FCSE Focus Enhancements (MM)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.                                       Description of Business

Incorporated in 1992, Focus Enhancements, Inc. and its subsidiaries (the “Company” or “Focus”) develop and market proprietary video technology in two areas: semiconductor and systems. Semiconductor products include several series of Application Specific Integrated Circuits (“ASICs”), which address the wireless video and data market using Ultra Wideband (“UWB”) technology and the video convergence market. The UWB ASICs are targeted for the wireless USB (Universal Serial Bus) market while the video convergence chips are deployed in portable media players, GPS navigation devices, video conferencing systems, media center and interactive TV applications. Focus systems products are designed to provide solutions for the professional video production market particularly for the video acquisition, media asset management and digital signage markets. Focus markets its systems products primarily through the professional channel. Focus production products include video scan converters, video mixers, standard and high definition digital video disk recorders, MPEG (Moving Picture Experts Group) recorders and file format conversion tools. Focus media asset management systems products include network-based video servers, long-duration program monitors and capture/playout components. Focus digital signage and retail media solutions products include standard and high definition MPEG players and servers. Focus markets its products globally to original equipment manufacturers (“OEMs”), and dealers and distributors in the consumer and professional channels.

2.                                       Basis of Presentation — Interim Financial Information

The accompanying unaudited condensed consolidated financial statements of Focus have been prepared in conformity with accounting principles generally accepted in the United States of America and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not contain all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. The year-end condensed consolidated balance sheet data was derived from audited consolidated financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

In the opinion of management, the condensed consolidated financial statements include all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of Focus’ financial position, operating results and cash flows for the periods presented. The results of operations and cash flows for the nine months ended September 30, 2007 are not necessarily indicative of the results that may be expected for any future period.

The condensed consolidated financial statements of Focus as of September 30, 2007 and for the three and nine-month periods ended September 30, 2007 and 2006 are unaudited and should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2006 included in Focus’ Annual Report on Form 10-K for the year ended December 31, 2006.

3.                                       Equity-Based Compensation

Focus accounts for equity-based compensation in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”), which the Company adopted as of January 1, 2006 using the modified prospective method.

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The share-based compensation recognized for the three and nine months ended September, 2007 and 2006, respectively, was:

Stock Options

The exercise price of each stock option equals the market price of Focus’ common stock on the date of grant. Option grants generally vest over four years and expire 10 years from the grant date. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model. The weighted average assumptions used in the model are outlined in the following table:

The zero dividend yield is based on the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends. Expected volatility is based on the combination of historical volatility of the Company’s common stock and the expected moderation in future volatility over the period commensurate with the expected life of the options and other factors. The risk-free interest rates are taken from the Daily Federal Yield Curve Rates as of the grant dates as published by the Federal Reserve and represent the yields on actively traded Treasury securities for terms equal to the expected term of the options. The expected term calculation is based on the Company’s observed historical option exercise behavior and post-vesting forfeitures of options by employees.

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A summary of activity related to Focus’ stock option incentive plans for the nine months ended September 30, 2007 is presented below:

The weighted average grant date fair value of options granted during the three and nine months ended September 30, 2007 was $0.55 and $0.79 per share, respectively. The intrinsic value of options exercised during the nine months ended September 30, 2007 was $17,000. No options were exercised in the three month period ended September 30, 2007. At September 30, 2007, Focus had $1,060,000 of unrecognized compensation expense, net of estimated forfeitures, related to unvested stock options, which will be recognized over the weighted average period of 2.0 years. Cash received from stock option exercises was $80,000 for the nine months ended September 30, 2007.

The weighted average grant date fair value of options granted in the three and nine months ended September 30, 2006 was $0.72 and $0.51 per share, respectively. The intrinsic value of options exercised during the three and nine months ended September 30, 2006 was $145,000 and $194,000, respectively. Cash received from stock option exercises was $399,000 and $856,000 for the three and nine months ended September 30, 2006, respectively.

The options outstanding and exercisable at September 30, 2007 were in the following exercise price ranges:

At September 30, 2007, Focus had 1,928,567 shares of common stock available for grant under its current stock option and incentive plans, which include restricted stock.

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At September 30, 2007, Focus had $830,000 of unrecognized compensation expense, net of forfeitures, related to restricted stock awards, which will be recognized over the weighted average period of 2.8 years. During the nine months ended September 30, 2007, 197,266 shares of restricted stock with a fair market value of $258,000 vested. No restricted stock vested during the three months ended September 30, 2007. During the nine months ended September 30, 2006, 61,250 shares of restricted stock with a fair market value of $41,000 vested. No restricted stock vested during the three months ended September 30, 2006.

4.                                       Net Loss per Share

Basic net loss per share was computed by dividing the net loss by the weighted average number of shares of common stock outstanding during the period. Diluted net loss per share is computed by dividing the net loss by the weighted average number of shares of common stock and potential common stock equivalents outstanding during the period, if dilutive. Options to purchase 5,644,105 and 6,507,857 shares of common stock, unvested shares of restricted stock of 1,105,467 and 730,307, warrants to purchase 5,752,447 and 5,195,261 shares of common stock and 3,161 shares of preferred stock convertible into 3,161,000 shares of common stock were outstanding at September 30, 2007 and 2006, respectively, but were not included in the computation of diluted net loss per share as the effect would have been anti-dilutive. In addition, promissory notes that are convertible into 11,493,000 and 10,425,000 shares of common stock were outstanding at September 30, 2007 and 2006, respectively, but were not included in the computation of diluted net loss per share as the effect would have been anti-dilutive.

5.                                       Significant Customers

Sales to one customer accounted for 14% of Focus’ revenue in the three months ended September 30, 2007.  Sales to one customer accounted for 13% of Focus’ revenue in the nine months ended September 30, 2007. Sales to one customer accounted for 48% of Focus’ revenue in the three months ended September 30, 2006.  Sales to one customer accounted for 26% of Focus’ revenue in the nine months ended September 30, 2006.

Two customers had accounts receivable balances in excess of 10% of Focus’ total accounts receivable at September 30, 2007. These customers accounted for 27% of Focus’ total accounts receivable at that date . One customer had an accounts receivable balance in excess of 10% of Focus’ total accounts receivable at September 30, 2006. This customer accounted for 24% of Focus’ total accounts receivable at that date .

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6.                                       Goodwill and Intangible Assets

Goodwill as of September 30, 2007 and December 31, 2006 included the following :

The following tables provide a summary of the carrying amounts of intangible assets:

7.                                       Inventories

Inventories are stated at lower of cost (first-in, first-out) or market:

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8.                                       Borrowings

Accounts Receivable-Based Line of Credit

In November 2004, Focus obtained a $4.0 million line of credit from Greater Bay Bank (“the Bank”) under which it can borrow up to 90% of its eligible outstanding accounts receivable. The credit line expires on February 23, 2008 as a result of an extension granted in February 2007 and is collateralized by a personal guarantee from Carl Berg, a Company director and shareholder. In connection with this credit line, the Bank has obtained a first priority security interest in Focus’ accounts receivable through an agreement with Mr. Berg, which enables Mr. Berg to retain his existing security interest in all of Focus’ assets while subordinating his pre-existing security interest in Focus’ accounts receivable. In connection with the February 2007 extension, Focus agreed to pay loan commitment fees of $22,500 and agreed to issue a warrant to the Bank to purchase 48,148 shares of common stock at an exercise price of $1.35 per share. In addition, Mr. Berg agreed to continue to personally guarantee both the $4.0 million accounts receivable-based line of credit and the $2.5 million term loan to the Bank. In connection with Mr. Berg’s continued extension of his personal guarantee, Focus agreed to issue to Mr. Berg a warrant to purchase 48,148 shares of common stock at an exercise price of $1.35 per share. The warrants issued in this extension transaction were valued at $26,000 using the Black-Scholes option pricing model. The warrant issued to the Bank will be amortized to interest expense over the term of the line of credit and the warrant issued to Mr. Berg was charged to general and administrative expense at the time of issuance.

The credit line is subject to ongoing covenants including a covenant based on operating results. Borrowings under the credit line bear interest at a rate of prime plus 1%, which was 8.75% at September 30, 2007. At September 30, 2007, there was an outstanding balance on this credit line of $4.0 million. Based on Focus' September 30, 2007 eligible account receivable, the maximum amount available to borrow was $3.6 million. Therefore, on October 16, 2007 Focus repaid $400,000 under the line of credit. The credit line expires on February 28, 2008.

Term Loan

On June 28, 2005, Focus signed a term loan agreement with the Bank under which Focus can borrow up to $2.5 million. The term loan expires on February 23, 2008 as a result of extensions granted in February and March 2007. Mr. Berg has personally guaranteed the loan, which is interest only until maturity and is in addition to Focus’ existing $4.0 million accounts receivable-based secured line of credit that Focus has with the Bank. Interest is payable under this term loan at prime plus 1%, which was 8.75% at September 30, 2007. At September 30, 2007, there was an outstanding balance under this term loan of $1.7 million, which gave Focus the ability to borrow an additional $800,000 to the maximum amount of $2.5 million.

Convertible Notes

On January 27, 2006, Focus issued $10.0 million in aggregate principal amount of 10% secured convertible notes due January 1, 2011 to certain purchasers. The following are the key features of the notes:

•                   Interest accrues on the principal amount of the notes at a rate of 10% per annum, payable semi-annually on June 30 and December 30 of each year.

•                   Interest due on the first three semi-annual payments may, at the issuers option, be paid in the form of a note with the same terms and conditions of the original notes, including conversion rights.

•                   The notes are convertible, at the option of the holder, into shares of Focus common stock at a conversion price of $1.00 per share. The conversion price is subject to adjustment for stock splits, reverse stock splits, recapitalizations and similar corporate actions.

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•                   The notes are collateralized by all of the assets of Focus in accordance with the terms and subject to the conditions contained in a security agreement entered into concurrently with the issuance of the notes.

•                   The notes are redeemable, at the option of Focus, at any time at a redemption price equal to 102% times the face rate of the notes, plus any accrued interest.

•                   Upon a fundamental change, which includes a change in control of Focus or failure of Focus’ common stock to be listed for quotation on the Nasdaq Stock Market or another established automated over-the-counter trading marking in the United States, each holder of the notes may require Focus to repurchase all of its debt at a purchase price equal to 101% of the principal amount of the notes plus accrued and unpaid interest.

Pursuant to a Registration Rights Agreement with the Purchasers dated January 24, 2006 (the “Registration Rights Agreement”), Focus agreed to file a resale registration statement covering the resale of the shares issuable to the investors upon the conversion of the notes. The due date may accelerate in the event Focus commences any case relating to bankruptcy or insolvency, or related events of default.

On June 30, 2007, December 30, 2006 and June 30, 2006, Focus issued additional notes in the amounts of $547,167, $521,250 and $425,000, in lieu of the cash interest payments due on June 30, 2007, December 30, 2006 and June 30, 2006, respectively. These notes retain the same terms and conditions as the $10.0 million convertible notes issued on January 27, 2006.

9.                                       Commitments and Contingencies

Research and Development Agreements

In October 2004, Focus entered into a design services contract under which Focus agreed to pay $2.9 million to a third party for the design and development of high performance UWB integrated circuits. The contract amount was subsequently increased to $3.2 million. Payments were made upon the completion of specific milestones by the third party. The contract was completed in April 2007.

For the three months ended September 30, 2007, there were no expenses related to this project, which was completed in April 2007. For the three months ended September 30, 2006, $58,000 was charged to research and development based on the level of effort incurred by the third party. For the nine months ended September 30, 2007, research and development expenses were reduced by $117,000 upon a final reconciliation of time and materials related to the contract. For the nine months ended September 30, 2006, $467,000 was charged to research and development based on the level of effort incurred by the third party. No amounts related to this contract were included within the condensed consolidated balance sheet at September 30, 2007. At December 31, 2006, $141,000 was included within other accrued liabilities on the condensed consolidated balance sheet.

In September 2007, Focus entered into a design services contract under which Focus agreed to pay approximately $1.3 million to a third party for the design and development of new UWB integrated circuits. Payments will be made upon the completion of specific milestones by the third party. Work had not begun as of September 30, 2007.

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Leases

Focus leases office facilities and certain equipment under operating and capital leases. Under the lease agreements, Focus is obligated to pay for utilities, taxes, insurance and maintenance.

Minimum lease commitments at September 30, 2007 were as follows:

Inventory Purchase Commitments

Under contract manufacturing arrangements, contract manufacturers procure inventory to manufacture products based upon a forecast of customer demand provided by Focus. Focus is responsible for the financial impact on the contract manufacturer of any reduction or product mix shift in the forecast relative to materials that the contract manufacturer had already purchased, and is unable to return, under a prior forecast. Such a variance in forecasted demand could require a cash payment for finished goods in excess of current customer demand or for costs of excess or obsolete inventory.

At September 30, 2007, Focus had issued non-cancelable purchase orders for approximately $1.3 million for finished goods from its contract manufacturers, and had not incurred any significant liability for finished goods in excess of current customer demand or for the costs of excess or obsolete inventory.

Product Warranty Costs.

Focus’ warranty period for its products is generally 90 days to two years. Focus accrues for warranty costs, based on estimated warranty return rates and costs to repair, at the time revenue is recognized. At September 30, 2007 and December 31, 2006, Focus’ reserves for warranty costs were $159,000 and $191,000, respectively.

Changes in Focus’ product warranty liability during the nine months ended September 30, 2007 and 2006 were as follows:

General

From time-to-time, Focus is party to certain claims and legal proceedings that arise in the ordinary course of business which, in the opinion of management, will not have a material adverse effect on Focus’ financial position or results of operation.

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10.                                Stockholders’ Equity

As of September 30, 2007, Focus was obligated under certain circumstances, to issue the following additional shares of common stock pursuant to derivative securities, instruments or agreements:

In September 2007, Focus entered into two separate transactions with certain investors, relating to the issuance and sale of (i) 2,272,728 shares of Focus common stock at a purchase price of $0.88 per share and warrants to purchase 568,182 shares of common stock at an exercise price of $1.05 per share and (ii) 3,863,635 shares of common stock at a purchase price of $0.88 per share and warrants to purchase 965,910 shares of Focus common stock at an exercise price of $1.05 per share. In aggregate, Focus sold 6,136,363 shares of common stock and issued warrants to purchase an additional 1,534,092 shares of common stock. In connection with this transaction Focus received net proceeds of approximately $4.9 million.

In February 2007, Focus entered into two separate transactions with certain investors, relating to the issuance and sale of (i) 4,500,000 shares of Focus common stock at a purchase price of $1.26 per share and warrants to purchase 450,000 shares of common stock at an exercise price of $2.00 per share and (ii) 500,000 shares of common stock at a purchase price of $1.26 per share and warrants to purchase 50,000 shares of Focus common stock at an exercise price of $2.00 per share. In aggregate, Focus sold 5,000,000 shares of common stock and issued warrants to purchase an additional 500,000 shares of common stock. In connection with this transaction Focus received net proceeds of approximately $6.2 million.

During the nine months ended September 30, 2007, Focus repurchased 19,612 shares of common stock for $25,000 and included the repurchased shares in treasury stock at September 30, 2007. Such shares had originally been issued in connection with the Company’s stock compensation plans as restricted stock.

11.                                Related Party Transactions

Carl Berg

In December 2002, Mr. Berg provided Samsung Semiconductor Inc., one of Focus’ contracted ASIC manufacturers, with a personal guarantee to secure Focus’ working capital requirements for ASIC purchase order fulfillment. Mr. Berg provided the personal guarantee without additional cost or collateral, as Mr. Berg maintains a secured priority interest in substantially all of Focus’ assets. At September 30, 2007, Focus owed Samsung $239,000 under net 30 terms.

In November 2004, Focus secured a line of credit of up to $4.0 million under which Focus could borrow up to 90% of its eligible outstanding accounts receivable. This line of credit is secured by a personal guarantee from Mr. Berg. In connection with this line of credit, the Bank obtained a priority security interest in Focus’ accounts receivable. Mr. Berg will maintain his security interest in all Focus’ assets, subject to the Bank’s lien on accounts receivable.

On March 19, 2007, as described above in Note 8, Mr. Berg received a warrant to purchase 48,148 shares of common stock in connection with Mr. Berg maintaining his personal guarantee of the term loan and accounts receivable-based line of credit, which were both extended to February 23, 2008. The warrant was issued at $1.35 per share and expires on March 19, 2012. The warrant was valued at $26,000 using the Black-Scholes option pricing model and was charged to general and administrative expense at the time of issuance.

In connection with the $10.0 million convertible note financing completed in January 2006, Focus entered into an amendment to the Intercreditor Agreement by and among the Bank, Mr. Berg and Focus, pursuant to which the  Bank, Mr. Berg and the holders of the notes defined their relative rights and priorities with respect to the shared collateral, with the Bank having a first priority security interest in certain specified collateral of Focus and an Intercreditor Agreement specifying the shared interests of the note holders and Mr. Berg in the collateral securing both the notes (all of Focus’ assets) and Mr. Berg’s guaranty of Focus’ obligations to the  Bank, all subject to the priority security interest of the Bank in such respective collateral.

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Dolby Laboratories Inc.

N. William Jasper Jr., the Chairman of Focus’ Board of Directors, is also the President and Chief Executive Officer of Dolby Laboratories, Inc. (“Dolby”), a signal processing technology company located in San Francisco, California. Focus is required to submit quarterly royalty payments to Dolby based on Dolby technology incorporated into certain products. For the three months ended September 30, 2007 and 2006, Focus paid Dolby $9,000 and $8,000, respectively, in royalties, which were recorded in cost of revenue. For the nine months ended September 30, 2007 and 2006, Focus paid Dolby $30,000 and $17,000, respectively in royalties, which were recorded in cost of revenue. Focus’ arrangements with Dolby are on standard commercial terms.

Norman Schlomka

Norman Schlomka, General Manager of COMO and an executive officer of Focus since February 2006, owns one third of the building, located in Raisdorf, Germany, that COMO occupies. For the three month periods ended September 30, 2007 and 2006, Focus paid rent related to this building of approximately $24,000 and $15,000, respectively. For the nine months ended September 30, 2007 and 2006, Focus paid rent related to this building of approximately $72,000 and $45,000, respectively. The rent is on commercial terms deemed to be fair market value and comparable to other rents in the area.

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12.          Business Segment Information

Focus’ reportable segments are Systems and Semiconductor. These reportable segments have distinct products — Systems consists of products designed to provide solutions in video acquisition, media asset management and digital signage and Semiconductor consists of ASICs. Focus’ chief operating decision maker is the CEO.

Focus evaluates segment performance based on operating income (loss) and does not allocate net interest, other income or taxes to operating segments. Additionally, Focus does not allocate assets by operating segment.