our IP portfolio with new patents awarded and applications submitted, which differentiates us from the competition and enhances our value

·

 High potential impact discussions are ongoing with a telecom company for the PowerPlay™ product for consumer cell phone recharging.

·

We have recently been able to successfully remove the Depository Trust Clearing Corporation (DTCC) trading restrictions (‘Chill’) that were implemented on the stock.

·

On June 26, 2012, we announced an initial order from a Fortune 150, U.S.-based defense supplier, for the PowerChip™ fuel cell, which has reiterated its interest in the Company.

·

We have two proposals jointly submitted with the previously mentioned customer for soldier power and unmanned surface vehicle applications, which we believe are impacted by sequestration.

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Note 2. 

Basis of Presentation and Summary of Significant Accounting Policies

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and note disclosures required by U.S. generally accepted accounting principles for complete financial statements. The accompanying unaudited financial information should be read in conjunction with the audited consolidated financial statements, including the notes thereto, as of and for the fiscal year ended September 30, 2012, included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on December 31, 2012. The information furnished in this Report reflects all adjustments (consisting of normal recurring adjustments), which are, in the opinion of management, necessary for a fair presentation of our consolidated financial position, results of operations and cash flows for each period presented. The results of operations for the interim period ended June 30, 2013 may not be indicative of future results.

Fair value of financial instruments

The carrying value of cash and cash equivalents approximate their fair value (determined based on level 1 inputs in the fair value hierarchy) based on the short-term nature of these financial instruments. The carrying values of the note receivable and notes payable and accrued interest approximate their fair value (determined based on level 3 inputs in the fair value hierarchy) because interest rates approximate market interest rates.

Use of estimates in the preparation of financial statements

Preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. The more significant accounting estimates inherent in the preparation of our condensed consolidated financial statements include estimates as to the valuation of equity related instruments.

Revenue Recognition

Revenue for the three and nine months ended June 30, 2013 and 2012 consists primarily of revenues from a research and development contract. In general, we recognize revenue when we have persuasive evidence of an arrangement, the services/goods have been provided or delivered to the customer, the price is fixed and determinable, no significant unfulfilled obligations exist, and collectability is reasonably assured. Revenue from research and development arrangements is recognized either (a) as performance is estimated to be completed which is based on factors such as costs or direct labor hours of the project, or (b) using the milestone method if the contractual milestones in the arrangement are determined to be substantive. Each research and development arrangement is analyzed to determine the appropriate revenue recognition method to be utilized. Estimates of performance completion are reviewed on a periodic basis and are subject to change, and changes could occur in the near term. If an estimate is changed, revenue could be impacted significantly. Payments received in excess of amounts earned are recorded as deferred revenue. At June 30, 2013 there is $10,001 of deferred revenue included in other liabilities on the condensed consolidated balance sheet (none at September 30, 2012).

Note 3. Going concern

The accompanying condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplate continuation of our Company as a going concern. Since inception, we have reported net losses, including losses of $999,544 and $1,633,217 during the years ended September 30, 2012 and 2011, respectively. We have reported a net loss of $1,726,817 during the nine months ended June 30, 2013, and we expect losses to continue in the near future as we grow our operations. At June 30, 2013, we have a working capital deficit of $1,386,662 and an accumulated deficit of $57,876,740. Net cash used by operating activities was $549,835 and $1,194,439 during the nine months ended June 30, 2013 and 2012, respectively. We have funded our operations primarily through sales of our common and preferred stock, short-term borrowings, and cash receipt from sales. In this regard, during the nine months ended June 30, 2013, we raised $355,500 from our financing activities, and received approximately $191,980 in cash pursuant to terms on sales contracts.

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Investment funds received have not been sufficient to continue to support certain operating activities, which led to postponement in the deployment of our business strategy and the scaling back of research and development activities. We continue at reduced staffing levels as we focus on raising additional capital and engaging prospective customers. Without additional funding, our cash is estimated to support our operations into September 2013. These factors, and those of the preceding paragraph, raise substantial doubt about our ability to continue as a going concern.

We require additional financing to execute our business strategy and to satisfy our near-term working capital requirements. Our operating expenses will use a significant amount of our cash resources. Our management seeks to raise additional financing to fund future operations and to provide additional working capital to fund our business. There is no assurance that such financing will be obtained in sufficient amounts necessary or on terms favorable or on terms acceptable to us to meet our needs. In the event that we cannot obtain additional funds, on a timely basis or our operations do not generate sufficient cash flow, we may be forced to curtail our development or cease our operations altogether, which may include seeking protection under the bankruptcy laws.

The accompanying condensed consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or amounts and classifications of liabilities that may result from the outcome of this uncertainty

Note 4. Net Income and Loss per Share

Earnings and Loss per Share

Basic and diluted net income (loss) per common share is computed by dividing the net income (loss) by the weighted average number of common shares outstanding during the period. All common stock equivalents for 2013 are excluded as the effect would be anti-dilutive due to our net losses. The following numbers of shares have been excluded from net loss per share computations for the three and nine months ended June 30, 2013 and 2012:

We calculate our basic earnings per share (“EPS”) using net earnings and the weighted-average number of shares outstanding during the reporting period. Diluted EPS includes any dilutive effect of outstanding convertible preferred stock, stock options, stock warrants, and convertible debt.

Settlement of Notes Payable

In December 2012, one of our note holders assigned their note to a third party who converted the note into 3,367,003 shares of common stock and we recorded a loss on settlement of liabilities of $14,916 in our condensed consolidated statement of operations. We recorded a reduction to our Notes Payable in the amount of $10,000 for this transaction.

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During the three months ended March 31, 2013, six of our note holders assigned their notes to a third party who then converted the notes into 7,159,628 shares of common stock. We recorded a loss on settlement of liabilities of $31,790 in our condensed consolidated statement of operations and a reduction to Notes Payable in the amount of $29,289 for this transaction.

Issuance of Convertible Promissory Note

In April 2012, we issued a convertible promissory note in the amount of $53,000 to an investor for net proceeds of $50,000. The note bore interest at an annual rate of 8% and had a maturity date of January 13, 2013.  In October and November of 2012, the debenture was converted in full into 9,654,476 shares of common stock under the conversion terms of the note.

During the nine months ended June 30, 2013, we issued four convertible promissory notes in the aggregate amount of $160,500 to an investor for net proceeds of $150,000. The notes are interest bearing at an annual rate of 8% and have maturity dates of July 5, 2013, September 4, 2013, October 28, 2013, and March 14, 2014. After six months from the date of issue, the promissory notes may be converted into shares of common stock at a rate of 58% of the average of the three lowest closing bid prices during the ten trading days prior to notice to convert. During the nine months ended June 30, 2013, we recorded debt discount for beneficial conversion feature on these notes in the amount of $142,381. In April of 2013, the investor converted in full one of  the notes of $53,000 principal into 14,494,254 shares of common stock under the conversion terms of the note, and in June 2013 the investor converted $32,500 of another note into 10,937,500 shares of common stock

During the nine months ended June 30, 2013, one of our convertible promissory note holders converted $55,619 of their note into 10,169,444 shares of our common stock on which we recorded $37,104 as loss on settlement of liabilities in our condensed consolidated statement of operations.

Issuance of Promissory Note

During the three months ended March 31, 2013, we issued a non-interest bearing promissory note in the amount of $15,000 in full satisfaction of an outstanding liability. As of June 30, 2013, the note has been paid in full.

Note 6.  Preferred Stock and Common Stock

Preferred Stock - Our board of directors has the authority to designate and issue up to 5,000,000 shares of $0.001 par value preferred stock in one or more series, and to fix and determine the relative economic rights and preferences of preferred shares any or all of which may be greater than the rights of our common stock, as well as the authority to issue such shares without further stockholder approval. As a result, our board of directors could authorize the issuance of a series of preferred stock that would grant to holders preferred rights to our assets upon liquidation, the right to receive dividends before dividends are declared to holders of our common stock, and the right to the redemption of such preferred shares, together with a premium, prior to the redemption of the common stock. In addition, shares of preferred stock could be issued with terms calculated to delay or prevent a change in control or make removal of management more difficult. As of June 30, 2013, we had three classes of preferred stock designated, of which 2,500,000 shares were designated as Series A preferred stock, 1,000,000 shares as Series B preferred stock, and 1,000,000 shares as Series C preferred stock, leaving 500,000 shares of undesignated preferred stock.

Series A Preferred Stock - As of June 30, 2013 and September 30, 2012, we had no shares of Series A preferred stock issued and outstanding

Series B Preferred Stock -  As of June 30, 2013 and September 30, 2012, we have 227,700 and 420,700 shares of Series B preferred stock respectively issued and outstanding.  In July 2011, we filed a Certificate of Designation with the Nevada Secretary of State, to set forth the rights, preferences and privileges of the Series B preferred stock (“Series B”).   Holders of Series B have no redemption rights and each share of Series B is entitled to interest at a simple interest rate of 6% per annum. Series B is convertible, at the discretion of our management, into shares of our common stock, except that the holders of the Series B may elect to convert the Series B into common stock upon or after the resignation or termination of our Chief Executive Officer. The number of shares of common stock issuable upon conversion is calculated by (i) multiplying the number of Series B being converted by the per share purchase price received by the Company for such Series B , and then, multiplying such number by 130% and then dividing this calculated value by the average closing bid price, as defined, or by (ii) first, allocating the Series B proportionately according to the amounts by date of individual cash tranches received by the Company then, second, multiplying the number of Series B being converted, identified by tranche, by the per share purchase price received by the Company for such Series B, and then, multiplying such number or numbers by 130% and, finally, dividing the calculated value(s) by the average closing bid price, as defined. The holders of the Series B are entitled to vote with the holders of our common stock with the number of votes equal to the number of common shares available by conversion to the holders of the Series B. We have the right to redeem the Series B in cash at the face amount plus any accrued, but unpaid dividends.

In June 2013, the company exercised its right to convert 193,000 shares of Series B preferred stock, together with $6,379 of accrued dividends, into 45,795,900 shares of common stock.

Series C Preferred Stock -  In November 2012, we converted 6,571 shares of Series C preferred stock into 6,571,000 shares of common stock.  As a result, we have no shares of Series C preferred stock issued and outstanding at June 30, 2013.

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Common Stock - We are authorized to issue up to 1.8 billion shares of $0.001 par value common stock. Holders of our common stock are entitled to one vote for each share held of record on all matters submitted to a vote of the holders of our common stock. Subject to the rights of the holders of any class of our capital stock having any preference or priority over our common stock, the holders of shares of our common stock are entitled to receive dividends that are declared by our board of directors out of legally available funds. In the event of our liquidation, dissolution or winding up, the holders of our common stock are entitled to share ratably in our net assets remaining after payment of liabilities, subject to prior rights of preferred stock, if any, then outstanding. Our common stock has no preemptive rights, conversion rights, redemption rights, or sinking fund provisions, and there are no dividends in arrears or in default. All shares of our common stock have equal distribution, liquidation and voting rights and have no preferences or exchange rights.

Common Stock and Warrants issued for services – We entered into an agreement with Agoracom Investor Relations Corp where we in December 2012 issued 3,178,000 shares of our common stock valued at $37,500. In addition, we issued warrants to purchase 1,580,000 shares of common stock at a price of $0.0095 and valued at $14,483 which are exercisable after 180 days. We recorded $51,983 to Prepaid Expense on issuance of which all has been amortized as general and administrative expense during the nine months ended June 30, 2013 in our condensed consolidated statements of operations.

We entered into a three month agreement with Hart Partners, LLC where we in March 2013 issued 800,000 shares of common stock valued at $8,000. June 30, 2013, the $8,000 has been fully amortized to general and administrative expense.

In March 2013, we issued 333,333 warrants to purchase common stock at the exercise price of $.0106 to SMZ Research valued at $3,288. We recorded this to general and administrative expense in our condensed consolidated statements of operations.

Common Stock issued for settlement of vendor balance – In March 2013 we issued 1,813,819 shares of our common stock valued at $20,000 as a final payment to StoryCorp Consulting of which we recorded $4,000 to general and administrative expense and $16,000 against the balance due the vendor recorded in accounts payable.

Common Stock and Warrants issued for cash – In March 2013 the company sold 32,608,696 restricted common shares and a  3-year warrant to purchase 3,896,104 restricted common shares at the exercise price of $0.015 per share to PSN Components, LLC (“PSN”) for the purchase price of $150,000 pursuant to the terms of a Securities Purchase Agreement. As part of the transaction, the Company granted the Investor observer status privileges at all Board of Director meetings provided Investor retains beneficial ownership of at least 80% of the equity securities purchased. In addition and also as part of the transaction, the Company signed a manufacturing rights agreement with the Investor pursuant to the principal terms of which: the Investor will have the right of first offer and the right of first refusal to manufacture, on a high-volume program basis, the Company’s products at the most cost effective price, and; the right, in the event of a joint venture manufacturing effort, to invest up to 51% of any required equity funding for any such joint venture. As of June 30, 2013, we are still negotiating the terms and conditions that shall govern the observer status privileges at Board of Director meetings and the manufacturing rights agreement.

In May 2013 the company sold 4,347,826 shares of restricted common stock and a 3-year warrant to purchase 519,480 shares of common stock at the exercise price of $0.0154 per share to Millennium Trust Company for the purchase price of $20,000 pursuant to the terms of a Securities Purchase Agreement.

In May 2013 the company sold 5,434,783 shares of restricted common stock and a 3-year warrant to purchase 649,351 shares of common stock at the exercise price of $0.0154 per share to an employee for the purchase price of $25,000 pursuant to the terms of a Securities Purchase Agreement.

Long Term Incentive Compensation Plan – Our Long Term Incentive Compensation Plan (“the Plan") was adopted in 2006 and amended in 2009. The Plan is administered by our Board of Directors. Our Board of Directors has amended the Stock Incentive Plan to increase the aggregate number of shares available for issuance under the plan to 25,000,000 shares conditional upon approval by our shareholders. We have granted stock options under the plan to employees, members of our Board of Directors, and advisors and consultants. No options have been exercised. Options are exercisable for ten years from date of grant. As of June 30, 2013, there are 21,282,543 options outstanding under this plan, all of which are exercisable.

Stock-based compensation expense related to these options was approximately $11,000 and $56,000 during the three and nine months ended June 30, 2012, respectively, substantially all of which was recognized as general administrative expense. There was no stock-based compensation expense related to these options in 2013 and as of June 30, 2013, there is no unrecognized compensation cost related to these options.

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Director, Officer, and Employee Sales Incentive Plan – As of June 30, 2013, and September 30, 2012, we have 219,200,000 and 225,200,000 sales incentive options issued respectively. These options expire in 2022, are performance based, and vest upon the attainment of certain sales targets.

The vesting of these options is conditional on certain sales targets being met. As of June 30, 2013, the minimum revenue target of $100,000 was met, and the company recorded $16,863 substantially all of which was recognized as general and administrative expense and there is $1,780,164 of unrecognized compensation cost for these options.

The following table summarizes stock option activity for the nine months ended June 30, 2013:

As of June 30, 2013, the aggregate intrinsic value of options outstanding, representing the excess of the closing market price of our common stock over the exercise price, is nil.

Warrants – At June 30, 2013, there were warrants outstanding for the purchase of 353,724,802 shares of our common stock at a weighted average exercise price of $0.015 per share. During the nine months ended June 30, 2013, we issued warrants to purchase a total of 6,978,268, shares of common stock at a weighted average exercise price of $0.014 per share. The fair value of the warrants was calculated using the Black-Scholes-Merton model. Warrants outstanding at June 30, 2013 expire at various dates from August 2014 to December 2018. A summary of warrant activity during the nine months ended June 30, 2013 follows:

Employee Stock Purchase Plan - In 2008, we adopted an Employee Stock Purchase Plan, under which the number of shares of common stock that may be sold shall not exceed 900,000 shares. No shares have been purchased under this plan.

Note 7. Commitments and Contingencies

Lease - Our corporate offices and laboratory facilities are leased under a lease agreement amended in November 2011.  Under the terms of the lease amendment, the term of the lease continues through October 31, 2013 at a monthly rent of $9,500, plus expenses.

2011 Contested Loan Write-Offs - As described in the notes to our consolidated financial statements for the year ended September 30, 2012 in our annual report on Form 10-K, during fiscal 2011 we wrote off certain contested notes payable to CAMHZN Master LDC, Agile Opportunity Fund (“Agile”), and Capitoline Advisors, Inc. (“Capitoline”) in an aggregate amount of approximately $1.6 million. In addition, during fiscal 2011, we rescinded 2,422,979 shares of our common stock previously issuable to Agile and Capitoline.  We wrote off the balance of these notes and shares after concluding that the total amount of our equity payments made on each of these notes represented payments in excess of the loan principal plus the maximum interest allowed under the applicable laws of the state of New York, the state by which the notes were governed.  These lenders dispute our conclusions and continue to allege that we are in default of our obligations. Although we believe that we have paid our obligations on the notes to the maximum amount permitted or required under applicable law, it is reasonably possible that one or more of these lenders may bring legal action against us and there are no assurances whether we would prevail in any such action.

Disputes With Various Vendors and Lenders - Certain of our vendors and lenders have brought suits and/or obtained judgments in their favor regarding past due balances owed them by us. We have recorded these past due balances in liabilities in our condensed consolidated balance sheets at June 30, 2013, and September 30, 2012.

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Note 8. Related Party Transactions

Note 9. Subsequent Events

In July 2013, we issued to a lender 3,250,000 shares of common stock for a note obligation in the amount of $5,000 together with $1,500 of interest in satisfaction of the remainder of a convertible note.

In July 2013 the company sold 10,395,010 shares of restricted common stock and a 3-year warrant to purchase 324,675 shares of common stock at the exercise price of $0.0154 per share to Mr. Jeffrey B. Sakaguchi, Chairman of our Board of Directors, for the purchase price of $25,000 pursuant to the terms of a Securities Purchase Agreement.

In July 2013 the company sold 49,064,449 shares of restricted common stock and a 3-year warrant to purchase 1,532,468 shares of common stock at the exercise price of $0.0154 per share to an investor for the purchase price of $118,000 pursuant to the terms of a Securities Purchase Agreement.

In July 2013 the company entered into a Trade Debt Settlement Agreement and Promissory Note with Summit Trading Ltd for $100,000 for Marketing and Investor Relations services paid on behalf of the company. The Note is unsecured and interest bearing at 8% per annum with a maturity date of July 1, 2014.

In August 2013, the Board of Directors reorganized and consolidated the Company’s five outstanding employee/director compensation plans into the surviving Long Term Incentive Compensation Plan. The Board terminated the Employee Stock Purchase Plan adopted in 2008 (no awards/purchases made; 900,000 common share pool), the 2010 Retention Bonus Plan and the 2012 Retention Bonus Plan , with the proviso that the  nine (9 ) cash award grants, representing a maximum aggregate $193,600 potentially payable under the grants issued under the retention bonus plans shall survive the plan terminations. The payment of the cash awards issued under the bonus retention plans is subject in all cases to a “best efforts” condition  in favor of  the Company and ,therefore, are not accrued as liabilities in our financial statements; conjunctively, and in order to eliminate the complicated accounting issues resulting from their revenue-based vesting schedules, the Board also terminated the Sales Incentive Plan (8 awards- 300,000,000 common share pool) and the 8 recipients of stock option grants thereunder agreed to accept new stock option grants to be issued under the surviving Long Term Incentive Compensation Plan in exchange for their outstanding grants under the terminated Sales Incentive Plan. Accordingly, and  by virtue of an amendment to the Long Term Incentive Compensation Plan, the Board consolidated its 25,000,000 share pool with the 300,000,000 common share pool from the terminated Sales Incentive Plan. The 8 new stock option grants, representing an aggregate 213,200,000 underlying shares, issued to the recipients in exchange for the termination of their grants in the same aggregate share amount under the terminated Sales Incentive Plan, all have vesting schedules that provide for the vesting of 25% of each grant upon receipt, followed by 25% grant vesting over the next three successive six month intervals, all with exercise prices of $.00354 per share. This plan consolidation maintained the available common share pool previously spread over all of the terminated plans and did not result in any increase in the number of common shares previously dedicated to these plan reserves.

In August 2013, the company signed a 6% Convertible Redeemable Secured Note with GEL Properties, LLC for $38,500. The note is convertible at a price equal to 65% of the lowest closing bid price of the Common Stock as reported on the National Quotations Bureau OTCQB exchange for any of the five trading days including the day upon which a Notice of Conversion is received by the Company. The funds will be used to reduce the company’s obligation to the landlord. The Company and the landlord have agreed that the remaining balance of the obligation will be resolved in 45 days.

In August 2013, we issued to a lender 7,500,000 shares of common stock for a note obligation in the amount of $15,000 in partial satisfaction of a convertible note.

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ITEM 2.