Annual Report (10-k)

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

T	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended May 31, 2013

£	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 0-22182

PATRIOT SCIENTIFIC CORPORATION

(Exact name of registrant as specified in its charter)

Delaware

(State or other jurisdiction of incorporation or organization)

84-1070278

(I.R.S. Employer Identification No.)

701 Palomar Airport Road, Suite 170, Carlsbad, California

(Address of principal executive offices)

92011

(Zip Code)

(Registrant’s telephone number, including area code): (760) 547-2700

Securities registered pursuant to Section 12(b) of the Act: NONE

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.00001 par value

___________________

(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES £ NO T

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES £ NO T

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 T NO £

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 229.405 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 T NO £

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. £

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. (Check one):

Large accelerated filer £

Accelerated filer £

Non-accelerated filer £ (do not check if smaller reporting company)

Smaller reporting company T

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES £ NO T

Approximate aggregate market value of the registrant’s common stock held by non-affiliates on November 30, 2012 was $48,453,498 based on a closing price of $0.12 as reported on the OTC Electronic Bulletin Board system. F or purposes of this calculation, it has been assumed that all shares of the registrant's common stock held by directors, executive officers and shareholders beneficially owning five percent or more of the registrant's common stock are held by affiliates. The treatment of these persons as affiliates for purposes of this calculation is not conclusive as to whether such persons are, in fact, affiliates of the registrant.

On August 16, 2013, 405,247,405 shares of common stock, par value $0.00001 per share were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

None

Table of Contents

PART I			4

	ITEM 1.	Business	4
	ITEM 1A.	Risk Factors	7
	ITEM 1B.	Unresolved Staff Comments	10
	ITEM 2.	Properties	10
	ITEM 3.	Legal Proceedings	10
	ITEM 4.	Mine Safety Disclosures	11

PART II			11

	ITEM 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	11
	ITEM 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12
	ITEM 8.	Financial Statements and Supplementary Data	19
	ITEM 9.	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure	19
	ITEM 9A.	Controls and Procedures	19
	ITEM 9B.	Other Information	20

PART III			20

	ITEM 10.	Directors, Executive Officers and Corporate Governance	20
	ITEM 11.	Executive Compensation	23
	ITEM 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	25
	ITEM 13.	Certain Relationships and Related Transactions, and Director Independence	26
	ITEM 14.	Principal Accountant Fees and Services	26

PART IV			27

	ITEM 15.	EXHIBITS, AND FINANCIAL STATEMENT SCHEDULES	27

SIGNATURES

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K, including all documents incorporated by reference herein, includes certain statements constituting “forward-looking” statements within the meaning of Section 27A of the Securities Act, Section 21E of the Exchange Act and the Private Securities Litigation Reform Act of 1995, including statements concerning our beliefs, plans, objectives, goals, expectations, anticipations, estimates, intentions, operations, future results and prospects, and we rely on the “safe harbor” provisions in those laws. We are including this statement for the express purpose of availing ourselves of the protections of such safe harbors with respect to all such forward-looking statements. The forward-looking statements in this report reflect our current views with respect to future events and financial performance. In this report, the words “anticipates,” “believes,” “expects,” “intends,” “future,” “estimates,” “may,” “could,” “should,” “would,” “will,” “shall,” “propose,” “continue,” “predict,” “plan” and similar expressions are generally intended to identify certain of the forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date made. Any forward-looking statement is not a guarantee of future performance.

These forward-looking statements are subject to certain risks and uncertainties, and actual results may differ materially from those in the forward-looking statements as a result of various factors, including, but not limited to those items shown under “Item 1A. Risk Factors.” You should read this report completely with the understanding that our actual results may differ materially from what we expect. Unless required by law, we undertake no obligation to publicly release the result of any revision of these forward-looking statements to reflect events or circumstances after the date they are made or to reflect the occurrence of unanticipated events.

PART I

ITEM 1.

BUSINESS

The Company

Patriot Scientific Corporation (the “Company”, “PTSC”, “we”, “us”, or “our”) is an intellectual-property licensing company with several patents (described below) covering the design of microprocessor chips. Chips with our patented technology are used throughout the world in products ranging from computers and cameras to printers, automobiles and industrial devices. Through our joint venture, Phoenix Digital Solutions, LLC (“PDS”) we pursue the commercialization of our patented microprocessor technologies through broad and open licensing and by litigating against those who may be infringing on our patents.

Our business address is 701 Palomar Airport Road, Suite 170, Carlsbad, California 92011; our main telephone number is (760) 547-2700. Our internet website page is located at http://www.ptsc.com. All of our reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are available free of charge on our internet website. The information on, or that can be accessed through, our website is not part of this Annual Report.

PTSC is a corporation organized under Delaware law on March 24, 1992, and is the successor by merger to Patriot Financial Corporation, a Colorado corporation, incorporated on June 10, 1987. In June 2005, we entered into a joint venture agreement with Technology Properties Limited, Inc. (“TPL”) to form PDS. In September 2008, we acquired Patriot Data Solutions Group, Inc. formerly known as Crossflo Systems, Inc. (“PDSG”) which engaged in data-sharing services and products primarily in the public safety/government sector. During April 2012, we sold substantially all of the assets of PDSG.

PDSG was a segment of our business prior to the quarter ended February 29, 2012 and it is now classified as discontinued operations in our consolidated financial statements.

Our Technology

The global semiconductor (or silicon “chip”) market has many segments and categories. The best-known - and most profitable - of these is the microprocessor segment. Microprocessor chips are the “brains” of most electronic and electrical devices throughout the world. Although microprocessors are often closely associated with personal computers (“PCs”), PCs account for only a small fraction of the microprocessor chips made and sold every year. The vast majority of microprocessors are used in everyday items like automobiles, digital cameras, cell phones, video game players, data networks, industrial flow-control valves, sensors, medical devices, weapons, home appliances, robots, security systems, televisions, and much more. These “embedded microprocessors” (so called because they’re embedded into another product) are far more ubiquitous than the chips inside personal computers. This is the market that our technology serves.

Some highlights of the patent portfolio are:

●

US 5,809,336 (the “’336 patent”). The ’336 patent covers an early and seminal approach to making microprocessor chips go faster. It allows the “core” of the microprocessor to run at a different speed (usually faster) than the rest of the chip. There are many advantages to this, including higher performance, lower power consumption, and simpler manufacturing.

	●	US 5,784,584 (the “’584 patent”). The ’584 patent covers an important method for a microprocessor chip to fetch multiple instructions at once. Like speed reading, multiple-instruction fetch allows a chip to get more done in less time - a valuable technique.

Our Partners and Affiliates

Phoenix Digital Solutions, LLC . On June 7, 2005, we entered into a Master Agreement (the “Master Agreement”) with TPL, and Charles H. Moore, an individual (“Moore”). We, TPL and Moore were parties to certain lawsuits filed by us alleging infringement (the “Infringement Litigation”) of seven U.S. patents issued dating back to 1989 on our microprocessor technology (the “Microprocessor Patents”) and a lawsuit also filed by us alleging claims for declaratory judgment for determination and correction of inventorship of the Microprocessor Patents (the “Inventorship Litigation”). The transactions described in the Master Agreement and related agreements (the “Transactions”) included the settlement or dismissal of the Inventorship Litigation.

Pursuant to the Master Agreement we agreed with TPL and Moore as follows:

●

We entered into a patent license agreement (the “Intel License”) with Intel Corporation (“Intel”) pursuant to which we licensed certain rights in the Microprocessor Patents to Intel.

●

We caused certain of our respective interests in the Microprocessor Patents to be licensed to PDS, a limited liability company owned 50% by us and 50% by TPL.

●

PDS engaged TPL to commercialize the Microprocessor Patents pursuant to a Commercialization Agreement among PDS, TPL and us (the “Commercialization Agreement”).

●

We paid $1,327,651 and TPL paid $1,000,000 to certain holders of rights in the Microprocessor Patents (“Rights Holders”) in exchange for the release of such Rights Holders in connection with the Transactions.

●

We agreed with TPL and Moore to settle or cause to be dismissed all litigation involving the Microprocessor Patents, pursuant to a stipulated final judgment, including the Inventorship Litigation.

●

We issued warrants to TPL which were exercised by TPL in September 2007, to acquire shares of our common stock, $0.00001 par value (“Common Stock”). 1,400,000 warrants were exercisable upon issue; 700,000 warrants became exercisable when our Common Stock traded at $0.50 per share; an additional 700,000 warrants became exercisable when our Common Stock traded at $0.75 per share; and an additional 700,000 warrants became exercisable when our Common Stock traded at $1.00 per share, all such vesting having been achieved as of the date of this filing.

●

We agreed with TPL and Moore to indemnify each other for, among other things, any inaccuracy or misrepresentation in any representation or warranty contained in the Master Agreement, any breach of the Master Agreement, certain liabilities relating to the respective interests of each of us in the Microprocessor Patents and the Transactions, and certain tax liabilities.

Pursuant to the Commercialization Agreement, PDS granted to TPL the exclusive right to grant licenses and sub-licenses of the Microprocessor Patents and to pursue claims against violators of the Microprocessor Patents, in each case, on behalf of PDS, us, TPL and Moore, and TPL agreed to use reasonable best efforts to commercialize the Microprocessor Patents in accordance with a mutually agreed business plan. Pursuant to the Commercialization Agreement, PDS agreed to a reimbursement policy with regard to TPL’s expenses incurred in connection with the commercialization of the Microprocessor Patents. All proceeds generated by TPL in connection with the commercialization of the Microprocessor Patents were paid directly to PDS. From the inception of the Commercialization Agreement to May 31, 2013, gross license revenues to PDS totaled $301,522,535.

Pursuant to the Master Agreement, we and TPL entered into the Limited Liability Company Operating Agreement of PDS (“LLC Agreement”). We and TPL each own 50% of the membership interests of PDS, and each have the right to appoint one member of the not to exceed three (3) member management committee. The two (2) current appointees are required to select a mutually acceptable third member of the management committee. There has not been a third management committee member since May 2010. Pursuant to the LLC Agreement, we and TPL must each contribute to the working capital of PDS and at the discretion of PDS’ management committee we may be obligated to make future contributions in equal amounts in order to maintain a working capital fund. The LLC Agreement provides that PDS shall indemnify its members, managers, officers and employees, to the fullest extent permitted by applicable law, for any liabilities incurred as a result of their involvement with PDS, if the person seeking indemnification acted in good faith and in a manner reasonably believed to be in the best interest of PDS.

On July 11, 2012, we entered into a Licensing Program Services Agreement (the “Program Agreement”) with PDS, TPL, and Alliacense Limited, LLC (“Alliacense”, an affiliate of TPL) creating an amendment to the Commercialization Agreement, and an Agreement (the “TPL Agreement”) with TPL. Pursuant to the Program Agreement, PDS engaged Alliacense to negotiate Moore Microprocessor Patent (“MMP”) portfolio licenses and to pursue claims against violators of the MMP portfolio on behalf of PDS, TPL, and the Company. The Program Agreement continues through the useful life of the MMP portfolio patents. Pursuant to the TPL Agreement, we and TPL agreed to certain allocations of obligations in connection with the engagement of Alliacense.

On July 17, 2012, we entered into an Agreement with PDS, TPL, and Alliacense whereby we agreed to certain additional allocations of obligations relating to the Program Agreement.

The July 2012 agreements paved the way for an aggressive litigation strategy subsequently initiated on July 24, 2012 whereby we, TPL, and PDS filed parallel actions with the U.S. International Trade Commission (“ITC”) and in U.S. District Court against multiple companies alleged to be infringers of the MMP portfolio. We believe that the significant investment in legal effort and costs incurred to date at PDS, in addition to this expanded litigation strategy, is necessary for the protection of our interests in the MMP portfolio and its future success.

Licenses, Patents, Trade Secrets and Other Proprietary Rights

We rely on a combination of patents, copyright and trademark laws, trade secrets, software security measures, license agreements and nondisclosure agreements to protect our proprietary technologies. Our policy is to seek the issuance of patents that we consider important to our business to protect inventions and technology that support our microprocessor technology.

As of the date of this filing, we have four unexpired U.S. patents issued dating back to 1997 on our microprocessor technology. These patents will expire between 2014 and 2015. We also have three European and two Japanese patents all expiring in 2016. We also have three U.S. patents, six European, and one Japanese patent all of which expired between August 2009 and June 2013. These patents, while expired, may have certain retrospective statutory benefits that will fully diminish six years after the patent expiration date (e.g. for the expired U.S. patents).

In addition to such factors as innovation, technological expertise and experienced personnel, we believe that a strong patent position is important to compete effectively in the semiconductor industry. It may become necessary or desirable in the future for us to obtain patent and technology licenses from other companies relating to technology that may be employed in future products or processes. To date, we have not received notices of claimed infringement of patents based on our existing processes or products but, due to the nature of the industry, we may receive such claims in the future.

There can be no assurance that any patents will be issued from future applications or that any patents that are issued will provide meaningful protection or other commercial advantages to us. Although we intend to protect our rights vigorously, there can be no assurance that these measures will be successful.

We generally require all of our employees and consultants, including our management, to sign a non-disclosure and invention assignment agreement upon employment with us.

Products and Services

On April 30, 2012 substantially all of the assets of PDSG were sold in exchange for a royalty on PDSG revenues for a period of three years. Accordingly, our investment in the MMP portfolio represents virtually all of our business interests at this time.

Employees

At May 31, 2013, we have three employees. All employees are full time. We also engage consultants and part-time persons, as needed.

Our future success depends in significant part upon the continued services of our key personnel. The competition for highly qualified personnel is intense, and there can be no assurance that we will be able to retain key employees. None of our employees are represented by a labor union, and we consider our relations with our employees to be good. None of our employees are covered by key man life insurance policies.

Available Information

We file annual, quarterly and special reports, proxy statements and other information with the Securities and Exchange Commission (“SEC”). Materials filed with the SEC can be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549, on official business days during the hours of 10 a.m. to 3 p.m. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet web site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. Our filings are available to the public at the website maintained by the SEC, http://www.sec.gov. We also make available, free of charge, through our web site at www.ptsc.com, our reports on Forms 10-K, 10-Q, and 8-K, and amendments to those reports, as soon as reasonably practicable after they are filed with or furnished to the SEC. The information on, or that can be accessed through, our website is not part of this Annual Report.

ITEM 1A.

RISK FACTORS

We urge you to carefully consider the following discussion of risks as well as other information contained in this Form 10-K. We believe the following to be our most significant risk factors as of the date this report is being filed. The risks and uncertainties described below are not the only ones we face.

We May Be Required To Fund Our Joint Venture’s Legal Costs.

On March 20, 2013 TPL filed a petition under Chapter 11 of the United States Bankruptcy Code. While TPL’s petition does not at present affect the licensing agreement between PDS and Alliacense, PDS has incurred increased third-party legal costs as the litigation with HTC Corporation, and Acer, Inc., in the U.S. District Court, and the actions with the ITC Investigation No. 337-TA-853 progress. If PDS does not receive sufficient licensing revenues to pay these expenses, we may be required to pay these expenses. In the event the cost of the U.S. District Court and ITC Investigation actions exceeds our ability to fund these efforts, our options for additional sources of financing may be limited.

We Have Reported Licensing Income In Prior Fiscal Years Which May Not Be Indicative Of Our Future Income.

We have entered into license agreements through our joint venture with TPL and have reported income from the joint venture for the fiscal years 2006 to 2011 and 2013. Because of the uncertain nature of the negotiations that lead to license revenues, pending litigation with companies which we allege have infringed on our patent portfolio, the possibility of legislative action regarding patent rights, and the possible effect of new judicial interpretations of patent laws, we may not receive revenues from such agreements in the future consistent with amounts received in the past, and we may not receive future revenues from license agreements at all.

We Are Dependent Upon A Joint Venture In Which Our Role Is Of A Passive Nature For Substantially All Of Our Income.

In June 2005, we entered into a joint venture with TPL, which as a result of agreements entered into in June 2005 and July 2012, TPL and its affiliate Alliacense are responsible for the licensing and enforcement of our microprocessor patent portfolio. This joint venture has been the source of substantially all of our income since June 2005. Therefore, in light of the absence of significant revenue from other sources, we should be regarded as entirely dependent on the success or failure of the licensing and prosecution efforts of TPL and Alliacense on behalf of the joint venture, and the ability of TPL and Alliacense to obtain capital when necessary to fund their operations.

Our Joint Venture Is At Risk For Going Concern And An Inability To Meet Certain Obligations.

PDS, our joint venture with TPL, which received a going concern opinion in its May 31, 2013, 2012 and 2011 financial statements, has experienced significant declines in revenues while at the same time incurring significant legal costs associated with pending litigation with companies which we allege have infringed on our patent portfolio. Terms of the July 2012 licensing agreement with Alliacense will require TPL and us to fund PDS in the event PDS does not generate enough licensing revenue to cover the licensing and litigation support fees of Alliacense.

PDS’ licensing revenues have declined over recent years to a point where PDS’ ability to make future payments is in substantial doubt unless licensing revenues substantially increase in the near term. In the event that PDS does not have the funds to pay one or more of the aforementioned costs we and TPL must decide whether to contribute additional capital to PDS to fund such payments and due to TPL’s bankruptcy filing, we may be required to pay these expenses.

Our Microprocessor Patents Are In The Process Of Expiring.

We have four unexpired U.S. patents, two of which will expire in 2014 and two of which will expire in 2015, and three European and two Japanese patents expiring in 2016. We also have three U.S. patents, six European, and one Japanese patent all of which expired between August 2009 and June 2013. While expired patents may have certain retrospective statutory benefits, their value as assets for licensing and cash generation is significantly diminished.

A Successful Challenge To Our Intellectual Property Rights Could Have A Significant And Adverse Effect On Us.

A successful challenge to our ownership of our technology or the proprietary nature of our intellectual property could materially damage our business prospects. We rely on a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures and licensing arrangements to protect our intellectual property rights. With respect to our core technologies, we currently have four unexpired U.S., three European and two Japanese patents issued. Any issued patent may be challenged and invalidated. Any claims allowed from existing patents may not be of sufficient scope or strength to provide significant protection. Our competitors may also be able to design around our patents.

Vigorous protection and pursuit of intellectual property rights or positions characterize the fiercely competitive semiconductor industry, which has resulted in significant and often protracted and expensive litigation. Therefore, our competitors and others may assert that our technologies infringe on their patents or proprietary rights. Persons we believe are infringing our patents are likely to vigorously defend their actions and assert that our patents are invalid. Problems with patents or other rights could result in significant costs, and limit future license revenue. If infringement claims against us are deemed valid or if our infringement claims are successfully opposed, we may not be able to obtain appropriate licenses on acceptable terms or at all. Litigation could be costly and time-consuming but may be necessary to protect our future patent and/or technology license positions or to defend against infringement claims. From time to time parties have petitioned the USPTO to re-examine certain of our patents. An adverse decision in litigation or in the re-examination process could have a very significant and adverse effect on our business.

We are party to multiple lawsuits regarding the MMP Portfolio. See footnote 9 to our consolidated financial statements and Part I, Item 3. “Legal Proceedings” in this Report on Form 10-K for more information.

In the event that one or more of these lawsuits regarding the MMP Portfolio are not resolved in our favor, such outcome (or lack of an outcome) could significantly weaken the MMP Portfolio which would have a negative affect on PDS' ability to generate future license revenues and, therefore, adversely affect PDS' and our cash flows.

We Are Dependent On A Single Law Firm To Defend And Enforce Our Intellectual Property Rights.

A single law firm has been engaged to defend and enforce our intellectual property rights. Any significant interruption in their services, or the loss of their services for any reason, would have a material adverse effect on our ability to defend and prosecute such lawsuits and, therefore, have a material adverse effect on our business, financial condition and result of operations. The law firm’s services could be disrupted for a variety of reasons, and any disruption would have a material adverse effect on our business. Our inability to engage the services of a new law firm in a timely manner could have a substantial negative effect on our business.

A Change In Our Relationship With PDS Could Change The Way We Account For Our Interest In The Future.

For our investment in PDS accounted for under the equity method, we record as part of other income or expense our share of the increase or decrease in the equity of this company in which we have invested. It is possible that, in the future, our relationships and/or our interests in or with this equity method investee could change. Such potential future changes could result in consolidation of such entity which could result in changes in our reported results.

We May Issue Preferred Stock, And The Terms Of Such Preferred Stock May Reduce The Value Of Our Common Stock.

We are authorized to issue up to a total of 5,000,000 shares of preferred stock in one or more series. Our Board of Directors may determine whether to issue shares of preferred stock without further action by holders of our Common Stock. If we issue shares of preferred stock, it could affect the rights or reduce the value of our Common Stock. In particular, specific rights granted to future holders of preferred stock could be used to restrict our ability to merge with or sell our assets to a third party. These terms may include voting rights, preferences as to dividends and liquidation, conversion and redemption rights, and sinking fund provisions. If we seek capital for our business, such capital may be raised through the issuance of preferred stock.

If A Large Number Of Our Shares Are Sold All At Once Or In Blocks, The Market Price Of Our Shares Would Most Likely Decline.

Most of our shareholders are not restricted in the price at which they can sell their shares. Shares sold at a price below the current market price at which our Common Stock is trading may cause the market price of our Common Stock to decline.

The Market For Our Stock Is Subject To Rules Relating To Low-Priced Stock (“Penny Stock”) Which May Limit Our Ability To Raise Capital.

Our Common Stock is currently listed for trading in the OTCQB operated by OTC Markets, Inc. and is subject to the “penny stock rules” adopted pursuant to Section 15(g) of the Exchange Act. In general, the penny stock rules apply to non-NASDAQ or non-national stock exchange companies whose common stock trades at less than $5.00 per share or which have tangible net worth of less than $5,000,000 ($2,000,000 if the company has been operating for three or more years). Such rules require, among other things, that brokers who trade “penny stock” on behalf of persons other than “established customers” complete certain documentation, make suitability inquiries of investors and provide investors with certain information concerning trading in the security, including a risk disclosure document, quote information, broker’s commission information and rights and remedies available to investors in penny stocks. Many brokers have decided not to trade “penny stock” because of the requirements of the penny stock rules, and as a result, the number of broker-dealers willing to act as market makers in such securities is limited. The “penny stock rules,” therefore, may have an adverse impact on the market for our Common Stock and may affect our ability to raise additional capital if we decide to do so.

Our Share Price Could Decline As A Result Of Short Sales.

When an investor sells stock that he does not own, it is known as a short sale. The seller, anticipating that the price of the stock will go down, intends to buy stock to cover his sale at a later date. If the price of the stock goes down, the seller will profit to the extent of the difference between the price at which he originally sold it less his later purchase price. Short sales enable the seller to profit in a down market. Short sales could place significant downward pressure on the price of our Common Stock. Penny stocks which do not trade on an exchange, such as our Common Stock, are particularly susceptible to short sales.

Our Future Success Depends In Significant Part Upon The Continued Services Of Key Personnel.

Our future success depends in significant part upon the continued services of our key personnel. The competition for highly qualified personnel is intense, and we may not be able to retain our key employees or attract and retain additional highly qualified personnel in the future. None of our employees are represented by a labor union, and we consider our relations with our employees to be good. None of our employees are covered by key man life insurance policies.

ITEM 1B.

UNRESOLVED STAFF COMMENTS

None.

ITEM 1B.

PROPERTIES

We currently lease 1,371 square feet of office space located at 701 Palomar Airport Road, Suite 170, Carlsbad, California. The lease expires January 31, 2014.

The current floor space provides adequate and suitable facilities for all of our corporate functions.

ITEM 3.

LEGAL PROCEEDINGS

Litigation

On February 8, 2008, we, TPL and Alliacense Ltd. were named as defendants in separate lawsuits filed in the United States District Court for the Northern District of California by HTC Corporation, and Acer, Inc., and affiliated entities of each of them. (Those cases are deemed related and are referred to herein as the “N.D. Cal. Case”). HTC and Acer seek declaratory relief that their products do not infringe enforceable claims of the '336 patent. We allege counterclaims for patent infringement of the '336 and '890 patents as to certain of their products.

The Court issued a first claim construction ruling in the N.D. Cal. Case on June 12, 2012, which preserved our ability to proceed on our infringement claims against Acer and HTC. Thereafter, Chief District Judge James Ware retired and the N.D. Cal. case was reassigned to Magistrate Judge Paul S. Grewal, who held a supplemental claim construction hearing on November 30, 2012. Judge Grewal then issued a supplemental claim construction ruling on December 5, 2012, which preserved our ability to proceed with our infringement claims. Judge Grewal considered a number of motions challenging our claims on August 13, 2013 but has not yet ruled on them. The N.D. Cal. case is set for a jury trial starting on September 23, 2013.

On July 24, 2012 complaints were filed on behalf of us, TPL, and PDS against Acer, Inc., Amazon.com, Inc., Barnes & Noble, Inc., Garmin, Ltd., HTC Corporation, Huawei Technologies Co., Ltd., Kyocera Corporation, LG Electronics, Nintendo C., Ltd., Novatel Wireless, Inc., Samsung Electronics Co., Ltd., Sierra Wireless, Ltd. and ZTE Corporation with the U.S. International Trade Commission ("ITC") (ITC Investigation No. 337-TA-853, or the “853 Investigation”) alleging infringement of the ‘336 patent. We also filed new parallel proceedings in the U.S. District Court for the Northern District of California alleging infringement of the ‘749, ‘890 and ‘336 patents against Amazon.com Inc., Barnes & Noble Inc., Garmin Ltd., Huawei Technologies Co. Ltd., Kyocera Corporation, LG Electronics, Nintendo Co. Ltd., Novatel Wireless Inc., Samsung Electronics Co. Ltd., Sierra Wireless Inc., and ZTE Corporation. We subsequently reached a settlement with Sierra Wireless, Inc. Trial proceedings before the ITC began on June 3, 2013 and concluded the following week. An initial determination is expected from the ITC by September 6, 2013. The target date in the ITC proceeding, in which the ITC could potentially issue an importation ban on infringing products, is January 6, 2014. All of the district court actions against the new parties (i.e., all respondents other than Acer and HTC) are currently stayed pending resolution of the 853 Investigation.

ITEM 4.

MINE SAFETY DISCLOSURES

Not applicable.

PART II

ITEM 5.

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our Common Stock is currently listed for trading in the OTCQB operated by OTC Markets, Inc. under the symbol PTSC. Prices reported represent prices between dealers, do not include markups, markdowns or commissions and do not necessarily represent actual transactions. The market for our shares has been sporadic and at times very limited.

The following table sets forth the high and low closing bid quotations for our Common Stock for the fiscal years ended May 31, 2013 and 2012.

	BID QUOTATIONS
	HIGH	LOW
Fiscal Year Ended May 31, 2013
First Quarter	$0.17	$0.08
Second Quarter	$0.12	$0.08
Third Quarter	$0.16	$0.11
Fourth Quarter	$0.15	$0.09

Fiscal Year Ended May 31, 2012
First Quarter	$0.09	$0.05
Second Quarter	$0.09	$0.04
Third Quarter	$0.20	$0.05
Fourth Quarter	$0.17	$0.09

On August 16, 2013 the closing price of our stock was $0.11 and we had approximately 679 stockholders of record. Because most of our Common Stock is held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of beneficial owners represented by these record holders.

Dividend Policy

On February 22, 2007, our Board of Directors adopted a semi-annual dividend payment policy, subject to determination by our Board of Directors in light of our financial condition, other possible applications of our available resources, and relevant business considerations. We paid no dividends during the fiscal years ended May 31, 2013 and 2012.

Equity Compensation Plan Information

Our stockholders previously approved our 2006 Stock Option Plan. The following table sets forth certain information concerning aggregate stock options authorized for issuance under our 2006 Stock Option Plan as of May 31, 2013. For a narrative description of the material features of the plan, refer to footnote 7 of our consolidated financial statements.

Plan Category

Number of securities
to be issued
upon exercise of outstanding
options

Weighted-average
exercise price of outstanding
options

Number of securities remaining available for future issuance under equity compensation plan

Equity compensation plan approved by security holders

750,000

0.10

9,175,000

At May 31, 2013, there are 9,175,000 shares available for future issuance under our 2006 stock option plan.

Recent Sale of Unregistered Securities

None.

Issuer Purchases of Equity Securities

On April 28, 2006 our Board of Directors authorized a stock repurchase program. We commenced the program in July 2006 and plan to repurchase outstanding shares of our Common Stock on the open market from time to time. We repurchased no Common Stock during the fourth quarter of fiscal year 2013.

The repurchase plan has no maximum number of shares and is solely at the discretion of the Board of Directors. The repurchase plan has no set expiration date.

ITEM 7.

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

THIS ANNUAL REPORT ON FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS CONCERNING FUTURE EVENTS AND PERFORMANCE OF OUR COMPANY. YOU SHOULD NOT RELY ON THESE FORWARD-LOOKING STATEMENTS, BECAUSE THEY ARE ONLY PREDICTIONS BASED ON OUR CURRENT EXPECTATIONS AND ASSUMPTIONS. MANY FACTORS COULD CAUSE OUR ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE INDICATED IN THESE FORWARD-LOOKING STATEMENTS. YOU SHOULD REVIEW CAREFULLY THE RISK FACTORS IDENTIFIED IN THIS REPORT AS SET FORTH BELOW AND UNDER THE CAPTION “RISK FACTORS.” WE DISCLAIM ANY INTENT TO UPDATE ANY FORWARD-LOOKING STATEMENTS TO REFLECT SUBSEQUENT ACTUAL EVENTS OR DEVELOPMENTS.

In June 2005, we entered into a series of agreements with TPL and others to facilitate the pursuit of unlicensed users of our intellectual property. In October 2011 we settled litigation with TPL that was initiated by us over matters related to the management of the MMP Portfolio. In July 2012 we entered into additional agreements with TPL, PDS and the TPL affiliate Alliacense in furtherance of the management and commercialization of the MMP Portfolio. The July 2012 agreements paved the way for an aggressive litigation strategy subsequently initiated on July 24, 2012 whereby Alliacense filed parallel actions with the ITC and in U.S. District Court against multiple companies alleged to be infringers of the MMP portfolio. We believe that the significant investment in legal effort and costs incurred to date at PDS, in addition to this expanded litigation strategy, is necessary for the protection of our interests in the MMP portfolio and its future success. We intend to continue our joint venture with TPL to pursue license agreements with unlicensed users of our technology. It has been our belief that continuing to work through TPL and its affiliate Alliacense, as compared to pursuing other alternatives, including creating and using our own licensing team for those activities, avoids a competitive devaluation of our principal assets and is a prudent way to achieve the desired results as we seek to obtain fair value from users of our intellectual property.

During fiscal 2012 and through the date of this filing, we and TPL each contributed $1,747,809 to fund the working capital of PDS. To the extent MMP portfolio license proceeds are insufficient, we expect working capital contributions to PDS to continue in the future. Cash shortfalls currently experienced by PDS will have an adverse effect on our liquidity. To date, we have determined that it is in the best interests of the MMP licensing program that we contribute our 50% share of additional capital to PDS to provide for PDS litigation support payments to Alliacense, in the event license revenues received by PDS are insufficient to meet these needs.

On August 16, 2013 PDS’ cash balance was $206,605. Management’s plans for the continued operation of PDS rely on the ability of Alliacense to obtain license agreements to cover the operational costs of PDS. Notwithstanding the November 30, 2012 and May 31, 2013 fiscal quarters, PDS has experienced a decline in licensing revenues and has experienced significant legal costs due to the patent litigation actions currently in progress. As the litigation with HTC Corporation, and Acer, Inc., in the U.S. District Court, and the actions with the ITC Investigation No. 337-TA-853 progress, PDS is incurring significant third-party costs for expert testimony, depositions and other related legal costs. We will be required to make capital contributions to PDS for these costs in the event that PDS does not receive sufficient licensing revenues to pay these expenses.

On March 20, 2013, TPL filed a petition under Chapter 11 of the United States Bankruptcy Code. We have been appointed to the creditors’ committee and will be closely monitoring the progress in this matter as it relates to our interest in PDS. If we provide funding to PDS that is not reciprocated by TPL, our ownership percentage in PDS will increase and we will have a controlling financial interest in PDS, in which case, we will consolidate PDS in our consolidated financial statements. If we determine that it is appropriate to consolidate PDS, we would measure the assets, liabilities and noncontrolling interests of PDS at their fair values at the date that we have the controlling financial interest.

On April 30, 2012, substantially all of the assets of PDSG were sold. The results of PDSG, which were previously reported as a separate business segment, are being presented as discontinued operations in the consolidated statements of operations for all periods presented.

Discontinued Operations and Assets Held for Sale

On February 17, 2012 our board of directors authorized management to sell the assets of PDSG due to the inability of PDSG to meet its business plan and continuing projected negative cash flows. In accordance with authoritative guidance we have classified the assets, liabilities, operations and cash flows of PDSG as discontinued operations for all periods presented. During March 2012, we entered into an interim agreement with the purchaser of the assets of PDSG which required the purchaser to pay PDSG $93,450 to subsidize the April 2012 expenses of PDSG during the sale transaction negotiations. On April 30, 2012, we negotiated a sale transaction in which we sold substantially all of the assets of PDSG in exchange for a royalty on PDSG revenues for a period of three years. From April 30, 2012 to May 31, 2013, the gain on the asset sale of PDSG is approximately $4,000.

Summarized operating results of discontinued operations for the fiscal years ended May 31, 2013 and 2012 are as follows:

	May 31, 2013			May 31, 2012
Revenues	$	–		$	179,871
Gross profit	$	–		$	132,277
Operating loss from discontinued operations	$	(3,224	)	$	(1,446,690	)
Other income from discontinued operations	$	–		$	93,959
Gain (loss) on sale of discontinued operations	$	15,376		$	(10,988	)
Income (loss) before income taxes	$	12,152		$	(1,363,719	)
Income (loss) from discontinued operations	$	12,152		$	(1,363,719	)

PDSG activity for the fiscal year ended May 31, 2013 consists of operating expenses for: legal, insurance, taxes and bank fees offset by PDSG royalty revenues.

The following table summarizes the carrying amount of the major classes of assets and liabilities of PDSG classified as discontinued operations at May 31, 2013 and May 31, 2012:

	May 31, 2013		May 31, 2012
Current assets:
Other current assets	$	40,682	$	7,273
	$	40,682	$	7,273
Long-lived assets:
Other receivable	$	–	$	42,000
	$	–	$	42,000

Critical Accounting Policies and Estimates

Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, which require us to make estimates and judgments that significantly affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Actual results could differ from those estimates, and such differences could affect the results of operations reported in future periods. We believe the following critical accounting policies affect our most significant estimates and judgments used in the preparation of our consolidated financial statements.

Investments in Marketable Securities

We determine the appropriate classification of our investments at the time of purchase and reevaluate such designation at each balance sheet date. Our investments in marketable securities have been classified and accounted for as available-for-sale based on management’s investment intentions relating to these securities. Available-for-sale marketable securities are stated at fair market value. Unrealized gains and losses, net of deferred taxes, are recorded as a component of other comprehensive income (loss). We follow the authoritative guidance to assess whether our investments with unrealized loss positions are other than temporarily impaired. Realized gains and losses and declines in fair value judged to be other than temporary are determined based on the specific identification method and are reported in other income (expense), net in the condensed consolidated statements of operations.

Investment in Affiliated Company

We have a 50% interest in PDS. We account for our investment using the equity method of accounting since the investment provides us the ability to exercise significant influence, but not control, over the investee. Significant influence is generally deemed to exist if we have an ownership interest in the voting stock of the investee of between 20% and 50%, although other factors, such as representation on the investee’s Board of Directors, are considered in determining whether the equity method of accounting is appropriate. Under the equity method of accounting, the investment, originally recorded at cost, is adjusted to recognize our share of net earnings or losses of the investee and is recognized in the consolidated statements of operations in the caption “Equity in earnings (loss) of affiliated company” and also is adjusted by contributions to and distributions from PDS.

PDS, as an unconsolidated equity investee, recognizes revenue from technology license agreements at the time a contract is entered into, the license method is determined (paid-in-advance or on-going royalty), performance obligations under the license agreement are satisfied, and the realization of revenue is assured which is generally upon the receipt of the license proceeds. PDS may at times enter into license agreements whereby contingent revenues are recognized as one or more contractual milestones are met.

We review our investment in PDS to determine whether events or changes in circumstances indicate that the carrying amount may not be recoverable. The primary factors we consider in our determination are the financial condition, operating performance and near term prospects of the PDS. If a decline in value is deemed to be other than temporary, we would recognize an impairment loss.

Share-Based Compensation

Share-based compensation expense recognized during the period is based on the grant date fair value of the portion of share-based payment awards ultimately expected to vest during the period . As share-based compensation expense recognized in the consolidated statements of operations is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeiture rates are based on historical forfeiture experience and estimated future employee forfeitures.

Income Taxes

We follow authoritative guidance in accounting for uncertainties in income taxes. This authoritative guidance prescribes a recognition threshold and measurement requirement for the financial statement recognition of a tax position that has been taken or is expected to be taken on a tax return and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Under this guidance we may only recognize tax positions that meet a “more likely than not” threshold.

We follow authoritative guidance to evaluate whether a valuation allowance should be established against our deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. In making such judgments, significant weight is given to evidence that can be objectively verified. We are assessing our deferred tax assets under more likely than not scenarios in which they may be realized through future income.

We have determined that it was not more likely than not that all of our deferred tax assets will be realized in the future due to our continuing pre-tax and taxable losses. As a result of this determination we have placed a full valuation allowance against our deferred tax assets.

Assessment of Contingent Liabilities

We are involved in various legal matters, disputes, and patent infringement claims which arise in the ordinary course of our business. We accrue for any estimated losses at the time when we can make a reliable estimate of such loss and it is probable that it has been incurred. By their very nature, contingencies are difficult to estimate. We continually evaluate information related to all contingencies to determine that the basis on which we have recorded our estimated exposure is appropriate.

RESULTS OF OPERATIONS

Comparison of fiscal 2013 and 2012

		May 31, 2013				May 31, 2012
Selling, general and administrative		$	1,381,430			$	1,994,784

Selling, general and administrative expenses decreased from approximately $1,995,000 for the fiscal year ended May 31, 2012 to approximately $1,381,000 for the fiscal year ended May 31, 2013. The decrease consisted primarily of approximately $327,000 in legal fees primarily associated with the Crossflo officers’ legal mater in fiscal 2012, $153,000 in salaries and related payroll costs, and approximately $78,000 in consulting fees.

	May 31, 2013		May 31, 2012
Other income (expense):
Interest income	$	17,494	$	16,591
Other income		217,618		1,555
Realized recovery on marketable securities		55,873		347,452
Equity in earnings (loss) of affiliated company		2,174,395		(1,828,375	)
Total other income (expense), net	$	2,465,380	$	(1,462,777	)

Our other income and (expenses) for the fiscal year ended May 31, 2013 and 2012 included equity in the earnings of PDS of approximately $2,174,000 for the fiscal year ended May 31, 2013 and equity in the loss of PDS of approximately $1,828,000 for the fiscal year ended May 31, 2012. Our investment in PDS is accounted for in accordance with the equity method of accounting for investments. The change in the earnings of PDS is due to the increase in licensing revenues during fiscal 2013 as compared to the prior fiscal year. T he increase in other income for the fiscal year ended May 31, 2013 as compared to the prior fiscal year is primarily due to the one time receipt of proceeds associated with the settlement of certain litigation unrelated to our patent portfolio. I ncluded in other income and expense for the fiscal years ending May 31, 2013 and 2012 is approximately $56,000 and approximately $347,000, respectively, of recovery on the $600,879 realized loss on sale of marketable securities relating to our auction rate securities recognized during the fiscal year ended May 31, 2011. Through August 2013 we have received proceeds totaling $403,325 relating to the recovery of our fiscal 2011 realized loss.

		May 31, 2013				May 31, 2012
Income (loss) from continuing operations before income taxes		$	1,083,950			$	(3,457,561	)

Income from continuing operations before income taxes of approximately $1,084,000 for the fiscal year ended May 31, 2013 increased from a loss before income taxes of approximately $3,458,000 for fiscal year ended May 31, 2012 primarily due to our current year equity in earnings of PDS.

Benefit for income taxes

During the fiscal years ended May 31, 2013 and 2012, we recorded a benefit for income taxes related to federal and California taxes of approximately $(100) and $(900), respectively.

Results of Discontinued Operations

Comparison of fiscal 2013 and 2012

May 31, 2013

May 31, 2012

Dollars

% of
Revenue

Dollars

Revenue:

License and service revenue

–

179,871

100.0%

Cost of sales:

License and service revenue

–

47,594

26.5%

Gross profit

–

132,277

73.5%

Revenue consisted of software licenses and associated services relating to PDSG’s CDX product. Cost of sales included the direct time of PDSG employees on each project.

		May 31, 2013				May 31, 2012
Research and development		$	–			$	688,599

Research and development costs consisted of PDSG’s payroll and related expenses for software engineers as well as outside contractors retained to assist in the development of PDSG’s software product. For the fiscal year ended May 31, 2012, approximately $1,500 of share-based compensation was recorded in connection with vesting of employee stock options.

		May 31, 2013				May 31, 2012
Selling, general and administrative		$	3,224			$	890,368

Selling, general and administrative expenses decreased from approximately $890,000 for the fiscal year ended May 31, 2012 to approximately $3,000 for the fiscal year ended May 31, 2013, due to the sale of substantially all of PDSG’s assets in April 2012. For fiscal year ended May 31, 2012, approximately $15,000 of share-based compensation was recorded in connection with vesting of employee stock options.

		May 31, 2013				May 31, 2012
Operating loss		$	(3,224	)		$	(1,446,690	)

Operating loss decreased from approximately $(1,447,000) for the fiscal year ended May 31, 2012 to approximately $(3,000) for the fiscal year ended May 31, 2013 primarily due to the sale of substantially all of the assets of PDSG in fiscal 2012.

	May 31, 2013		May 31, 2012
Other income (expense):
Interest and other income	$	15,376	$	93,959
Loss on sale of company		–		(10,988	)
Total other income, net	$	15,376	$	82,971

Other income decreased for the fiscal year ended May 31, 2013 as compared to the fiscal year ended May 31, 2012 due to the reimbursement of April 2012 operating expenses agreed upon by the purchaser of substantially all of the assets of PDSG included in interest and other income in fiscal 2012.

Income (loss) from discontinued operations, net

We recorded net income from discontinued operations for the fiscal year ended May 31, 2013 of $12,152 consisting of royalty revenue earned under the terms of the asset sale agreement net of residual expenses and a net loss from discontinued operations for the fiscal year ended May 31, 2012 of $(1,363,719).

Net income (loss)

We recorded net income (loss) for the fiscal years ended May 31, 2013 and 2012 of $1,096,215 and $(4,820,405), respectively.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity

Our cash and short-term marketable securities balances increased from approximately $7,606,000 as of May 31, 2012 to approximately $7,767,000 as of May 31, 2013. We also have a restricted cash balance amounting to approximately $21,000 as of May 31, 2013 and 2012. Total current assets increased from approximately $7,860,000 as of May 31, 2012 to approximately $8,040,000 as of May 31, 2013. Total current liabilities amounted to approximately $278,000 and approximately $307,000 as of May 31, 2013 and May 31, 2012, respectively. The change in our working capital position as of May 31, 2013 as compared with May 31, 2012 results primarily from our capital contributions to and distributions from PDS during fiscal 2013.

The cost of accessing the credit markets could be challenging as many lenders and institutional investors have enacted tighter lending standards and reduced or ceased to provide funding to borrowers. Credit sources if identified, could come at significant cost. Adverse changes in the economy could limit our ability to obtain financing from debt or equity sources or could adversely affect the terms on which we may be able to obtain any such financing.

Cash shortfalls currently experienced by PDS will have an adverse effect on our liquidity. During the fiscal year ended May 31, 2012 we and TPL each contributed $650,000 in additional capital to PDS, in order to fund a portion of a legal retainer. During the fiscal year ended May 31, 2013 we and TPL each contributed $1,097,809 in additional capital to fund the operations of PDS. To date we have determined that it is in the best interests of the MMP licensing program that we provide our 50% share of capital to provide for PDS expenses including legal retainer payments, as well as licensing and litigation support payments to Alliacense, in the event license revenues received by PDS are insufficient to meet these needs. We believe it is likely that contributions to PDS to fund working capital will continue to be required.

As the litigation with HTC Corporation, and Acer, Inc., in the U.S. District Court, and the actions with the ITC Investigation No. 337-TA-853 progress, PDS is incurring significant third-party costs for expert testimony, depositions and other related legal costs. We will be required to make capital contributions to PDS for these costs in the event that PDS does not receive sufficient licensing revenues to pay these expenses.

Our current liquid cash resources as of May 31, 2013, are expected to provide the funds necessary to support our operations through at least the next twelve months. The cash flows from our interest in PDS represent our only significant source of cash generation. In the event of a continued decrease or interruption in MMP Portfolio licensing we will incur a significant reduction to our cash position. It is highly unlikely that we would be able to obtain any additional sources of financing to supplement our cash and short-term investment position of $7,767,350 at May 31, 2013.

On March 20, 2013, TPL filed a petition under Chapter 11 of the United States Bankruptcy Code. We have been appointed to the creditors’ committee and will be closely monitoring the progress in this matter as it relates to our interest in PDS. In the event that we provide funding to PDS that is not reciprocated by TPL, which would result in our having a larger ownership percentage in PDS, we will have a controlling financial interest in PDS, in which case, we will consolidate PDS in our consolidated financial statements. If we determine that it is appropriate to consolidate PDS, we would measure the assets, liabilities and noncontrolling interests of PDS at their fair values at the date that we have the controlling financial interest.

C ash Flows From Operating Activities

Cash used in operating activities of continuing operations for the fiscal years ended May 31, 2013 and 2012 was approximately $1,031,000 and $2,040,000, respectively. The principal component of the current fiscal year was the equity in earnings of affiliated company of approximately $2,174,000 offset by the net income from continuing operations of approximately $1,084,000. The principal components of the prior fiscal year are the prior year net loss from continuing operations of $3,456,686 offset by the equity in loss of affiliated company of $1,828,375.

Cash provided by operating activities of discontinued operations for the fiscal year ended May 31, 2013 was approximately $21,000 as compared to cash used in operating activities of discontinued operations for the fiscal year ended May 31, 2012 of approximately $362,000. T he decrease in cash used in operating activities of discontinued operations for the current fiscal year is due to the sale of substantially all of the assets of PDSG in April 2012.

Cash Flows From Investing Activities

Cash provided by investing activities for the fiscal year ended May 31, 2013 was approximately $3,934,000 as compared to cash used by investing activities for the fiscal year ended May 31, 2012 of approximately $1,228,000. Cash activities for the current fiscal year were primarily attributable to purchases and sales of marketable securities and contributions to and distributions from PDS. Cash activities for the prior fiscal year were primarily attributable to purchases and sales of marketable securities and contributions to PDS.

Cash Flows From Financing Activities

Cash used in financing activities for the fiscal years ended May 31, 2013 and 2012 was approximately $50,000 and $124,000, respectively. For the fiscal years ended May 31, 2013 and 2012, cash of approximately $57,000 and $124,000 was used to purchase our common stock for treasury.

Capital Resources

Our current liquid cash resources as of May 31, 2013, are expected to provide the funds necessary to support our operations through at least the next twelve months. The cash flows from our interest in PDS represent our primary significant source of cash generation. In the event of a continued decrease or interruption in MMP Portfolio licensing we will incur a significant reduction to our cash position. It is highly unlikely that we would be able to obtain any additional sources of financing to supplement our cash and short-term investment position of $7,767,350 at May 31, 2013.

RECENT ACCOUNTING PRONOUNCEMENTS

None.

ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The financial statements and supplementary data required by this item are included in Part IV, Item 15 of this Report and begin on page F-1 with the index to consolidated financial statements.

ITEM 9.

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

ITEM 9A.

CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including our Interim Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined in Rule 13a-15(e) of the Exchange Act, as of the end of the period covered by this report. Based on this evaluation, our Interim Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and is accumulated and communicated to our management, including our Interim Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Under the supervision and with the participation of our management, including our Interim Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of May 31, 2013 based on the criteria set forth in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, our management concluded that our internal control over financial reporting was effective as of May 31, 2013.

This Annual Report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting. Management's report was not subject to attestation by our independent registered public accounting firm pursuant to the rules of the SEC that permit us to provide only management's report in this Annual Report.

Changes in Internal Controls over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during the fourth fiscal quarter ended May 31, 2013, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Inherent Limitations on Internal Control

A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple errors. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

In addition, projections of any evaluation of effectiveness to future periods are subject to risks that controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.

ITEM 9B.

OTHER INFORMATION

None.

PART III

ITEM 10.

DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

Director Qualifications – We believe that individuals who serve on our Board should possess the requisite education and experience to make a significant contribution to the Board and bring a range of skills, diverse perspectives and backgrounds to its deliberations; and should have the highest ethical standards, a strong sense of professionalism and dedication to serving the interests of our stockholders. The following are qualifications, experience and skills for Board members which are important to our business:

Leadership Experience – We seek directors who demonstrate extraordinary leadership qualities. Strong leaders bring vision, diverse perspectives, and broad business insight to the company. They demonstrate practical management experience, skills for managing change, and knowledge of industries, geographies and risk management strategies relevant to the company.

Finance Experience – We believe that all directors should possess an understanding of finance and related reporting processes. We also seek directors who qualify as “audit committee financial experts” as defined in rules of the SEC for service on the Audit Committee.

Industry Experience – We seek directors who have relevant industry experience including: existing and new technologies, new or expanding businesses and a deep understanding of the Company’s business environments.

The following table and biographical summaries set forth information, including principal occupation, business experience, other directorships and director qualifications concerning the members of our Board of Directors and our executive officer as of May 31, 2013. There is no blood or other familial relationship between or among our directors or executive officer.

NAME	AGE	POSITION and TERM
Carlton M. Johnson, Jr.	53	Director (since August 2001)
Gloria H. Felcyn	66	Director (since October 2002)
Clifford L. Flowers	55	Chief Financial Officer/Secretary (since September 17, 2007) Interim CEO (since October 5, 2009) Director (since January 19, 2011)

CARLTON M. JOHNSON, JR. Carlton Johnson has served as a director of the Company since 2001, and is Chairman of the Executive Committee of the Board of Directors. Mr. Johnson is in-house legal counsel for Roswell Capital Partners, LLC, a position he has held since June 1996. Mr. Johnson has been admitted to the practice of law in Alabama since 1986, Florida since 1982 and Georgia since 1997. He has been a shareholder in the Pensacola, Florida AV- rated law firm of Smith, Sauer, DeMaria Johnson and was President-Elect of the 500 member Escambia-Santa Rosa Bar Association. He also served on the Florida Bar Young Lawyers Division Board of Governors. Mr. Johnson earned a degree in History/Political Science at Auburn University and Juris Doctor at Samford University - Cumberland School of Law. Since 1999, Mr. Johnson has served on the board of directors of Peregrine Pharmaceuticals, Inc., a publicly held emerging bio-tech company, and currently serves as chairman of Peregrine’s board of directors. Mr. Johnson serves as chairman of Peregrine’s audit committee and is a member of Peregrine’s compensation and nominating committees. From May 2009 to March 2012, Mr. Johnson served on the board of directors of CryoPort, Inc. a publicly held company providing cost-efficient frozen shipping to biopharmaceutical and biotechnology industries. Mr. Johnson served as chairman of CryoPort’s compensation committee and as a member of its audit committee and nomination and governance committee. From November 2009 to December 2011, Mr. Johnson served on the board of directors of ECOtality, Inc. a leader in clean electric transportation and storage technologies. Mr. Johnson served on the audit committee and compensation committee of ECOtality.

The Board of Directors concluded that Mr. Johnson should serve as a director in light of the extensive public company finance and corporate governance experience that he has obtained through serving on the boards and audit committees of Peregrine Pharmaceuticals, Inc., CryoPort, Inc., and ECOtality, Inc.

GLORIA H. FELCYN. Gloria Felcyn has served as a director of the Company since October, 2002 and is the Chairman of the Audit Committee of the Board of Directors. Since 1982, Ms. Felcyn has been the principal in her own certified public accounting firm, during which time she represented Helmut Falk Sr. and nanoTronics, along with other major individual and corporate clients in Silicon Valley. Following Mr. Falk’s death, Ms. Felcyn represented his estate and family trust as Executrix and Trustee of the Falk Estate and The Falk Trust. Prior to establishing her firm, Ms. Felcyn worked for the national accounting firm of Hurdman and Cranston from 1969 through 1970 and Price Waterhouse & Co. in San Francisco and New York City from 1970 through 1976, during which period, she represented major Fortune 500 companies. Subsequent to that, Ms. Felcyn worked in the field of international tax planning with a major real estate syndication company in Los Angeles until 1982 when she decided to start her own practice in Northern California. A major portion of Ms. Felcyn’s current practice is “Forensic Accounting”, which involves valuation of business entities and investigation of assets. Ms. Felcyn has published tax articles for “The Tax Advisor” and co-authored a book published in 1982, “International Tax Planning”. Ms. Felcyn has a degree in Business Economics from Trinity University and is a member of the American Institute of CPA’s.

The Board of Directors concluded that Ms. Felcyn should serve as a director and the chairperson of the Audit Committee in light of the extensive financial and accounting experience that she has obtained over her career.

CLIFFORD L. FLOWERS. Cliff Flowers became our Chief Financial Officer and Secretary on September 17, 2007. On October 5, 2009 Mr. Flowers was named Interim CEO and was elected a director of the Company on January 19, 2011. From May 2007 to September 17, 2007, Mr. Flowers was the interim CFO for BakBone Software Inc., working as a consultant on behalf of Resources Global Professionals, Inc. From June 2004 through December 2006, Mr. Flowers was the senior vice president of finance and operations and CFO for Financial Profiles, Inc. a developer and marketer of software for the financial planning industry. Prior to joining Financial Profiles, Mr. Flowers served as CFO of Xifin, Inc., a provider of hosted software services to the commercial laboratory marketplace. Prior to Xifin, Mr. Flowers served for nine years in positions of increasing responsibility at Previo, Inc., a developer and marketer of various PC and server-based products, including back up and business continuity offerings. As CFO of Previo, Mr. Flowers’ global responsibilities included all financial operations and legal affairs. He earlier served as an audit manager with Price Waterhouse, LLP. Mr. Flowers is a graduate of San Diego State University with a B.S. summa cum laude in Business Administration with an emphasis in accounting.

The Board of Directors concluded that Mr. Flowers should serve as a director due to his leadership and financial experience combined with the perspective and experience he brings as our current Chief Financial Officer and interim Chief Executive Officer.

Board Leadership Structure

Our bylaws provide that the Chairman of the Board shall preside over all meetings of the Board of Directors. Our bylaws also state that the Chairman of the Board shall serve as the Chief Executive Officer unless determined otherwise by our Board. Since October 5, 2009 our Chief Financial Officer has served as our interim CEO and our Board has not appointed a Chairman of the Board. During meetings of our Board of Directors, Mr. Johnson, an independent director, acts as Chairman of the Board.

Our independent directors meet in executive sessions without management present to evaluate whether management is performing its responsibilities in a manner consistent with the direction of the Board. Additionally, all Board committee members are independent directors. The committee chairs have authority to hold executive sessions without management present. The Board has determined that its current structure is in the best interests of the Company and its stockholders. We believe the independent nature of the Audit Committee and the Compensation Committee as well as the practice of the independent directors regularly meeting in executive session without Mr. Flowers present ensures that the Board maintains a level of independent oversight of management that is appropriate for the Company.

Board Risk Oversight

Our Board oversees and maintains our governance and compliance processes and procedures to promote the conduct of our business in accordance with applicable laws and regulations and with the highest standards of responsibility, ethics and integrity. As part of its oversight responsibility, our Board is responsible for the oversight of risks facing the Company and seeks to provide guidance with respect to the management and mitigation of those risks. Our board also delegates specific areas of risk to the Audit Committee which is responsible for the oversight of risk policies and processes relating to our financial statements and financial reporting processes. The Audit Committee reviews and discusses with management and the independent auditors significant risks and exposures to the company and steps management has taken or plans to take to minimize or manage such risks. The Audit Committee meets in executive session with our Chief Financial Officer and our independent auditor at each regular meeting of the Audit Committee.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the Exchange Act requires our directors, executive officers and persons who beneficially own 10% or more of a class of securities registered under Section 12 of the Exchange Act to file reports of beneficial ownership and changes in beneficial ownership with SEC. Directors, executive officers and greater than 10% stockholders are required by the rules and regulations of the SEC to furnish us with copies of all reports filed by them in compliance with Section 16(a).

Based solely on our review of the copies of such forms received by us, or written representations from reporting persons, we believe that our insiders complied with all applicable Section 16(a) filing requirements during fiscal year 2013.

Code of Ethics

We have adopted a Code of Ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. Our Code of Ethics is available on our website at www.ptsc.com under the link “Investors” and “Management Team”.

Audit Committee

We have an audit committee established in accordance with Section 3(a)(58)(A) of the Exchange Act, currently comprised of: Gloria H. Felcyn (Committee Chair) and Carlton M. Johnson, Jr. Each member of our Audit Committee (the “Audit Committee”) is independent as defined under the applicable rules of the SEC and NASDAQ Stock Market LLC (“NASDAQ”) listing standards. The Board of Directors has determined that Gloria H. Felcyn, who serves on the Audit Committee, is an “audit committee financial expert” as defined in applicable SEC rules.

Director Legal Proceedings

During the past ten years, no director, executive officer or nominee for our Board of Directors has been involved in any legal proceedings that are material to an evaluation of their ability or integrity to become our director or executive officer.

ITEM 11.

EXECUTIVE COMPENSATION

The following table summarizes the compensation of the named executive officers for the fiscal years ended May 31, 2013 and 2012. For fiscal 2013 and 2012, the named executive officers are our Chief Executive Officer and our Chief Financial Officer.

Summary Compensation Table

For Fiscal Years Ended May 31, 2013 and 2012

Name and Principal Position	Year	Salary ($)		Bonus ($) (1)		Option Awards ($)(2)		All Other Compensation ($) (3)		Total Compensation ($)
Clifford L. Flowers, Interim	2013	$	323,428	$	–	$	–	$	9,989	$	333,417
CEO and CFO

Clifford L. Flowers, Interim	2012		310,748		125,500		–		10,398		446,646
CEO and CFO

Mr. Flowers was paid a $125,500 discretionary bonus during fiscal 2012 per his employment contract.

Represents the aggregate grant date fair value of grants awarded in fiscal 2013 and 2012 computed in accordance with authoritative guidance issued by the Financial Accounting Standards Board.

See the All Other Compensation Table below for details of the total amounts represented.

All Other Compensation Table

For Fiscal Years Ended May 31, 2013 and 2012

Name and Principal Position	Year	401(k) Company Match ($)		Total ($)
Clifford L. Flowers, Interim	2013	$	9,989	$	9,989
CEO and CFO

Clifford L. Flowers, Interim	2012		10,398		10,398
CEO and CFO

The following table shows the number of shares covered by exercisable and un-exercisable options held by our named executive officers as of May 31, 2013.

Outstanding Equity Awards

As of May 31, 2013

Name

Number of Securities Underlying Options (#)Exercisable

Number of Securities Underlying Unexercised Options (#) Unexercisable

Option Exercise Price($)

Option
Expiration Date

Clifford L. Flowers

75,000

–

0.10

6/3/2015

Employment Contracts

In connection with Mr. Flowers’ appointment as Chief Financial Officer on September 17, 2007, we entered into an Employment Agreement (the “Flowers Agreement”) with Mr. Flowers for an initial 120-day term if not terminated pursuant to the Flowers Agreement, with an extension period of one year and on a day-to-day basis thereafter. Pursuant to the Flowers Agreement, Mr. Flowers’ initial base salary was $225,000 per year and he is eligible to receive an annual merit bonus of up to 50% of his base salary, as determined in the sole discretion of the Board of Directors. Effective October 1, 2008, October 5, 2009 and December 15, 2011, Mr. Flowers’ base salary was increased to $231,750, $291,750 and $327,750, respectively. Also pursuant to the Flowers Agreement and on the date of the Flowers Agreement, Mr. Flowers received a fully vested grant of non-qualified stock options to purchase 150,000 shares of our Common Stock and a grant of non-qualified stock options to purchase 600,000 shares of our Common Stock vesting over four years. Mr. Flowers’ right to exercise the foregoing stock options became fully vested on October 9, 2009, in connection with his appointment as Interim CEO. The Flowers Agreement also provides for Mr. Flowers to receive customary employee benefits, including health, life and disability insurance.

Pursuant to the Flowers Agreement, if Mr. Flowers is terminated without cause or resigns with good reason any time after two years of continuous employment, he is entitled to receive an amount equal to 12 months of his annual base salary. Mr. Flowers is also entitled to certain payments upon a change of control of the Company if the surviving corporation does not retain him. All such payments are conditional upon the execution of a general release.

Director Compensation

As described more fully below, this table summarizes the annual cash compensation for our non-employee directors during the fiscal year ended May 31, 2013.

Director Compensation

For Fiscal Year Ended May 31, 2013

Name	Fees Earned or Paid in Cash ($)			Option Awards ($)		All Other Compensation		Total Compensation ($)
Carlton M. Johnson, Jr.	$	122,400	(1)	$	–		–	$	122,400
Gloria H. Felcyn		96,000	(2)		–		–		96,000

1.	Consists of $28,800 board fee, $36,000 Phoenix Digital Solutions, LLC management committee fee, $28,800 Compensation Committee Chair fee and $28,800 Executive Committee Chair fee.

2.	Consists of $28,800 board fee and $67,200 Audit Committee Chair fee.

At May 31, 2013, the aggregate number of options outstanding was: Mr. Johnson – 250,000 shares and Ms. Felcyn – 250,000 shares.

Directors who are not our employees are compensated for their service as a director as shown in the table below:

Schedule of Director Fees

May 31, 2013

Compensation Item	Amount
Board	$	28,800
Audit Committee Chair		67,200
Compensation Committee Chair		28,800
Executive Committee Chair		28,800
Phoenix Digital Solutions, LLC Management Committee Board Member		36,000

All retainers are paid in monthly installments.

Other

We reimburse all directors for travel and other necessary business expenses incurred in the performance of their services for us.

ITEM 12.

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The following table sets forth, as of August 16, 2013, the stock ownership of each of our officers and directors, of all our officers and directors as a group, and of each person known to us to be a beneficial owner of 5% or more of our Common Stock. The number of shares of Common Stock outstanding as of August 16, 2013, was 405,247,405. Except as otherwise noted, each person listed below is the sole beneficial owner of the shares and has sole investment and voting power over such shares. Each individual’s address is 701 Palomar Airport Road, Suite 170, Carlsbad, California 92011-1045.

Name	Amount & Nature of Beneficial Ownership		Percent of Class
Gloria H. Felcyn, CPA		1,501,690 (1)		*
Carlton M. Johnson, Jr.		1,075,000 (2)		*
Clifford L. Flowers		250,000 (3)		*
All directors & officers as a group (3 persons)		2,826,690 (4)		0.70%

*Less than 1%

(1)	Includes 550,000 shares issuable upon the exercise of outstanding stock options exercisable within 60 days of August 16, 2013.

(2)	Includes 550,000 shares issuable upon the exercise of outstanding stock options exercisable within 60 days of August 16, 2013.

(3)	Includes 175,000 shares issuable upon the exercise of outstanding stock options exercisable within 60 days of August 16, 2013.

(4)	Includes 1,275,000 shares issuable upon the exercise of outstanding stock options exercisable within 60 days of August 16, 2013.

ITEM 13.

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

Transactions With Directors, Executive Officers and Principal Stockholders

There were no transactions, or series of transactions during the fiscal year ended May 31, 2013, nor are there any currently proposed transactions, or series of transactions, to which we are a party, in which the amount exceeds $120,000, and in which to our knowledge any director, executive officer, nominee, five percent or greater stockholder, or any member of the immediate family of any of the foregoing persons, has or will have any direct or indirect material interest other than as described below.

Director Independence

Our Board of Directors has determined that a majority of the members of, and nominees to, our Board of Directors qualify as “independent,” as defined by the listing standards of NASDAQ. Consistent with these considerations, after review of all relevant transactions and relationships between each director and nominee, or any of his or her family members, and us, our senior executive management and our independent auditors, the Board of Directors has determined further that all of our directors and nominees are independent under the listing standards of NASDAQ. In making this determination, the Board of Directors considered that there were no new transactions or relationships between its current independent directors and the Company, its senior management and its independent auditors since last making this determination. Each member of our Audit Committee, and each member of the Compensation Committee of our Board of Directors, is independent as defined by the listing standards of NASDAQ.

ITEM 14.

PRINCIPAL ACCOUNTANT FEES AND SERVICES

Pursuant to the Policy on Engagement of Independent Auditor, the Audit Committee is directly responsible for the appointment, compensation and oversight of the independent auditor. The Audit Committee pre-approves all audit services and non-audit services to be provided by the independent auditor and has approved 100% of the audit, audit-related and tax fees listed below. The Audit Committee may delegate to one or more of its members the authority to grant the required approvals, provided that any exercise of such authority is presented at the next Audit Committee meeting for ratification.

Each audit, non-audit and tax service that is approved by the Audit Committee will be reflected in a written engagement letter or writing specifying the services to be performed and the cost of such services, which will be signed by either a member of the Audit Committee or by one of our officers authorized by the Audit Committee to sign on our behalf.

The Audit Committee will not approve any prohibited non-audit service or any non-audit service that individually or in the aggregate may impair, in the Audit Committee’s opinion, the independence of the independent auditor.

In addition, our independent auditor may not provide any services to our officers or Audit Committee members, including financial counseling or tax services.

Audit Fees

During the fiscal years ended May 31, 2013 and 2012, the aggregate fees billed by our principal accountants for professional services rendered for the audit of our annual consolidated financial statements, and reviews of quarterly consolidated financial statements included in our reports on Form 10-Q, and audit services provided in connection with other statutory or regulatory filings were $121,000 and $128,590, respectively.

Audit-Related Fees

None.

Tax Fees

During the fiscal years ended May 31, 2013 and 2012, the aggregate fees billed by our principal accountant for tax compliance, tax advice and tax planning rendered on our behalf were $12,600 and $15,650, respectively, which are related to the preparation of federal and state income tax returns.

All Other Fees

Our principal accountant billed no other fees for the fiscal years ended May 31, 2013 and 2012, except as disclosed above.

PART IV

ITEM 15.

EXHIBITS, FINANCIAL STATEMENT SCHEDULES

(a) The following documents are filed as a part of this report:

Financial Statements . The following consolidated financial statements and Report of Independent Registered Public Accounting Firm are included starting on page F-1 of this Report:

Patriot Scientific Corporation

Report of KMJ Corbin & Company LLP, Independent Registered Public Accounting Firm

Consolidated Balance Sheets as of May 31, 2013 and 2012

Consolidated Statements of Operations for the Years Ended May 31, 2013 and 2012

Consolidated Statements of Stockholders’ Equity for the Years Ended May 31, 2013 and 2012

Consolidated Statements of Cash Flows for the Years Ended May 31, 2013 and 2012

Notes to Consolidated Financial Statements

Phoenix Digital Solutions, LLC

Report of KMJ Corbin & Company LLP, Independent Registered Public Accounting Firm

Balance Sheets as of May 31, 2013 and 2012

Statements of Operations for the Years Ended May 31, 2013 and 2012

Statement of Members’ Equity (Deficit) for the Years Ended May 31, 2013 and 2012

Statements of Cash Flows for the Years Ended May 31, 2013 and 2012

Notes to Financial Statements

Financial Statement Schedules . All financial statement schedules have been omitted since the information is either not applicable or required or is included in the consolidated financial statements or notes thereof.

Exhibits . Those exhibits marked with a (*) refer to exhibits filed herewith. The other exhibits are incorporated herein by reference, as indicated in the following list. Those exhibits marked with a (†) refer to management contracts or compensatory plans or arrangements.

Exhibit No.

Document

2.1

Agreement and Plan of Merger dated August 4, 2008, among the Company, PTSC Acquisition 1 Corp, Crossflo Systems, Inc. and the Crossflo principal officers, incorporated by reference to Exhibit 99.1 to Form 8-K filed August 11, 2008 (Commission file No. 000-22182)

3.1

Original Articles of incorporation of the Company’s predecessor, Patriot Financial Corporation, incorporated by reference to Exhibit 3.1 to registration statement on Form S-18, (Commission file No. 33-23143-FW)

3.2

Articles of Amendment of Patriot Financial Corporation, as filed with the Colorado Secretary of State on July 21, 1988, incorporated by reference to Exhibit 3.2 to registration statement on Form S-18, (Commission file No. 33-23143-FW)

3.3

Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on March 24, 1992, incorporated by reference to Exhibit 3.3 to Form 8-K dated May 12, 1992 (Commission file No. 33-23143-FW)

3.3.1

Certificate of Amendment to the Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on April 18, 1995, incorporated by reference to Exhibit 3.3.1 to Form 10-KSB for the fiscal year ended May 31, 1995 (Commission file No. 000-22182)

3.3.2

Certificate of Amendment to the Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on June 24, 1997, incorporated by reference to Exhibit 3.3.2 to Form 10-KSB for the fiscal year ended May 31, 1997, filed July 18, 1997 (Commission file No. 000-22182)

3.3.3

Certificate of Amendment to the Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on April 28, 2000, incorporated by reference to Exhibit 3.3.3 to Registration Statement on Form S-3 filed May 5, 2000 (Commission file No. 333-36418)

3.3.4

Certificate of Amendment to the Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on May 6, 2002, incorporated by reference to Exhibit 3.3.4 to Form 10-Q for the quarterly period ended February 28, 2009, filed April 9, 2009 (Commission file No. 000-22182)

3.3.5

Certificate of Amendment to the Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on October 16, 2003, incorporated by reference to Exhibit 3.3.5 to Registration Statement on Form SB-2 filed May 21, 2004 (Commission file No. 333-115752)

3.3.6

Certificate of Amendment to the Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on April 29, 2005, incorporated by reference to Exhibit 3.3.6 to Form 10-Q for the quarterly period ended February 28, 2009, filed April 9, 2009 (Commission file No. 000-22182)

3.3.7

Certificate of Amendment to the Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on November 14, 2005, incorporated by reference to Exhibit 3.3.7 to Form 10-Q for the quarterly period ended February 28, 2009, filed April 9, 2009 (Commission file No. 000-22182)

3.3.8

Certificate of Amendment to the Certificate of Incorporation of the Company, as filed with the Delaware Secretary of State on March 18, 2009, incorporated by reference to Exhibit 3.3.8 to Form 10-K for the fiscal year ended May 31, 2009, filed August 14, 2009 (Commission file No. 000-22182)

3.4	Articles and Certificate of Merger of Patriot Financial Corporation into the Company dated May 1, 1992, with Agreement and Plan of Merger attached thereto as Exhibit A, incorporated by reference to Exhibit 3.4 to Form 8-K dated May 12, 1992 (Commission file No. 33-23143-FW)
3.5	Certificate of Merger issued by the Delaware Secretary of State on May 8, 1992, incorporated by reference to Exhibit 3.5 to Form 8-K dated May 12, 1992 (Commission file No. 33-23143-FW)
3.6	Certificate of Merger issued by the Colorado Secretary of State on May 12, 1992, incorporated by reference to Exhibit 3.6 to Form 8-K dated May 12, 1992 (Commission file No. 33-23143-FW)
3.7	Bylaws of the Company, incorporated by reference to Exhibit 3.7 to Form 8-K dated May 12, 1992 (Commission file No. 33-23143-FW)
3.7.1	Amendment to bylaws of the Company, incorporated by reference to Exhibit 3.7.1 to our Current Report on Form 8-K dated November 4, 2010 (Commission file No. 000-22182)
4.1	Specimen common stock certificate, incorporated by reference to Exhibit 4.1 Form 8-K dated May 12, 1992 (Commission file No. 33-23143-FW)
4.2†	2006 Stock Option Plan of the Company as amended and restated, incorporated by reference to Appendix C to the Company Proxy Statement filed September 22, 2008 (Commission file No. 000-22182)
10.1	Master Agreement, dated as of June 7, 2005, by and among the Company, Technology Properties Limited Inc., a California corporation and Charles H. Moore, an individual, incorporated by reference to Exhibit 10.40 to Form 8-K filed June 15, 2005 (Commission file No. 000-22182)
10.2	Commercialization Agreement dated as of June 7, 2005 by and among the JV LLC, Technology Properties Limited Inc., a California corporation, and the Company, incorporated by reference to Exhibit 10.41 to Form 8-K filed June 15, 2005 (Commission file No. 000-22182)
10.3	Limited Liability Company Operating Agreement of JV LLC, a Delaware limited liability company, dated as of June 7, 2005, incorporated by reference to Exhibit 10.42 to Form 8-K filed June 15, 2005 (Commission file No. 000-22182)
10.4†	Employment Agreement dated September 17, 2007 by and between the Company and Clifford L. Flowers, incorporated by reference to Exhibit 10.1 to Form 8-K filed September 19, 2007 (Commission file No. 000-22182)
10.5	Form of Indemnification Agreement by and between the Company and the Board of Directors, incorporated by reference to Exhibit 10.6 to Form 10-K filed August 29, 2011 (Commission file No. 000-22182)
10.6	Licensing Program Services Agreement effective July 11, 2012 among Phoenix Digital Solutions, LLC, Alliacense Limited, LLC, Technology Properties Limited, LLC and the Company, incorporated by reference to Exhibit 10.7 to Form 8-K filed July 17, 2012 (Commission file No. 000-22182) (Confidential treatment has been requested with respect to portions of this agreement.)
10.7	Agreement effective July 11, 2012 between Technology Properties Limited, LLC and the Company, incorporated by reference to Exhibit 10.8 to Form 8-K filed July 17, 2012 (Commission file No. 000-22182) (Confidential treatment has been requested with respect to portions of this agreement.)
10.8	Agreement effective July 17, 2012 among Phoenix Digital Solutions, LLC, Alliacense Limited, LLC, Technology Properties Limited, LLC and the Company, incorporated by reference to Exhibit 10.9 to Form 8-K filed July 17, 2012 (Commission file No. 000-22182) (Confidential treatment has been requested with respect to portions of this agreement.)

14.1

Code of Ethics for Senior Financial Officers incorporated by reference to Exhibit 14.1 to Form 10-K for the fiscal year ended May 31, 2003, filed August 29, 2003 (Commission file No. 000-22182)

21*

List of subsidiaries of the Company

23.1*

Consent of Independent Registered Public Accounting Firm

31.1*

Certification of Clifford L. Flowers, Interim CEO, pursuant to Rule 13a-15(e) or Rule 15d-15(e)

31.2*

Certification of Clifford L. Flowers, CFO, pursuant to Rule 13a-15(e) or Rule 15d-15(e)

32.1*

Certification of Clifford L. Flowers, Interim CEO and CFO, pursuant to 18 U.S.C. Section 1350

99.1

Form of Incentive Stock Option Agreement to the Company’s 2006 Stock Option Plan incorporated by reference to Exhibit 99.10 on Form 10-K for the fiscal year ended May 31, 2009, filed August 14, 2009 (Commission file No. 000-22182)

99.2

Form of Non-Qualified Stock Option Agreement to the Company’s 2006 Stock Option Plan incorporated by reference to Exhibit 99.11 on Form 10-K for the fiscal year ended May 31, 2009, filed August 14, 2009 (Commission file No. 000-22182)

101.INS

XBRL Instance Document

101.SCH

XBRL Schema Document

101.CAL

XBRL Calculation Linkbase Document

101.DEF

XBRL Definition Linkbase Document

101.LAB

XBRL Label Linkbase Document

101.PRE

XBRL Presentation Linkbase Document

Patriot Scientific Corporation

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

		Page

Report of Independent Registered Public Accounting Firm		F-2
Financial Statements:
Consolidated Balance Sheets		F-3
Consolidated Statements of Operations		F-4
Consolidated Statements of Stockholders’ Equity		F-5
Consolidated Statements of Cash Flows		F-6
Notes to Consolidated Financial Statements		F-7

F- 1

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Stockholders and Board of Directors

Patriot Scientific Corporation

We have audited the accompanying consolidated balance sheets of Patriot Scientific Corporation and subsidiaries (the “Company”) as of May 31, 2013 and 2012, and the related consolidated statements of operations, stockholders’ equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit on its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

As described in Notes 5 and 9, the Company has extensive transactions with Technology Properties Limited, LLC and Alliacense Limited, LLC both related parties. Accordingly, the accompanying consolidated financial statements may not be indicative of the financial position or results of operations that would have occurred had the Company operated without such related party relationships.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Patriot Scientific Corporation and subsidiaries as of May 31, 2013 and 2012, and the consolidated results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

/s/ KMJ Corbin & Company LLP

Costa Mesa, California

August 22, 2013

F- 2

Patriot Scientific Corporation

Consolidated Balance Sheets

May 31,	2013			2012
ASSETS
Current assets:
Cash and cash equivalents	$	7,572,887		$	4,699,174
Restricted cash and cash equivalents		21,018			20,913
Current portion of marketable securities		194,463			2,907,106
Accounts receivable – affiliated company		16,538			–
Prepaid expenses and other current assets		194,901			225,077
Current assets of discontinued operations		40,682			7,273
Total current assets		8,040,489			7,859,543

Marketable securities, net of current portion		–			229,045
Property and equipment, net		5,078			7,536
Other assets		3,036			–
Investment in affiliated company		366,304			–
Non-current assets of discontinued operations		–			42,000
Total assets	$	8,414,907		$	8,138,124

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	219,213		$	239,546
Accrued expenses and other		58,521			64,643
Income tax payable		–			2,513
Total current liabilities		277,734			306,702

Cumulative losses in excess of investment in affiliated company		–			740,824
Total liabilities		277,734			1,047,526

Commitments and contingencies

Stockholders’ equity
Preferred stock, $0.00001 par value; 5,000,000 shares authorized: none outstanding		–			–
Common stock, $0.00001 par value: 600,000,000 shares authorized: 438,242,618 shares issued and 405,247,405 shares outstanding at May 31, 2013 and 438,167,618 shares issued and 405,735,958 shares outstanding at May 31, 2012		4,382			4,381
Additional paid-in capital		77,338,434			77,330,935
Accumulated deficit		(54,801,249	)		(55,897,464	)
Common stock held in treasury, at cost – 32,995,213 shares at May 31, 2013 and 32,431,660 shares at May 31, 2012		(14,404,394	)		(14,347,254	)
Total stockholders’ equity		8,137,173			7,090,598
Total liabilities and stockholders’ equity	$	8,414,907		$	8,138,124

See accompanying notes to consolidated financial statements

F- 3

Patriot Scientific Corporation

Consolidated Statements of Operations

Years Ended May 31,	2013			2012
Operating expenses:
Selling, general and administrative	$	1,381,430		$	1,994,784
Total operating expenses		1,381,430			1,994,784

Other income (expense):
Interest income		17,494			16,591
Other income		217,618			1,555
Realized recovery on marketable securities		55,873			347,452
Equity in earnings (loss) of affiliated company		2,174,395			(1,828,375	)
Total other income (expense), net		2,465,380			(1,462,777	)

Income (loss) from continuing operations before income taxes		1,083,950			(3,457,561	)

Benefit for income taxes		(113	)		(875	)

Income (loss) from continuing operations		1,084,063			(3,456,686	)

Income (loss) from discontinued operations, net		12,152			(1,363,719	)

Net income (loss)	$	1,096,215		$	(4,820,405	)

Basic and diluted income (loss) per common share:
Income (loss) from continuing operations	$	–		$	(0.01	)
Income (loss) from discontinued operations	$	–		$	–
Net income (loss)	$	–		$	(0.01	)

Weighted average number of common shares outstanding – basic		402,522,925			403,626,888
Weighted average number of common shares outstanding – diluted		405,425,823			403,626,888

See accompanying notes to consolidated financial statements.

F- 4

Patriot Scientific Corporation

Consolidated Statements of Stockholders’ Equity

	Common Stock
	Shares			Amounts		Additional Paid-in Capital		Accumulated Deficit			Treasury Stock			Stockholders’ Equity
Balance, June 1, 2011		407,526,799		$	4,381	$	77,314,301	$	(51,077,059	)	$	(14,223,037	)	$	12,018,586
Share-based compensation		–			–		16,634		–			–			16,634
Purchase of common stock for treasury		(1,790,841	)		–		–		–			(124,217	)		(124,217	)
Net loss		–			–		–		(4,820,405	)		–			(4,820,405	)
Balance, May 31, 2012		405,735,958			4,381		77,330,935		(55,897,464	)		(14,347,254	)		7,090,598
Exercise of options at $0.10 per share		75,000			1		7,499		–			–			7,500
Purchase of common stock for treasury		(563,553	)		–		–		–			(57,140	)		(57,140	)
Net income		–			–		–		1,096,215			–			1,096,215
Balance, May 31, 2013		405,247,405		$	4,382	$	77,338,434	$	(54,801,249	)	$	(14,404,394	)	$	8,137,173

See accompanying notes to consolidated financial statements.

F- 5

Patriot Scientific Corporation

Consolidated Statements of Cash Flows

Years Ended May 31,	2013			2012
Operating activities:
Net income (loss)	$	1,096,215		$	(4,820,405	)
Less: Net income (loss) from discontinued operations		12,152			(1,363,719	)
Net income (loss) from continuing operations		1,084,063			(3,456,686	)
Adjustments to reconcile net income (loss) before discontinued operations to net cash used in operating activities:
Depreciation		2,590			3,191
Accrued interest income added to investments		(8,270	)		(5,641	)
Equity in (earnings) loss of affiliated company		(2,174,395	)		1,828,375
Realized recovery on sale of marketable securities		(55,873	)		(347,452	)
Loss on sale of assets		2,036			736
Changes in operating assets and liabilities:
Accounts receivable – affiliated company		120,730			(7,923	)
Prepaid expenses and other current assets		27,140			613
Accounts payable, accrued expenses, and other		(26,456	)		(55,564	)
Income taxes payable		(2,513	)		–
Net cash used in operating activities of continuing operations		(1,030,948	)		(2,040,351	)
Net cash provided by (used in) operating activities of discontinued operations		20,744			(361,774	)
Net cash used in operating activities		(1,010,204	)		(2,402,125	)

Investing activities:
Proceeds from sales of marketable securities		7,651,525			4,616,847
Purchases of marketable securities		(4,645,799	)		(5,193,000	)
Purchases of property and equipment		(2,168	)		(1,996	)
Investment in affiliated company		(1,097,809	)		(650,000	)
Distributions from affiliated company		2,027,808			–
Net cash provided by (used in) investing activities		3,933,557			(1,228,149	)

Financing activities:
Repurchase of common stock for treasury		(57,140	)		(124,217	)
Exercise of stock options		7,500			–
Net cash used in financing activities		(49,640	)		(124,217	)
Net increase (decrease) in cash and cash equivalents		2,873,713			(3,754,491	)
Cash and cash equivalents, beginning of year		4,699,174			8,453,665
Cash and cash equivalents, end of year	$	7,572,887		$	4,699,174

Supplemental Disclosure of Cash Flow Information:
Cash payments for income taxes	$	2,400		$	–
Cash receipts from income tax refunds	$	–		$	907,588

See accompanying notes to consolidated financial statements.

F- 6

Patriot Scientific Corporation

Notes to Consolidated Financial Statements

1. Organization and Business

Patriot Scientific Corporation (the “Company”, “PTSC”, “we”, “us”, or “our”), was organized under Delaware law on March 24, 1992 and is the successor by merger to Patriot Financial Corporation, a Colorado corporation, incorporated on June 10, 1987 . In June 2005, we entered into a joint venture agreement with Technology Properties Limited, Inc. (“TPL”) to form Phoenix Digital Solutions, LLC (“PDS”). In September 2008, we acquired Patriot Data Solutions Group, Inc. formerly known as Crossflo Systems, Inc. (“PDSG”) which engaged in data-sharing services and products primarily in the public safety/government sector. I n January 2010, we sold the assets of Verras Medical, Inc. and in August 2010 we sold the Vigilys business line both formerly associated with PDSG. D uring April 2012, we sold substantially all of the assets of PDSG.

Through our joint venture PDS we pursue the commercialization of our patented microprocessor technologies through broad and open licensing and by litigating against those who may be infringing on our patents.

Reclassification

Certain amounts presented in the prior periods’ consolidated financial statements related to discontinued operations, recovery on marketable securities, and interest and other income have been reclassified to conform to the current period’s presentation.

Liquidity and Management’s Plans

Cash shortfalls currently experienced by PDS will have an adverse effect on our liquidity. During the fiscal year ended May 31, 2012 we and TPL each contributed $650,000 in additional capital to PDS, in order to fund a portion of a legal retainer. During the fiscal year ended May 31, 2013 we and TPL each contributed $1,097,809 in additional capital to fund the operations of PDS. To date we have determined that it is in the best interests of the Moore Microprocessor Patent (“MMP”) licensing program that we provide our 50% share of capital to provide for PDS expenses including legal retainer payments, as well as licensing and litigation support payments to Alliacense Limited, LLC (“Alliacense”, an affiliate of TPL), in the event license revenues received by PDS are insufficient to meet these needs. We believe it is likely that contributions to PDS to fund working capital will continue to be required.

As the litigation with HTC Corporation and Acer, Inc., in the U.S. District Court, and the actions with the ITC Investigation No. 337-TA-853 progress, PDS is incurring significant third-party costs for expert testimony, depositions and other related legal costs. We will be required to make capital contributions to PDS for these costs in the event that PDS does not receive sufficient licensing revenues to pay these expenses.

Our current liquid cash resources as of May 31, 2013, are expected to provide the funds necessary to support our operations through at least the next twelve months. The cash flows from our interest in PDS represent our only significant source of cash generation. In the event of a continued decrease or interruption in MMP Portfolio licensing we will incur a significant reduction to our cash position. It is highly unlikely that we would be able to obtain any additional sources of financing to supplement our cash and cash equivalents and short-term investment position of $7,767,350 at May 31, 2013.

F- 7

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

2. Summary of Significant Accounting Policies

Basis of Consolidation

The consolidated balance sheets at May 31, 2013 and 2012 and consolidated statements of operations for the fiscal years ended May 31, 2013 and 2012 includes our accounts and those of our wholly owned subsidiary PDSG which includes Crossflo Systems, Inc. (“Crossflo”), and our inactive subsidiary Plasma Scientific Corporation. All significant intercompany accounts and transactions have been eliminated.

PDSG is being presented as discontinued operations in the consolidated statements of operations for all periods presented. See “Discontinued Operations” below for additional information.

Discontinued Operations

Summarized operating results of discontinued operations for the fiscal years ended May 31, 2013 and 2012 are as follows:

	May 31, 2013			May 31, 2012
Revenues	$	–		$	179,871
Gross profit	$	–		$	132,277
Operating loss from discontinued operations	$	(3,224	)	$	(1,446,690	)
Other income from discontinued operations	$	–		$	93,959
Gain (loss) on sale of discontinued operations	$	15,376		$	(10,988	)
Income (loss) before income taxes	$	12,152		$	(1,363,719	)
Income (loss) from discontinued operations	$	12,152		$	(1,363,719	)

PDSG activity for the fiscal year ended May 31, 2013 consists of operating expenses for: legal, insurance, taxes and bank fees offset by PDSG royalty revenues.

The following table summarizes the carrying amount of the major classes of assets and liabilities of PDSG classified as discontinued operations at May 31, 2013 and May 31, 2012:

	May 31, 2013		May 31, 2012
Current assets:
Other current assets	$	40,682	$	7,273
	$	40,682	$	7,273
Long-lived assets:
Other receivable	$	–	$	42,000
	$	–	$	42,000

Financial Instruments and Concentrations of Credit Risk

Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash, cash equivalents, and investments in marketable securities.

F- 8

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Financial Instruments and Concentrations of Credit Risk (continued)

At times, our balance of cash maintained with our bank may exceed the Federal Deposit Insurance Corporation’s (“FDIC”) insured limit of $250,000. At May 31, 2013, our cash and cash equivalents balances subject to FDIC insurance exceeded the FDIC limit by $35,084. At May 31, 2013 and 2012, our cash and cash equivalents balance consisting of money market accounts not subject to FDIC insurance was $5,225,176 and $2,559,456, respectively. We limit our exposure of loss by maintaining our cash with financially stable financial institutions. When we have excess cash, our cash equivalents are placed in certificates of deposit and high quality money market accounts with major financial institutions. We believe this investment policy limits our exposure to concentrations of credit risk.

At May 31, 2013 and 2012, investments in marketable securities consist of certificates of deposit with maturities greater than three months. Each certificate of deposit is invested with a financial institution for $245,000 or less so as not to exceed the FDIC insurance limit.

Fair Value of Financial Instruments

Our financial instruments consist principally of cash and cash equivalents, investments in marketable securities, accounts payable and accrued expenses. The carrying value of these financial instruments approximates fair value because of the immediate or short-term maturity of the instruments. T he fair value of our cash equivalents and investments in marketable securities is determined based on quoted prices in active markets for identical assets or Level 1 inputs. We believe that the carrying values of all other financial instruments approximate their current fair values due to their nature and respective durations.

Cash Equivalents, Restricted Cash, and Short-Term Marketable Securities

We consider all highly liquid investments acquired with a maturity of three months or less to be cash equivalents.

Restricted cash and cash equivalents at May 31, 2013 and 2012 consist of a savings account held as collateral for our corporate credit card account.

At May 31, 2013 and 2012 our short-term marketable securities in the amount of $194,463 and $2,907,106 consist of certificates of deposit with various financial institutions, with maturity dates of twelve months or less.

Investments in Marketable Securities

Property, Equipment and Depreciation

Property and equipment are stated at cost and are depreciated using the straight-line method over the estimated useful lives of the assets, ranging from three to five years. Major betterments and renewals are capitalized, while routine repairs and maintenance are charged to expense when incurred.

F- 9

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Investment in Affiliated Company

Treasury Stock

We account for treasury stock under the cost method and include treasury stock as a component of stockholders’ equity.

Income Taxes

We follow authoritative guidance to evaluate whether a valuation allowance should be established against our deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. In making such judgments, significant weight is given to evidence that can be objectively verified. We assess our deferred tax assets annually under more likely than not scenarios in which they may be realized through future income.

We follow authoritative guidance to adjust our effective tax rate each quarter to be consistent with the estimated annual effective tax rate. We are also required to record the tax impact of certain discrete items, unusual or infrequently occurring, including changes in judgment about valuation allowances and effects of changes in tax laws or rates, in the interim period in which they occur. In addition, jurisdictions with a projected loss for the year or a year-to-date loss where no tax benefit can be recognized are excluded from the estimated annual effective tax rate. The impact of such an exclusion could result in a higher or lower effective tax rate during a particular quarter, based upon the mix and timing of actual earnings or losses versus annual projections.

F- 10

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Assessment of Contingent Liabilities

Earnings (Loss) Per Share

Basic earnings per share for continuing and discontinued operations includes no dilution and is computed by dividing earnings available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share for continuing and discontinued operations reflect the potential dilution of securities that could share in the earnings of an entity.

For the fiscal year ended May 31, 2013 potential common shares of 175,000 related to our outstanding options were not included in the calculation of diluted income per share for continuing and discontinued operations. For the fiscal year ended May 31, 2013, we included the PDSG escrow shares of 2,844,630 in the calculation of diluted income per share for continuing and discontinued operations.

At May 31, 2012 potential common shares of 2,360,838 related to our outstanding options were not included in the calculation of diluted loss per share for continuing and discontinued operations as we recorded a loss. Had we reported net income for the year ended May 31, 2012 an additional 0 shares of common stock would have been included in the calculation of diluted income per share for continuing and discontinued operations.

In connection with our acquisition of Crossflo, which became a part of PDSG, we issued escrow shares that are contingent upon certain representations and warranties made by Crossflo at the time of the merger agreement (see Note 9). We exclude these escrow shares from the basic loss per share calculations and include the escrowed shares in the diluted loss per share calculations.

Use of Estimates

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities in the consolidated financial statements and accompanying footnotes. Actual results could differ from those estimates. On an ongoing basis we evaluate our estimates, including, but not limited to: fair values of investments in marketable securities, the use, recoverability, and /or realizability of certain assets, including investments in affiliated companies, deferred tax assets, and stock-based compensation.

Share-Based Compensation

Share-based compensation expense recognized during the year is based on the grant date fair value of the portion of share-based payment awards ultimately expected to vest during the year. As share-based compensation expense recognized in the consolidated statements of operations is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeiture rates are based on historical forfeiture experience and estimated future employee forfeitures.

F- 11

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Intellectual Property Rights

PDS, our investment in affiliate, relies on a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures and licensing arrangements to protect our intellectual property rights. PDS currently licenses four unexpired U.S. patents issued dating back to 1997 on our microprocessor technology in addition to three European and two Japanese patents. The U.S. patents will expire between 2014 and 2015 and the European and Japanese patents will expire in 2016. PDS also licenses three U.S. patents, six European, and one Japanese patent all of which expired between August 2009 and June 2013. These patents, while expired, may have certain retrospective statutory benefits that will fully diminish six years after the patent expiration date (e.g. for the expired U.S. patents). The patent useful life for purposes of negotiating licenses is finite and these patents are subject to legal challenges, which in combination with the limited life, could adversely impact the stream of revenues. A successful challenge to the ownership of the technology or the proprietary nature of the intellectual property would materially damage business prospects. Any issued patent may be challenged and invalidated.

3. C ash, Cash Equivalents, Restricted Cash and Marketable Securities

We consider all highly liquid investments with original maturities of three months or less to be cash equivalents.

Restricted cash and cash equivalents at May 31, 2013 and 2012 consist of deposits in a savings account required to be held as collateral for our corporate credit card.

At May 31, 2013 and 2012, our current portion of marketable securities in the amount of $194,463 and $2,907,106, respectively, consists of the par value plus accrued interest of our time deposits. At May 31, 2012, our non-current portion of marketable securities in the amount of $229,045 consists of the par value plus accrued interest of time deposits. These marketable securities are classified as available for sale and are reported at fair market value.

We follow authoritative guidance to account for our marketable securities as available for sale. Under this authoritative guidance we are required to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. We determine fair value based on quoted prices when available or through the use of alternative approaches, such as discounting the expected cash flows using market interest rates commensurate with the credit quality and duration of the investment or valuations by third party professionals. The three levels of inputs that we may use to measure fair value are:

Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

Level 2: Quoted prices in markets that are not active or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability; and

Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e. supported by little or no market activity).

F- 12

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Cash, Cash Equivalents, Restricted Cash and Marketable Securities (continued)

The following tables detail the fair value measurements within the fair value hierarchy of our cash, cash equivalents and investments in marketable securities:

Fair Value Measurements at May 31, 2013 Using

Quoted Prices

Significant

in Active

Other

Significant

Fair Value at

Markets for

Observable

Unobservable

May 31,

Identical Assets

Inputs

2013

(Level 1)

(Level 2)

(Level 3)

Cash and cash equivalents:

Cash

197,862

–

Money market funds

5,225,176

–

Certificates of deposit

2,149,849

–

2,149,849

–

Restricted cash

21,018

–

Marketable securities:

Short-term:

Certificates of deposit

194,463

–

194,463

–

Total

7,788,368

5,444,056

2,344,312

–

Fair Value Measurements at May 31, 2012 Using

Quoted Prices

Significant

in Active

Other

Significant

Fair Value at

Markets for

Observable

Unobservable

May 31,

Identical Assets

Inputs

2012

(Level 1)

(Level 2)

(Level 3)

Cash and cash equivalents:

Cash

77,745

–

Money market funds

2,559,456

–

Certificates of deposit

2,061,973

–

2,061,973

–

Restricted cash

20,913

–

Marketable securities:

Short-term:

Certificates of deposit

2,907,106

–

2,907,106

–

Long-term:

Certificates of deposit

229,045

–

229,045

–

Total

7,856,238

2,658,114

5,198,124

–

F- 13

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Cash, Cash Equivalents, Restricted Cash and Marketable Securities (continued)

Beginning in fiscal 2011, we purchased certificates of deposit with varying maturity dates greater than three months. The following table summarizes the maturities, gross unrealized gains or losses and fair value of the certificates of deposit as of May 31, 2013:

	May 31, 2013
	Cost		Gross Unrealized Gains/(Losses)		Fair Value
Maturity
Due in three months or less	$	2,149,849	$	–	$	2,149,849
Due in one year or less	$	194,463	$	–	$	194,463

The following table summarizes the maturities, gross unrealized gains or losses and fair value of the certificates of deposit as of May 31, 2012:

	May 31, 2012
	Cost		Gross Unrealized Gains/(Losses)		Fair Value
Maturity
Due in three months or less	$	2,061,973	$	–	$	2,061,973
Due in one year or less	$	2,907,106	$	–	$	2,907,106
Due in one year or more	$	229,045	$	–	$	229,045

4. Property and Equipment

Property and equipment consisted of the following at May 31, 2013 and 2012:

	2013			2012
Computer equipment and software	$	28,741		$	28,658
Furniture and fixtures		21,176			23,545
		49,917			52,203
Less: accumulated depreciation		(44,839	)		(44,667	)
Net property and equipment	$	5,078		$	7,536

Depreciation expense related to property and equipment was $2,590 and $3,191 for the years ended May 31, 2013 and 2012, respectively.

5. Investment in Affiliated Company

Phoenix Digital Solutions, LLC

On June 7, 2005, we entered into a Master Agreement (the “Master Agreement”) with TPL, and Charles H. Moore (“Moore”), the co-inventor of the technology which is the subject of the MMP Portfolio of microprocessor patents, pursuant to which the parties resolved all legal disputes between them. Pursuant to the Master Agreement, we and TPL entered into the Limited Liability Company Operating Agreement of PDS (the “LLC Agreement”) into which we and Moore contributed our rights to certain of our technologies.

F- 14

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Investment in Affiliated Company (continued)

We and TPL each own 50% of the membership interests of PDS, and each member has the right to appoint one member of the three member management committee. The two appointees are required to select a mutually acceptable third member of the management committee. There has not been a third management committee member since May 2010. Pursuant to the LLC Agreement, we and TPL initially agreed to establish a working capital fund for PDS of $4,000,000, of which our contribution was $2,000,000. The working capital fund was increased to a maximum of $8,000,000 as license revenues are achieved. We and TPL are obligated to fund future working capital requirements at the discretion of the management committee of PDS in order to maintain working capital of not more than $8,000,000. If the management committee determines that additional capital is required, neither we nor TPL are required to contribute more than $2,000,000 in any fiscal year. Since there is currently not a third member of the management committee, working capital contributions made to PDS require the approval of both management committee members. On December 14, 2011 we contributed $200,000 and TPL forfeited rights to $200,000 of special litigation support payments due it pursuant to the October 6, 2011 settlement agreement for an in-kind capital contribution of $200,000 in order to fund a portion of a retainer due to newly engaged counsel. On March 23, 2012, April 13, 2012, and May 15, 2012 we and TPL each contributed $150,000, $150,000, and $150,000 to PDS to fund a portion of a retainer due to such counsel. During the fiscal year ended May 31, 2013 we and TPL each contributed $1,097,809 to fund the remaining portions of the legal retainer and the operations of PDS. Distributable cash and allocation of profits and losses have been allocated to the members in the priority defined in the LLC Agreement.

Pursuant to our June 7, 2005 agreement with PDS and TPL to license the MMP Portfolio (“Commercialization Agreement”), PDS had committed to pay a quarterly amount ranging between $500,000 and $1,000,000 (based upon a percentage of the working capital fund balance of PDS) for supporting efforts to secure licensing agreements by TPL on behalf of PDS. During the fiscal years ended May 31, 2013 and 2012, PDS expensed $185,000 and $2,000,000, respectively, pursuant to this commitment. These expenses are recorded in the accompanying PDS statements of operations presented below. These expenses concluded with the execution of the July 11, 2012 Licensing Program Services Agreement (the “Program Agreement”).

PDS reimburses TPL for payment of all legal and third-party expert fees and other related third-party costs and expenses, and certain internally generated costs as approved on August 17, 2009 and more fully described below. During the fiscal years ended May 31, 2013 and 2012, PDS expensed $3,367,294 and $5,563,594, respectively, to TPL pursuant to the agreement. These expenses are recorded in the accompanying PDS statements of operations presented below net of $376,049 and $491,124, respectively, of legal fee reversals previously expensed and recorded as accounts payable to TPL during the fiscal years ended May 31, 2013 and 2012 as the statute of limitations had expired.

On July 11, 2012, we entered into the Program Agreement with PDS, TPL, and Alliacense, and an Agreement (the “TPL Agreement”) with TPL. Pursuant to the Program Agreement, PDS engaged Alliacense to negotiate MMP portfolio licenses and to pursue claims against violators of the MMP portfolio on behalf of PDS, TPL, and the Company. The Program Agreement continues through the useful life of the MMP portfolio patents. Pursuant to the TPL Agreement, we and TPL agreed to certain allocations of obligations in connection with the engagement of Alliacense.

On July 17, 2012, we entered into an Agreement with PDS, TPL, and Alliacense whereby we agreed to certain additional allocations of obligations relating to the Program Agreement.

Pursuant to the Program Agreement, PDS has committed to Alliacense a quarterly amount of $500,000 which represents the licensing services fees due Alliacense, subject to a contingency arrangement which provides for a percentage on future revenues, for its efforts to secure licensing agreements on behalf of PDS. These payments can be capped at $2,000,000 pursuant to six-month notice from PDS, at which time the PDS management committee will review and decide the warranting of future payments. These payments replace the quarterly amounts previously paid to TPL pursuant to the Commercialization Agreement. During the fiscal year ended May 31, 2013, Alliacense earned $1,858,647 pursuant to this commitment. This expense is recorded in the accompanying PDS statement of operations for the fiscal year ended May 31, 2013 presented below.

F- 15

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Investment in Affiliated Company (continued)

Pursuant to the Program Agreement, PDS has committed to pay Alliacense litigation support fees relating to Alliacense’s special work and effort regarding internal costs related to MMP maintenance and litigation support including support in the U.S. District Court and the complaints filed on behalf of TPL, PDS and us with the ITC. During the fiscal year ended May 31, 2013, PDS expensed $1,786,414 pursuant to this commitment. Future litigation support payments to Alliacense relating to the ITC litigation are subject to a contingency arrangement which provides for a percentage of future recoveries in these actions. This expense is recorded in the accompanying PDS statement of operations for the fiscal year ended May 31, 2013 presented below.

During January 2013, TPL and Moore settled their litigation. Terms of the settlement include the payment by PDS to Moore of a consulting fee of $250,000 for four years or until the completion of all outstanding MMP litigation whichever comes first. Per terms of the agreement PDS paid Moore $150,000 on the settlement date and will pay Moore $16,667 per month from August 2013 through January 2014 and $20,833 per month beginning February 2014 through January 2017.

We are accounting for our investment in PDS under the equity method of accounting, and accordingly have recorded our share of PDS’ net income during the fiscal year ended May 31, 2013 of $2,174,395 as an increase in our investment and net loss of $1,828,375 during the fiscal year ended May 31, 2012 as a decrease in our investment. Cash distributions of $2,027,808 received from PDS during the year ended May 31, 2013 have been recorded as a reduction in our investment. We received no cash distributions from PDS during the fiscal year ended May 31, 2012. Cash contributions of $1,097,809 and $650,000 made during the fiscal years ended May 31, 2013 and 2012, respectively, have been recorded as in increase in our investment. We have recorded our share of PDS’ net income and net loss as “Equity in earnings (loss) of affiliated company” in the accompanying consolidated statements of operations for the years ended May 31, 2013 and 2012, respectively.

During the fiscal year ended May 31, 2012 we accounted for an advance of $227,268 for legal services, which was reimbursable by PDS as equity in loss of PDS, under the equity method of accounting given that this amount remained unreimbursed at May 31, 2012. During the fiscal year ended May 31, 2012 we advanced PDS $10,000 for legal services and received $100,000 in payment on previous advances.

During the fiscal year ended May 31, 2012, our share of loss in PDS exceeded our investment in PDS by $740,824. Such amount has been recorded as “Cumulative losses in excess of investment in affiliated company” on our consolidated balance sheet at May 31, 2012, due to our and TPL’s intent to fund the working capital of PDS.

During the fiscal year ended May 31, 2013, PDS entered into licensing agreements with third parties, pursuant to which PDS recognized revenues of $10,620,000.

During the fiscal year ended May 31, 2013, PDS recognized revenues of $1,500,000 for license agreements previously entered into by TPL.

During the fiscal years ended May 31, 2013 and 2012, TPL entered into licensing agreements with third parties, pursuant to which PDS recorded license revenues of approximately $450,000 and $4,029,000, respectively.

F- 16

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Investment in Affiliated Company (continued)

At May 31, 2013, PDS had a prepaid balance to Alliacense of approximately $456,000 for advance payment of the June 1, 2013 quarterly payment less license fees earned. At May 31, 2013, PDS had accounts payable balances of approximately $1,494,000, $34,000, and $17,000 to TPL, Alliacense, and PTSC, respectively. At May 31, 2012, PDS had accounts payable and accrued expenses balances of approximately $2,611,000 and $137,000 to TPL and PTSC, respectively.

Variable Interest Entity Disclosures

At August 16, 2013, PDS’ cash balance was $206,605.

For the fiscal years ended May 31, 2013 and 2012, we and TPL have each contributed $1,097,809 and $650,000, respectively, to fund the operations of PDS.

Our variable interest in PDS consists of 50% of PDS’ Members Equity of $366,304 as well as the accounts payable balance due us of $16,538 for a total of $349,766 at May 31, 2013.

PDS’ balance sheets at May 31, 2013 and 2012 and statements of operations for the years ended May 31, 2013 and 2012 are as follows:

Balance Sheets

Assets:

	2013		2012
Cash and cash equivalents	$	1,320,932	$	1,003,489
Prepaid expenses		717,540		–
Licenses receivable		250,000		–
Total assets	$	2,288,472	$	1,003,489

Liabilities and Members’ Equity:

	2013		2012
Related party payables and accrued expenses	$	1,544,075	$	2,747,883
Income tax payable		11,790		11,790
Members’ equity (deficit)		732,607		(1,756,184	)
Total liabilities and members’ equity	$	2,288,472	$	1,003,489

F- 17

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Investment in Affiliated Company (continued)

Statements of Operations

	2013		2012
Revenues	$	12,570,000	$	4,029,300
Expenses		7,548,619		7,673,461
Operating income (loss)		5,021,381		(3,644,161	)
Income (loss) before income taxes and foreign taxes		5,021,381		(3,644,161	)
Provision for income taxes and foreign taxes		672,590		12,590
Net income (loss)	$	4,348,791	$	(3,656,751	)

PDS Related Party Balances And Transactions

Balances with related parties as of May 31, 2013 and 2012 are summarized as follows:

	May 31, 2013		May 31, 2012
Assets:
Prepaid expenses (Advances to Alliacense)	$	456,353	$	–
Liabilities:
Related party payables and accrued expenses (TPL) (1)	$	1,493,775	$	2,610,615
Related party payables (PTSC)		16,538		137,268
Related party payables (Alliacense)		33,762		–
Total liabilities	$	1,544,075	$	2,747,883

Transactions with related parties for the fiscal years ended May 31, 2013 and 2012 are as follows:

	May 31, 2013		May 31, 2012

Expenses paid or accrued (TPL)	$	3,552,294	$	7,563,594
Expenses paid or accrued (Alliacense)	$	3,645,061	$	–

(1)

Pursuant to the terms of the Commercialization Agreement, PDS will reimburse TPL for the payment of all legal and third party expert fees and other related third party costs and expenses upon TPL’s submission of documentation supporting that payment by them has occurred.

Significant Contractual Legal Relationship

PTSC through its unconsolidated affiliate, PDS has incurred legal fees from an unrelated law firm and legal subcontractors to provide substantial legal services for the commercialization of the MMP portfolio of microprocessor patents.

Accounts payable balances due this law firm and legal subcontractors as of May 31, 2013 and 2012 were $518,694 and $0, respectively.

F- 18

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Investment in Affiliated Company (continued)

Transactions with this law firm and legal subcontractors for the fiscal years ended May 31, 2013 and 2012 were as follows:

		May 31, 2013				May 31, 2012
Legal costs		$	3,689,419			$	2,474,072

Contractual Commitments

In January 2013, PDS entered into a contractual commitment with a related party entity to provide consulting services at a cost of $250,000 per year for a duration of four years or the completion of all outstanding MMP litigation, whichever comes first.

For the fiscal year ended May 31, 2013, PDS expensed $150,000 related to this agreement.

In connection with the Program Agreement, PDS is required to make payments to Alliacense of $500,000 no later than three days prior to the start of each calendar quarter. Such payments are non-accountable and non-recoupable, but are offset against the licensing series fees owed to Alliacense pursuant to the Program Agreement. Upon six months notice to Alliacense, and in conjunction with a proportionate reduction in the scope of the Project Description, as defined, PDS may determine to implement a maximum of advances not-yet-offset of $2,000,000.

6. Accrued Expenses and Other

At May 31, 2013 and 2012, accrued expenses and other consisted of the following:

	2013		2012
Accrued lease obligation	$	1,814	$	2,889
Compensation and benefits		56,707		61,754
	$	58,521	$	64,643

7. Stockholders’ Equity

Share Repurchases

During July 2006, we commenced our Board of Director approved stock buyback program in which we repurchase our outstanding common stock from time to time on the open market. The repurchase plan has no maximum number of shares and is solely at the discretion of the Board of Directors. The repurchase plan has no set expiration date.

The following table summarizes share repurchases during the years ended May 31, 2013 and 2012:

	2013		2012
Number of shares repurchased		563,553		1,790,841
Aggregate cost	$	57,140	$	124,217

F- 19

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Stockholders’ Equity (continued)

Share-based Compensation Summary of Assumptions and Activity

The fair value of share-based awards to employees and directors is calculated using the Black-Scholes option pricing model, even though this model was developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from our stock options. The Black-Scholes model also requires subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. The expected term of options granted is derived from historical data on employee exercises and post-vesting employment termination behavior. The risk-free rate selected to value any particular grant is based on the U.S. Treasury rate that corresponds to the pricing term of the grant effective as of the date of the grant. No stock options were granted during the fiscal years ended May 31, 2013 and 2012.

A summary of option activity as of May 31, 2013 and changes during the fiscal year then ended, is presented below:

	Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Term (Years)		Aggregate Intrinsic Value
Options outstanding at June 1, 2012		2,360,838		$	0.26
Options granted		–		$	–
Options exercised		(75,000	)	$	0.10
Options forfeited		(1,535,838	)	$	0.34
Options outstanding at May 31, 2013		750,000		$	0.10		1.70	$	–
Options vested and expected to vest at May 31, 2013		750,000		$	0.10		1.70	$	–
Options exercisable at May 31, 2013		750,000		$	0.10		1.70	$	–

The aggregate intrinsic value in the table above represents the differences in market price at the close of the fiscal year ($0.10 per share on May 31, 2013) and the exercise price of outstanding, in-the-money options (those options with exercise prices below $0.10) on May 31, 2013.

The following table summarizes employee and director stock-based compensation expense for PTSC and employee stock-based compensation expense for PDSG for the fiscal years ended May 31, 2013 and 2012, which was recorded as follows:

	Year Ended		Year Ended
	May 31, 2013		May 31, 2012
Research and development - PDSG	$	–	$	1,541
Selling, general and administrative expense - PDSG		–		15,093
Selling, general and administrative expense - PTSC		–		–
Total	$	–	$	16,634

F- 20

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Stockholders’ Equity (continued)

2003 Stock Option Plan

The 2003 Stock Option Plan, which expired in July 2013, provided for the granting of options to acquire up to 6,000,000 shares of our common stock to either full or part time employees, directors and our consultants at a price not less than the fair market value on the date of grant for incentive stock options or not less than 85% of the fair market value on the date of grant for non-qualified stock options. In the case of a significant stockholder, the option price of the share is not less than 110 percent of the fair market value of the shares on the date of grant. Any option granted under the 2003 Stock Option Plan must be exercised within ten years of the date they are granted (five years in the case of a significant stockholder). There were no grants made under the 2003 Stock Option Plan during the fiscal years ended May 31, 2013 and 2012. As of May 31, 2013, there are no options outstanding under the 2003 Stock Option Plan.

2006 Stock Option Plan

The 2006 Stock Option Plan, as amended, which expires in March 2016, provides for the granting of options to acquire up to 10,000,000 shares, with a limit of 8,000,000 Incentive Stock Option (“ISO”) shares of our common stock to either full or part time employees, directors and our consultants at a price not less than the fair market value on the date of grant. In the case of a significant stockholder, the option price of the share is not less than 110 percent of the fair market value of the shares on the date of grant. Any option granted under the 2006 Stock Option Plan must be exercised within ten years of the date they are granted (five years in the case of a significant stockholder). There were no grants made under the 2006 Stock Option Plan during the fiscal years ended May 31, 2013 and 2012. As of May 31, 2013, options to purchase 750,000 shares of common stock are outstanding under the 2006 Stock Option Plan.

8. Income Taxes

The provision (benefit) for income taxes from continuing operations is as follows for the years ended May 31:

	2013			2012
Current:
Federal	$	(2,513	)	$	(4,075	)
State		2,400			3,200
Total current		(113	)		(875	)

Deferred:
Federal		571,104			(1,531,321	)
State		146,377			(398,831	)
Total deferred		717,481			(1,930,152	)
Valuation allowance		(717,481	)		1,930,152
Total deferred		–			–
Total benefit	$	(113	)	$	(875	)

F- 21

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Income Taxes (continued)

The reconciliation of the effective income tax rate to the Federal statutory rate is as follows for the years ended May 31:

	2013			2012
Statutory federal income tax rate		35.0%			35.0%
State income tax rate, net of Federal effect		0.2%			-%
Change in tax rate		(1.0%	)		(1.0%	)
Stock option expense		7.6%			(2.2%	)
Tax exempt interest		-%			0.2%
FIN 48 liability		(0.2%	)		-%
Other		7.0%			0.4%
Change in valuation allowance		(48.6%	)		(32.4%	)
Effective income tax rate		0.0%			0.0%

Deferred tax assets and liabilities reflect the net tax effect of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. Significant components of our deferred tax assets from continuing operations are as follows as of May 31:

	2013			2012
Current deferred tax assets:
State taxes	$	815		$	815
Accrued expenses		14,751			24,949
Less: valuation allowance		(15,566	)		(25,764	)
Total net current deferred tax asset		-			-

Long-term deferred tax assets (liabilities):
Investment in affiliated company		(106,419	)		536,480
Basis difference in property and equipment		(2,166	)		(2,371	)
Basis difference in intangibles		18,334			9,943
Stock based compensation expense		227,284			374,131
Impairment of note receivable		331,896			331,896
Capital loss carryover		643,144			775,942
Net operating loss carryforwards		9,491,977			9,285,312
Credit carryover		107,017			107,017
Valuation allowance		(10,711,067	)		(11,418,350	)
Total net long-term deferred tax asset		-			-
Net deferred tax asset	$	-		$	-

F- 22

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Income Taxes (continued)

We have federal and state net operating loss carryforwards available to offset future taxable income of approximately $21,515,000 and $24,626,000, respectively, at May 31, 2013. These carryforwards begin to expire in the years ending May 31, 2023 and 2013, respectively. The state of California has suspended NOL deductions for taxable years beginning in 2008 or 2009 for taxpayers with business income of $300,000 or more.

On June 1, 2007, we adopted authoritative guidance which defines criteria that an individual tax position must meet for any part of the benefit of that position to be recognized in a company’s financial statements and also provides guidance on measurement, derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The adoption of this guidance did not result in any cumulative effect adjustment to retained earnings. Interest and penalties, if any, related to unrecognized tax benefits are recorded in income tax expense. As of May 31, 2013, we are subject to U.S. Federal income tax examinations for the tax years May 31, 1996 through May 31, 2012, and we are subject to state and local income tax examinations for the tax years May 31, 2004 through May 31, 2012 due to the carryover of net operating losses related to PDSG from previous years.

The table below summarizes our liability relating to unrecognized tax benefits under the authoritative guidance for the fiscal years ended May 31, 2013 and 2012:

Balance at June 1, 2011	$	6,588
Increase in unrecognized tax benefit liability		–
Decrease in unrecognized tax benefit liability		(4,075	)
Accrual of interest related to unrecognized tax benefits		–
Balance at May 31, 2012	$	2,513
Increase in unrecognized tax benefit liability		–
Decrease in unrecognized tax benefit liability		(2,513	)
Accrual of interest related to unrecognized tax benefits		–
Balance at May 31, 2013	$	–

Our liability relating to unrecognized tax benefits has been presented net of our prepaid income taxes on our consolidated balance sheet at May 31, 2012.

Our continuing practice is to recognize accrued interest and penalties related to unrecognized tax benefits as a component of tax expense. This policy did not change as a result of our adoption of the authoritative guidance on June 1, 2007. We do not expect our unrecognized tax benefits to change significantly over the next twelve months.

9. Commitments and Contingencies

Litigation

Patent Litigation

F- 23

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Commitments and Contingencies (continued)

Licensing Fee Dispute

In February 2013, PDS received a license fee installment attributable to the January 2013 satisfaction of a contingency contained in an MMP license agreement entered into in May 2012. Alliacense has asserted a claim against PDS for $300,000 under the premise that it is owed a percentage of the license fee installment pursuant to the Program Agreement it entered into with PDS, TPL and us in July 2012. TPL has also asserted a claim against PDS for $225,000 under the premise that it is owed a percentage of the license fee installment pursuant to the terms of the June 2005 Commercialization Agreement between PDS, TPL and us. Our position is that no percentage is due Alliacense as it had not been engaged for services at the time the May 2012 license agreement was entered into, and that it had no role in the satisfaction of the contingency that triggered the installment fee. Regarding TPL, our position is that a percentage to TPL could be justified, subject to, and fully offset by, advances previously made to it by PDS. We intend to vigorously defend our interest in PDS against the assertions made by Alliacense and TPL. While no amounts have been accrued in regards to these matters, we believe pursuant to the criteria defined in Accounting Standards Codification 450-20-50 Disclosure of Certain Loss Contingencies , it is reasonably possible PDS could recognize a charge to earnings in the range of $0 to $300,000.

401(k) Plan

We have a retirement plan that complies with Section 401(k) of the Internal Revenue Code. All employees are eligible to participate in the plan. We match 100% of elective deferrals subject to a maximum of 4% of the participant’s eligible earnings. Our participants vest 33% per year over a three year period in their matching contributions. Our matching contributions during the fiscal years ended May 31, 2013 and 2012 were $10,801 and $15,504, respectively.

F- 24

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

Commitments and Contingencies (continued)

PDSG had a retirement plan that complied with Section 401(k) of the Internal Revenue Code. All employees were eligible to participate in the plan and PDSG did not match participant voluntary contributions. On April 30, 2012 substantially all of the assets of PDSG were sold and the PDSG 401(k) plan was transferred to the purchaser’s 401(k) plan.

Employment Contracts

In connection with Mr. Flowers’ appointment as the Chief Financial Officer, and commencing on September 17, 2007, we entered into an employment agreement with Mr. Flowers for an initial 120-day term if not terminated pursuant to the agreement, with an extension period of one year and on a continuing basis thereafter. Pursuant to the agreement, if Mr. Flowers is terminated without cause or resigns with good reason any time after two years of continuous employment, he is entitled to receive an amount equal to twelve months of his annual base salary. Mr. Flowers is also entitled to certain payments upon a change of control of the Company if the surviving corporation does not retain him. All such payments are conditional upon the execution of a general release.

Guarantees and Indemnities

We have made certain guarantees and indemnities, under which we may be required to make payments to a guaranteed or indemnified party. We indemnify our directors, officers, employees and agents to the maximum extent permitted under the laws of the State of Delaware. In connection with our facility lease, we have indemnified our lessor for certain claims arising from the use of the facility. The duration of the guarantees and indemnities varies, and in many cases is indefinite. These guarantees and indemnities do not provide for any limitation of the maximum potential future payments we could be obligated to make. Historically, we have not been obligated to make any payments for these obligations and no liabilities have been recorded for these guarantees and indemnities in the accompanying consolidated balance sheets.

Escrow Shares

On August 31, 2009 we gave notice to the former shareholders of Crossflo and Union Bank of California (the “Escrow Agent”) under Section 2.5 of the Agreement and Plan of Merger between us and Crossflo (the “Agreement”), outlining damages incurred by us in conjunction with the acquisition of Crossflo, and seeking the return of 2,844,630 shares of our common stock held by the Escrow Agent. Subsequently, former shareholders of Crossflo representing a majority of the escrowed shares responded in protest to our claim, delaying the release of the escrowed shares until a formal resolution is reached. In the event we fail to prevail in our claim against the escrowed shares, we may be obligated to deposit into escrow approximately $256,000 of cash consideration due to the decline in our average stock price over the one year escrow period, calculated in accordance with the Section 2.5 of the Agreement. We have evaluated the potential for loss regarding our claim and believe that it is probable that the resolution of this issue will not result in a material obligation to the Company, although there is no assurance of this. Accordingly, we have not recorded a liability for this matter.

Operating Lease

We lease our facility through an operating lease that expires in January 2014. Rental expense is presented in the following table:

	Year Ended		Year Ended
	May 31, 2013		May 31, 2012
Rental expense	$	34,791	$	35,279

Future minimum payments under our operating lease commitment as of May 31, 2013 amount to $23,581.

F- 25

Patriot Scientific Corporation

Notes to Consolidated Financial Statements (Continued)

10. Subsequent Events

We have evaluated subsequent events after the balance sheet date and based on our evaluation, management has determined that no subsequent events have occurred that would require recognition in the accompanying consolidated financial statements or disclosure in the notes thereto other than as disclosed in the accompanying notes.

On June 4, 2013, we issued 760,000 stock options from our 2006 Stock Option Plan with an exercise price of $0.12 to our employees and directors. The options vested immediately upon issuance.

F- 26

Phoenix Digital Solutions, LLC

INDEX TO FINANCIAL STATEMENTS

		Page
Report of Independent Registered Public Accounting Firm		F-28
Financial Statements:
Balance Sheets		F-29
Statements of Operations		F-30
Statements of Members’ Equity (Deficit)		F-31
Statements of Cash Flows		F-32
Notes to Financial Statements		F-33

F- 27

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Members

Phoenix Digital Solutions, LLC

We have audited the accompanying balance sheets of Phoenix Digital Solutions, LLC (the "Company") as of May 31, 2013 and 2012, and the related statements of operations, members' equity (deficit) and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

As described in Notes 6, 8, and 9, the Company has extensive transactions with Technology Properties Limited, LLC and Alliacense Limited LLC both related parties. Accordingly, the accompanying financial statements may not be indicative of the financial position or results of operations that would have occurred had the Company operated without such related party relationships.

In our opinion, the financial statements referred to above, present fairly, in all material respects, the financial position of Phoenix Digital Solutions, LLC as of May 31, 2013 and 2012, and the results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

The accompanying financial statements have been prepared assuming the Company will continue as a going concern. As more fully described in Note 1 to the financial statements, because of the uncertain nature of the negotiations that lead to license revenues, there is no assurance that the Company will receive any future revenues from license agreements, or if it does, that such license revenues in the future will be consistent with amounts received in the past . These factors raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Our opinion is not modified with respect to this matter.

/s/ KMJ Corbin & Company LLP

Costa Mesa, California

August 22, 2013

F- 28

Phoenix Digital Solutions, LLC

Balance Sheets

May 31,	2013		2012

ASSETS

Current assets:
Cash	$	1,320,932	$	1,003,489
Prepaid expenses		717,540		–
Licenses receivable		250,000		–
Total assets	$	2,288,472	$	1,003,489

LIABILITIES AND MEMBERS’ EQUITY (DEFICIT)

Current liabilities:
Related party payables and accrued expenses	$	1,544,075	$	2,747,883
Income tax payable		11,790		11,790

Total liabilities		1,555,865		2,759,673

Commitments and Contingencies

Members’ equity (deficit)		732,607		(1,756,184	)

Total liabilities and members’ equity (deficit)	$	2,288,472	$	1,003,489

See accompanying notes to financial statements.

F- 29

Phoenix Digital Solutions, LLC

Statements of Operations

Years Ended May 31,	2013		2012

License revenues	$	12,570,000	$	4,029,300

Operating expenses:
General and administrative		7,548,619		7,673,461
Operating income (loss)		5,021,381		(3,644,161	)

Income (loss) before provision for income taxes and foreign taxes		5,021,381		(3,644,161	)

Provision for income taxes and foreign taxes		672,590		12,590

Net income (loss)	$	4,348,791	$	(3,656,751	)

See accompanying notes to financial statements.

F- 30

Phoenix Digital Solutions, LLC

Statements of Members’ Equity (Deficit)

Years Ended May 31, 2013 and 2012

Balance June 1, 2011	$	600,567
Contributions		1,300,000
Net loss		(3,656,751	)
Balance May 31, 2012		(1,756,184	)
Contributions		2,195,617
Distributions		(4,055,617	)
Net income		4,348,791
Balance May 31, 2013	$	732,607

See accompanying notes to financial statements.

F- 31

Phoenix Digital Solutions, LLC

Statements of Cash Flows

Years Ended May 31,	2013			2012
Operating activities:
Net income (loss)	$	4,348,791		$	(3,656,751	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Forgiveness of accounts payable		(376,049	)		(491,124	)
Changes in operating assets and liabilities:
Prepaid expenses		(717,540	)		600,000
Licenses receivable		(250,000	)		–
Related party payables and accrued expenses		(827,759	)		1,555,711
Net cash provided by (used in) operating activities		2,177,443			(1,992,164	)

Financing activities:
Contributions from members		2,195,617			1,100,000
Distributions to members		(4,055,617	)		–
Net cash (used in) provided by financing activities		(1,860,000	)		1,100,000
Net increase (decrease) in cash		317,443			(892,164	)
Cash , beginning of year		1,003,489			1,895,653
Cash , end of year	$	1,320,932		$	1,003,489

Supplemental Disclosure of Cash Flow Information:
Cash payments for income taxes	$	672,590	$	12,590

Supplemental Disclosure of Non-Cash Financing Activities:
In-kind capital contribution	$	–	$	200,000

See accompanying notes to financial statements.

F- 32

Phoenix Digital Solutions, LLC

Notes to Financial Statements

1. Organization and Business

Phoenix Digital Solutions, LLC (the “Company” or “PDS”) is a Delaware limited liability company organized on June 7, 2005. Through a commercialization agreement dated June 7, 2005 as amended in July 2012, the Company holds the rights to certain patents of its members. The Company receives license fees from license agreements entered into between licensees and the Company and distributes license fee proceeds to its members.

Basis of Presentation

The Company’s financial statements have been prepared using the accrual method of accounting in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and have been prepared on a going concern basis, which contemplates the realization of assets and the settlement of liabilities in the normal course of business.

Going Concern and Management’s Plans

At August 16, 2013, the Company’s cash balance was $206,605. The ability of PDS to continue as a going concern is dependent on its ability to generate or obtain sufficient cash to meet its obligations on a timely basis. The Company will need to generate proceeds from new license agreements or obtain equity or debt financing from its members to fund its planned operating expenses and working capital requirements for the foreseeable future. Currently, the Company has no commitments to obtain additional capital from sources outside of that which may be contributed by the members, and there can be no assurance that financing will be available in amounts or on terms acceptable to the Company, if at all.

Because of the uncertain nature of the negotiations that lead to license revenues, pending litigation with companies which the members believe have infringed on their patent portfolio, the possibility of legislative action regarding patent rights, and the possible effect of new judicial interpretations of patent laws, there is no assurance that the Company will receive any future revenues from license agreements, or if it does, that such license revenues in the future will be consistent with amounts received in the past.

In the event the Company is unable to successfully generate proceeds from license agreements at historical levels or obtain additional capital, it is unlikely that the Company will have sufficient cash flows and liquidity to finance its business operations as currently contemplated. Accordingly, in the event new financing is not obtained, the Company will likely reduce general and administrative expenses, including legal fees, litigation activity and other licensing costs, until it is able to obtain sufficient financing to do so.

On March 20, 2013, Technology Properties Limited Inc. (“TPL”) filed a petition under Chapter 11 of the United States Bankruptcy Code. Patriot Scientific Corporation (“PTSC”) has been appointed to the creditors’ committee and will be closely monitoring the progress in this matter as it relates to PTSC’s interest in PDS.

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed, the above conditions raise sufficient doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

2. Summary of Significant Accounting Policies

Limited Liability Company Operating Agreement

As a limited liability company, each member’s liability is limited to the capital invested. Allocation of profits, losses and distributions is in accordance with the terms as defined in the operating agreement.

F- 33

Phoenix Digital Solutions, LLC

Notes to Financial Statements (Continued)

Summary of Significant Accounting Policies (continued)

The Company is treated as a partnership for federal income tax purposes. Consequently, federal income taxes are not payable by the Company. The Company’s net income or loss is allocated among the members in accordance with the operating agreement of the Company and members are taxed individually on their share of the Company’s earnings. The State of California assesses a limited liability company fee based on the Company’s income in addition to a flat limited liability company tax. Accordingly the financial statements reflect a provision for these California taxes.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts and disclosures. Accordingly, actual results could differ from those estimates.

Revenue Recognition

The Company recognizes revenue from technology license agreements at the time a contract is entered into, the license method is determined (paid-in-advance or on-going royalty), performance obligations under the license agreement are satisfied, and the realization of revenue is assured which is generally upon the receipt of the license proceeds. The Company may at times enter into license agreements whereby contingent revenues are recognized as one or more contractual milestones are met.

Financial Instruments and Concentration of Credit Risk

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash.

At times, the Company’s balance of cash maintained with its bank may exceed the Federal Deposit Insurance Corporation’s (“FDIC”) insured limit of $250,000. At May 31, 2013, the Company’s cash balance subject to FDIC insurance exceeded the FDIC limit by $1,070,932. The Company limits its exposure of loss by maintaining its cash with financially stable financial institutions.

Legal Fees

For the year ended May 31, 2012, one legal service provider accounted for $2,609,573 of legal costs associated with the litigation of the Moore Microprocessor Patent (“MMP”) portfolio, this provider had no such costs for the year ended May 31, 2013. For the years ended May 31, 2013 and 2012 another legal service provider accounted for $2,082,638 and $2,474,072, respectively, of legal costs associated with the litigation of the MMP patent portfolio. These amounts are included in general and administrative expense in the accompanying statements of operations.

Intellectual Property Rights

The Company relies on a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures and licensing arrangements to protect its intellectual property rights. The Company currently licenses four unexpired U.S. patents issued dating back to 1997 on PTSC’s microprocessor technology in addition to three European and two Japanese patents. The U.S. patents will expire between 2014 and 2015 and the European and Japanese patents will expire in 2016. The Company also licenses three U.S. patents, six European, and one Japanese patent all of which expired between August 2009 and June 2013. These patents, while expired, may have certain retrospective statutory benefits that will fully diminish six years after the patent expiration date (e.g. for the expired U.S. patents). The patent useful life for purposes of negotiating licenses is finite and these patents are subject to legal challenges, which in combination with the limited life, could adversely impact the stream of revenues. A successful challenge to its ownership of the technology or the proprietary nature of the intellectual property would materially damage the Company’s business prospects. Any issued patent may be challenged and invalidated.

F- 34

Phoenix Digital Solutions, LLC

Notes to Financial Statements (Continued)

3. Fair Value of Financial Instruments

The Company’s financial instruments consist of cash, licenses receivable and certain of its accounts payable and accrued expenses. The carrying value of these financial instruments approximates fair value because of the immediate or short-term maturity of the instruments.

4. Prepaid Expenses

At May 31, 2013, prepaid expenses consist of:

	May 31, 2013
Prepaid Expenses	$	506,291
Retainers		211,249
Total	$	717,540

Prepaid expenses in the table above consist of the amount advanced to Alliacense Limited, LLC (“Alliacense”, an affiliate of TPL) in May 2013 for licensing services fees, less the amount of license fees earned for the quarter ended May 31, 2013. Also included in prepaid expenses are fees paid for the court reporter services for the U.S. International Trade Commission (“ITC”) trial held in June 2013.

Retainers in the table above consist of the balances with the court appointed Special Master and Technical Advisor in the United States District Court for the Northern District of California (“U.S. District Court”) and the amount the Company advanced to its current patent litigation firm for the ITC and U.S. District Court cases.

5. Licenses Receivable

At May 31, 2013, the balance in licenses receivable consists of a license agreement entered into during May 2013, for which payment was received by the Company during June and July 2013.

6. Formation of Joint Venture and Commercialization Agreement

The Company, a joint venture has two members: TPL, and PTSC. Each member owns 50% of the membership interests of the Company. Each member has the right to appoint one member of the three member management committee. The two appointees are required to select a mutually acceptable third member of the management committee. There has not been a third management committee member since May 2010.

F- 35

Phoenix Digital Solutions, LLC

Notes to Financial Statements (Continued)

Formation of Joint Venture and Commercialization Agreement (continued)

Contribution Requirements

Pursuant to the Company’s Limited Liability Company Operating Agreement (the “LLC Agreement”), the members agreed to establish a working capital fund for the Company of $4,000,000, of which each member contributed $2,000,000. The working capital fund increases to a maximum of $8,000,000 as license revenues are achieved. The members are obligated to fund future working capital requirements at the discretion of the management committee of the Company in order to maintain working capital of not more than $8,000,000. If the management committee determines that additional capital is required, neither member is required to contribute more than $2,000,000 in any fiscal year. Since there is currently not a third member of the management committee, working capital contributions made to the Company require the approval of both management committee members. During the fiscal years ended May 31, 2013 and 2012 PTSC and TPL each contributed $1,097,809 and $650,000, respectively, to the Company for working capital requirements. Distributable cash and allocation of profits and losses are allocated to the members in the priority defined in the LLC Agreement.

Joint Venture Contractual Agreements

On June 7, 2005, the Company entered into a Commercialization Agreement (the “Commercialization Agreement”) with TPL and PTSC. This Commercialization Agreement allows TPL to commercialize the patent portfolio by entering into settlement and/or license agreements, litigating in the name of TPL, PTSC, the Company and Charles Moore (“Moore”), and manage the use of the patent portfolio by third parties.

On July 11, 2012, the Company entered into a Licensing Program Services Agreement (the “Program Agreement”) with PTSC, TPL, and Alliacense creating an amendment to the Commercialization Agreement, and an Agreement (the “TPL Agreement”) between TPL and PTSC. Pursuant to the Program Agreement, the Company engaged Alliacense to negotiate MMP portfolio licenses and to pursue claims against violators of the MMP portfolio on behalf of the Company, TPL, and PTSC. The Program Agreement continues through the useful life of the MMP portfolio patents.

On July 17, 2012, the Company entered into an Agreement with PTSC, TPL, and Alliacense whereby the parties agreed to certain additional allocations of obligations relating to the Program Agreement.

Under terms of the Commercialization Agreement, the Company was required to pay a quarterly amount ranging between $500,000 and $1,000,000 (based upon a percentage of the working capital fund balance) to TPL for TPL’s supporting efforts to secure licensing agreements for the Company. During the years ended May 31, 2013 and 2012 the Company expensed $185,000 and $2,000,000, respectively, pursuant to the agreement. The Company is also required to reimburse TPL for payment of all legal and third-party expert fess and other related third party costs and expenses. During the years ended May 31, 2013 and 2012 the Company expensed $3,367,294 and $5,563,594, respectively, pursuant to the agreement.

Pursuant to the Program Agreement effective July 11, 2012, the Company has committed to Alliacense a quarterly amount of $500,000 which represents the licensing services fees due Alliacense, subject to a contingency arrangement which provides for a percentage on future revenues, for its efforts to secure licensing agreements on behalf of the Company. These payments can be capped at $2,000,000 pursuant to six-month notice from the Company, at which time the management committee will review and decide on future payments, if any. These payments replace the quarterly amounts previously paid to TPL pursuant to the Commercialization Agreement. During the fiscal year ended May 31, 2013, the Company expensed $1,815,000 pursuant to this contractual obligation.

F- 36

Phoenix Digital Solutions, LLC

Notes to Financial Statements (Continued)

Formation of Joint Venture and Commercialization Agreement (continued)

Pursuant to the Program Agreement effective July 11, 2012, the Company is contractually obligated to pay Alliacense litigation support fees relating to Alliacense’s special work and effort regarding internal costs related to MMP maintenance and litigation support including support in the U.S. District Court and the complaints filed on behalf of TPL, PTSC and the Company with the ITC. During the fiscal year ended May 31, 2013, the Company expensed $1,786,414 pursuant to this contractual obligation. Future litigation support payments to Alliacense relating to the ITC litigation are subject to a contingency arrangement which provides for a percentage of future recoveries in these actions.

During January 2013, TPL and Moore settled their litigation. Terms of the settlement include payment by the Company to Moore of a consulting fee of $250,000 for four years or until the completion of all outstanding MMP litigation whichever comes first. Per terms of the agreement the Company paid Moore $150,000 on the settlement date and will pay Moore $16,667 per month from August 2013 through January 2014 and $20,833 per month beginning February 2014 through January 2017.

Significant Contractual Legal Relationship

The Company has incurred legal fees from an unrelated law firm and legal subcontractors to provide substantial legal services for the commercialization of the MMP portfolio of microprocessor patents.

Accounts payable balances due this law firm and legal subcontractors as of May 31, 2013 and 2012 were $518,694 and $0, respectively.

Transactions with this law firm and legal subcontractors for the fiscal years ended May 31, 2013 and 2012 were as follows:

		May 31, 2013				May 31, 2012
Legal costs		$	3,689,419			$	2,474,072

7. Delinquent Accounts Payable

During the fiscal years ended May 31, 2013 and 2012, the Company reversed approximately $376,000 and $491,000, respectively, of legal fees previously expensed and recorded as accounts payable to TPL as the statute of limitations had expired. This reversal is recorded as a reduction of legal expenses in general and administrative expense in the accompanying statements of operations.

8. Commitments and Contingencies

Member Litigation

On October 6, 2011, PTSC settled a legal action. Pursuant to the executed settlement agreement with TPL, the Company agreed to pay TPL $172,000 for June 2011, and $86,000 per month thereafter until 60 days after the Markman hearing relating to TPL’s special work and effort regarding internal costs related to litigation support. Accordingly, the Company recognized $946,000 through May 31, 2012 pursuant to the executed settlement agreement. This amount has been recorded in general and administrative expense for the year ended May 31, 2012 in the accompanying statements of operations.

F- 37

Phoenix Digital Solutions, LLC

Notes to Financial Statements (Continued)

Commitments and Contingencies (continued)

Licensing Fee Dispute

In February 2013, the Company received a license fee installment attributable to the January 2013 satisfaction of a contingency contained in an MMP license agreement entered into in May 2012. Alliacense has asserted a claim against the Company for $300,000 under the premise that it is owed a percentage of the license fee installment pursuant to the Program Agreement it entered into with Patriot, TPL and the Company in July 2012. TPL has also asserted a claim against the Company for $225,000 under the premise that it is owed a percentage of the license fee installment pursuant to the terms of the June 2005 Commercialization Agreement between Patriot, TPL and the Company. The Company’s position is that no percentage is due Alliacense as it had not been engaged for services at the time the May 2012 license agreement was entered into, and that Alliacense had no role in the satisfaction of the contingency that triggered the installment fee. Regarding TPL, the Company’s position is that a percentage to TPL could be justified, subject to, and fully offset by, advances previously made to it by the Company. The Company intends to vigorously defend itself against the assertions made by Alliacense and TPL. While no amounts have been accrued in regards to these matters, the Company believes pursuant to the criteria defined in Accounting Standards Codification 450-20-50 Disclosure of Certain Loss Contingencies , it is reasonably possible the Company could recognize a charge to earnings in the range of $0 to $300,000.

Guarantees and Indemnities

Under the LLC Operating Agreement, the Company indemnifies its members, managers, officers and employees from any damages and liabilities by reason of their management or involvement in the affairs of the Company as long as the indemnitee acted in good faith and in the best interests of the Company.

Under the Commercialization Agreement, the Company and PTSC hold harmless TPL and its representatives with respect to all claims of any nature by or on behalf of the Company and PTSC related to the preparation, execution and delivery of duties and responsibilities under the Commercialization Agreement.

The duration of the guarantees and indemnities varies, and in many cases is indefinite. These guarantees and indemnities do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. Historically, the Company has not been obligated to make any payments for these obligations and no liabilities have been recorded for these guarantees and indemnities in the accompanying balance sheets.

Contractual Commitments

In January 2013, the Company entered into a contractual commitment with a related party entity to provide consulting services at a cost of $250,000 per year for duration of four years or the completion of all outstanding MMP litigation, whichever comes first.

For the fiscal year ended May 31, 2013, the Company expensed $150,000 related to this agreement.

In connection with the Program Agreement, the Company is required to make payments to Alliacense of $500,000 no later than three days prior to the start of each calendar quarter. Such payments are non-accountable and non-recoupable, but are offset against the licensing fees owed to Alliacense pursuant to the Program Agreement. Upon six months notice to Alliacense, and in conjunction with a proportionate reduction in the scope of the Project Description, as defined, the Company may determine to implement a maximum of advances not-yet-offset of $2,000,000.

F- 38

Phoenix Digital Solutions, LLC

Notes to Financial Statements (Continued)

9. Related Party Transactions

During the fiscal year ended May 31, 2013, TPL and PTSC each contributed $1,097,809 to the Company for working capital obligations.

During the fiscal year ended May 31, 2012, TPL contributed $450,000 in cash and forfeited rights to $200,000 of special litigation support payments due it for an in-kind capital contribution of $200,000 and PTSC contributed $650,000 to the Company for working capital obligations.

Per the Commercialization Agreement, the Company had committed to pay a quarterly amount ranging between $500,000 and $1,000,000 (based upon a percentage of the working capital fund balance of the Company) for supporting efforts to secure licensing agreements by TPL on behalf of the Company. During the fiscal years ended May 31, 2013 and 2012 the Company expensed $185,000 and $2,000,000, respectively, pursuant to this commitment.

During the fiscal year ended May 31, 2012, the Company expensed $946,000 pursuant to various settlement agreements with TPL (see Note 6) for TPL’s special work and effort regarding internal costs related to litigation support and patent re-examinations.

During the fiscal years ended May 31, 2013 and 2012, the Company expensed $3,367,294 and $4,617,594, respectively, for reimbursement of legal and related fees incurred by TPL due to patent litigation. These legal fees are net of $376,049 and $491,124, respectively, of legal fee reversals previously expensed and recorded as accounts payable to TPL during the fiscal years ended May 31, 2013 and 2012, as the statute of limitations had expired.

During the fiscal years ended May 31, 2013 and 2012, the Company expensed $194,422 and $104,377, respectively, for reimbursement of legal and related fees incurred by PTSC due to patent litigation.

Pursuant to the Program Agreement, the Company has committed to Alliacense a quarterly amount of $500,000 which represents the licensing services fees due Alliacense, subject to a contingency arrangement which provides for a percentage on future revenues, for its efforts to secure licensing agreements on behalf of the Company. These payments can be capped at $2,000,000 pursuant to six-month notice from the Company, at which time the management committee will review and decide the warranting of future payments. These payments replace the quarterly amounts previously paid to TPL pursuant to the Commercialization Agreement. During the fiscal year ended May 31, 2013 Alliacense earned $1,858,647 pursuant to this contingency commitment.

Pursuant to the Program Agreement, the Company has committed to pay Alliacense litigation support fees relating to Alliacense’s special work and effort regarding internal costs related to MMP maintenance and litigation support including support in the U.S. District Court and the complaints filed on behalf of TPL, PTSC and the Company with the ITC. During the fiscal year ended May 31, 2013, the Company expensed $1,786,414 pursuant to this commitment

At May 31, 2013, the Company had prepaid expenses (advances to Alliacense) of approximately $456,000.

At May 31, 2013, the Company had accounts payable balances of approximately $1,494,000, $34,000 and $17,000 to TPL, Alliacense, and PTSC, respectively, for direct expenses and third party fees incurred by TPL, Alliacense, and PTSC.

At May 31, 2012, the Company had accounts payable and accrued expenses balances of approximately $2,611,000 and $137,000 to TPL and PTSC, respectively, for direct expenses and third party fees incurred by TPL and PTSC.

F- 39

Phoenix Digital Solutions, LLC

Notes to Financial Statements (Continued)

Related Party Transactions (continued)

A summary of related party transactions described above is as follows:

Related party transactions as of May 31,	2013		2012

Advances to Alliacense	$	456,353	$	–
Accounts payable and accrued expenses due TPL	$	1,493,775	$	2,610,615
Accounts payable due Alliacense		33,762		–
Accounts payable due PTSC		16,538		137,268
Total payables and accrued expenses	$	1,544,075	$	2,747,883

Contributions (50% from TPL and PTSC)	$	2,195,617	$	1,300,000
Distributions (50% to TPL and PTSC)	$	4,055,617	$	–

Related party transactions for the years ended May 31,	2013			2012

PTSC Commercialization Agreement payments	$	185,000		$	2,000,000
Settlement costs expensed and paid or accrued to TPL		–			946,000
TPL legal fees and reimbursements expensed		3,743,343			5,108,718
Reversal of legal fees previously expensed as accounts payable to TPL		(376,049	)		(491,124	)
Total TPL expenses paid or accrued	$	3,552,294		$	7,563,594

Alliacense litigation support fees	$	1,786,414		$	–
Alliacense license fees earned		1,858,647			–
Total Alliacense expenses paid or accrued	$	3,645,061		$	–

PTSC legal fees and reimbursements expensed	$	194,422		$	104,377
Payments to Charles Moore per TPL and Moore litigation settlement	$	150,000		$	–

10. Subsequent Events

The Company has evaluated subsequent events after the balance sheet date and based on its evaluation, management has determined that no subsequent events have occurred that would require recognition in the accompanying financial statements or disclosure in the notes thereto other than as disclosed in the accompanying notes.

F- 40

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.

DATED: August 22, 2013	PATRIOT SCIENTIFIC CORPORATION

	/s/ CLIFFORD L. FLOWERS
	Clifford L. Flowers
	Interim Chief Executive Officer and Chief Financial Officer (Duly Authorized and Principal Financial Officer)

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