COMPUDYNE CORP
CompuDyne  Corporation (the "Company") was  reincorporated in Nevada in 1996. We were originally  incorporated in 1952. We believe that we are a leading provider of products  and  services to the public  security  markets.  We operate in four distinct  segments:  Institutional  Security Systems ("ISS");  Attack Protection ("AP");  Integrated  Electronic  Systems ("IES");  and Public Safety and Justice ("PS&J").  Revenues from external  clients,  gross profit,  pre-tax income and total assets for each  segment for the last three years are  discussed  in footnote 19 to the consolidated financial statements.  Four Business Segments - ----------------------  Institutional Security Systems  The  Institutional  Security  Systems  segment is  headquartered  in Montgomery, Alabama and operates under the trade name Norment  Security  Group  ("Norment"). The  clients  this  segment  serves   consist   primarily  of  state  and  local governmental  units.  This segment  provides  physical and  electronic  security products and services to the corrections industry (prisons and jails) and to the courthouse, municipal and commercial markets. ISS, through a network of regional offices,  provides  field level design,  installation  and  maintenance  of both physical and electronic security products.  Key products and services of the Institutional Security Systems segment include:       o    MaxWall: a modular steel, concrete-filled, prefabricated jail cell.       o    Airteq: a complete line of pneumatic and electro-mechanical  operating           devices, locks and hardware.       o    Integrated Security Systems: integrated central control and monitoring           products  for  locking,   paging,  audio,  closed  circuit  television           cameras, nurse call and duress signals.       o    Hardline products and construction services.  Attack Protection  The Attack Protection  segment is one of the country's largest  manufacturers of bullet,  blast and attack resistant windows and doors. The ultimate clients this segment  serves  consist  primarily  of units of the Federal  Government.  These products  are  designed  for  high  security  applications  such  as  embassies, courthouses and Federal buildings.  We also provide our products and services to corporate  headquarters  and other  facilities  requiring  the highest  level of protection  currently  available.  We believe that we are a premier  provider of Underwriters  Laboratory  ballistic standard UL-752 Level 8 security windows and doors,  the highest rating level of commercial  ballistic  security  windows and doors.  Additionally,  this segment  designs and installs  both fixed and pop-up bollards and barrier security systems.  Key products of the Attack Protection segment include:       o    Bullet  and  Blast  Protection:  integrated  and  structurally  secure           bullet, blast and attack resistant windows and doors.       o    Vehicle  Intrusion  Barriers:  fixed,  removable,  semi-automatic  and           automatic vehicle bollards and wedge barrier security systems.       o    Fiber SenSys: a sophisticated  fiber optic  monitoring  system used to           detect physical intrusion.       o    SecurLAN:  integrated  security  management  system designed to detect           intrusion  attempts  aimed at  secure  and  classified  communications           networks.                                          2     Integrated Electronic Systems  The  Integrated   Electronic   Systems  segment   consists  of  our  subsidiary, CompuDyne-Integrated Electronics Division, LLP. Our IES segment provides turnkey design, production,  installation, and integration of public security and safety systems.  The ultimate clients this segment serves consist primarily of units of the  Federal  Government.   This  segment  is  a  security  systems  integrator, specializing in a wide range of customized systems, including:       o    Access Control and Biometric      o    Asset Tracking      o    Badging and Identification      o    Barriers and Turnstiles      o    Command, Control, and Communications      o    Computer Aided Dispatch (CAD)/ Records Management      o    Electronic Article Surveillance      o    Fencing, Lighting, Uninterrupted Power      o    Fire/Life Safety      o    Information Technology      o    Intrusion Detection (Exterior, Interior, and Duress)      o    Fiber Optic Network      o    Perimeter Security      o    Smart Card      o    Surveillance and Assessment  Our IES segment provides  central station  oversight and control of multiple and separate  facilities  as well as security  and public  life  safety  systems and equipment.  Key products and services of the IES segment include:       o    Regionalization  Systems: Command and control centers that consolidate           the operation and management of 911 emergency services (fire,  rescue,           and  police),  radio  frequency  communications,  intrusion  detection           systems,  access control systems,  and video surveillance  systems for           multitudes of buildings at diverse geographical locations. This system           centralizes monitoring and dispatch functions,  maximizing utility and           efficiency of all resources.       o    Waterside Sentry Systems:  Multi-functional  security systems designed           to detect, alert, monitor, track, and record water-based and shoreline           attack threats.       o    Flightline Sentry Systems:  An integration of surveillance,  intrusion           detection,  access control, and other electro/mechanical  systems in a           comprehensive,  "layered"  approach to security,  which begins  inside           operations  centers and  extends  beyond  base  perimeters,  providing           protection against both overt and covert acts of aggression.       o    Signals Intelligence+ (SigInt) Systems:  Signal gathering and analysis           products and systems used for field-based  collections and monitoring,           providing the U.S.  intelligence  community and U.S.  allies with real           time intelligence for strategic and tactical decision making.  Public Safety and Justice  The Public Safety and Justice segment  consists of  CompuDyne-Public  Safety and Justice, Inc. (formerly Tiburon, Inc. ("Tiburon")), CorrLogic, LLC, the recently acquired  subsidiary Xanalys  Corporation and the acquired assets of 90 Degrees, Inc. ("90 Degrees") and Copperfire Software Solutions, Inc. ("Copperfire").  The clients this segment  serves consist  primarily of state and local  governmental units.  This segment  provides a fully  integrated  suite of products  including computer-assisted  dispatch, records management and court and probation software systems  for the law  enforcement,  fire and  rescue,  corrections  and  justice environments.  We  believe  that  we  are  a  worldwide  market  leader  in  the development,  implementation and support of public safety and justice automation systems. Tiburon, acquired by us in 2002, has been in business since 1980.  Key products and services of the Public Safety and Justice segment include:                                          3          o    Dispatch  Systems:  computer-assisted  dispatch  systems  designed for           first responders such as police,  fire and emergency medical personnel           that feature peer-to-peer technology that is less vulnerable to server           and database failures.       o    Records Management  Systems:  integrated  software modules to automate           today's law  enforcement and fire  protection  agencies,  from initial           incident entry to final disposition and related state reporting.       o    Mobile  Computing  Systems:  solutions that provide  instant access to           computer  assisted  dispatch  and  records  management  systems by law           enforcement and emergency personnel in the field.       o    Inmate Management Systems: development,  implementation and support of           complex, integrated inmate management software systems.       o    Investigative analysis software systems.  Substantially all of the Company's  research and development  expenditures occur in the PS&J segment.  The PS&J segment  incurred $7.8 million,  $7.1 million and $7.1 million of research and  development  expenses in the years ended  December 31, 2005, 2004 and 2003, respectively.  The Market - ----------  The market  opportunity for jail and prison  security  systems is related to new facility  construction,  existing  facility  renovations,  and the trend towards outsourcing government services. We believe approximately $3.0-$3.5 billion will be spent  in 2006 on  correctional  facility  construction,  of which  typically between 10% and 15% relates to security equipment and security electronics,  the markets that we currently  serve. Our modular cell product,  Maxwall,  generally constitutes  an  additional  10% to 15% of  the  overall  facility  construction budget.  Other  larger  security  markets  we  serve  include  state  and  local government  facilities,  federal  government  facilities  and  large  commercial installations.  In all four  segments of our business,  we face  considerable  competition  from large and small  companies.  We  compete  primarily  on a price  basis  with our competitors.  While  we  are  one of  the  largest  suppliers  of  physical  and electronic  security  to the  corrections  industry,  we  have  one  significant competitor and many small competitors.  Most of our business occurs on a bid or request for proposal  basis.  Because of the bid and request for proposal process, we do not generally have access to the underlying  assumptions  that resulted in our  competitors'  bids and therefore, other than price, we cannot determine why our bid was successful or unsuccessful for particular contracts. Much of the Integrated Electronic Systems work is on a cost  recoverable  basis and is subject to audit by the Defense  Contract  Audit Agency.  The Public Safety and Justice segment  competes in a market where the annual new solution  spending is approximately  $2 billion.  Solution  spending  represents resources dedicated to implement predefined  information systems through the mix of  hardware,   software  and  services  and  excludes   existing  warranty  and maintenance agreements.  Most of the competitors in this market are smaller than us,  providing  best  of  breed  solutions  as  opposed  to our  broad  solution capability. Our large competitors include divisions of Motorola,  Intergraph and Northrop Grumman.  Business Strategy - -----------------  We continually strive to position the Company to meet the expanding requirements of the public security market. We believe that we have market-leading  positions in key areas of high-end  security systems  integration,  security  electronics, advanced security technology  products and first responder support software.  We consider  ourselves  to be a  one-stop  shop  and  therefore  serve  as a single supplier  resource for the most difficult and complex public  security and first responder  requirements.  Not all of our competitors  have this  capability.  In order to  enhance  our  position  in the public  security  market,  our  current strategy is to:       Pursue our existing  business through  internal growth.  We believe that we      have market-leading positions in many product and service categories, which      provide us a leverageable and ready-made growth platform.       Expand  our client  base to  encompass  high-end  commercial  clients.  Our      products are now being marketed to banks, corporate  headquarters,  private      estates and other facilities.                                          4          Utilize our Institutional  Security  capabilities in other markets. Many of      our products and  technologies,  and the applications of those products and      technologies, were designed to keep offenders confined to certain areas and      to keep inmates from "breaking  out." These same products and  technologies      can be adapted to keep people from "breaking in." We are currently  working      towards adapting our products to this new market.       Make  selective   acquisitions   to  complement  and  enhance  our  current      technological  capabilities and market access.  Our acquisitions of Norment      and Tiburon  greatly  expanded our product  offerings  and  solidified  our      position within the  Institutional  Security  Systems and Public Safety and      Justice segments. We believe other acquisition opportunities exist which if      successfully  consummated  could  further  enhance our current  product and      service offerings.       Develop  strategic  alliances  with large defense  contractors  and teaming      agreements  with  other  integrators,  which  may put us in a  position  to      participate  in large blanket  procurement  projects from the Department of      Homeland Security in response to homeland security requirements.       Improve our cost structure,  quality, and client and employee satisfaction,      and  re-engineer  our  business  model to  generate  a  greater  degree  of      recurring revenue.       In addition,  we are  continually  evaluating our structure to determine if      another organizational  structure would be more advantageous to the Company      in light of the current operating environment.  Corporate Information - ---------------------  We were  reincorporated  in Nevada in 1996 and our  predecessor  corporation was incorporated  in  Pennsylvania  in 1952.  Our  principal  executive  offices are located at 2530 Riva Road, Suite 201,  Annapolis,  Maryland 21401. Our telephone number is (410) 224-4415.  General Information - -------------------  The Company  purchases  most of the parts and raw materials used in its products from various  suppliers.  The primary raw materials used in the manufacturing of its products are electronic  components and steel or aluminum sheets,  stampings and castings. These materials are generally available from a number of different suppliers.  While the bulk of such raw material is purchased from relatively few sources of supply,  the Company  believes that  alternative  sources are readily available.  There is no  significant  seasonality  in  CompuDyne's  business.  The Company's construction  related  business,  ISS,  however,  has  historically  been a very cyclical  business in line with the cycle of prison  construction  in the United States.  See the Management Outlook located in Item 7 for a discussion of backlogs.  At December 31, 2005, the Company had approximately 766 permanent employees.  Of the permanent employees,  approximately 93 are subject to collective  bargaining agreements.  The  Institutional  Security Systems Segment  regularly hires union personnel on a temporary basis for field  projects.  These personnel are subject to  various  collective  bargaining  agreements  depending  on their  skills and locale.  At December 31, 2005, there were no temporary  employees  covered under collective bargaining agreements.  The ultimate clients through which substantially all of the sales of the Company are  generated  are the  Federal  government  or  state  and  local  governments primarily in the United States of America.  Risks Related to Our Businesses - -------------------------------  Budget  constraints of state and local  governments  could adversely  affect our business. Contracts for which state or local governments are the ultimate customer account for  approximately  69% of our  business.  Our  Institutional  Security  Systems segment,  our largest  business  segment,  outfits  correctional  facilities and courthouses. Similarly, our Public Safety and Justice segment almost exclusively serves state and local  governments.  Many state and local  governments  operate under very tight  budget  constraints.  Continued  budget  constraints  on these governments  could cause them to delay or cancel pending  projects,  which could materially adversely affect our financial results.  The loss or reduction of U.S.  Government  contracts could adversely  affect our business. Contracts  where the U.S.  Government  is the ultimate  customer  accounted  for approximately  25% of our  revenues in the fiscal year ended  December 31, 2005. The  U.S.  Government  funds  these  contracts  in  annual  increments,  and the                                          5     contracts  require  subsequent  authorization and  appropriation,  which may not occur or which may provide  less than the total amount of the  contract.  We may not receive  future  contracts and the size of any contracts that we receive may vary. Fluctuations in spending by the U.S. Government for national defense could also adversely affect our ability to receive future contracts. Additionally, the U.S. Government may cancel its contracts unilaterally,  at its convenience.  The loss of, or a  significant  reduction  in, this  business  could have an adverse effect on our business.  We operate  under fixed price  contracts and our inability to estimate our costs may adversely affect our financial results. Much  of our  business  is  pursuant  to  fixed  price  contracts.  If we do not accurately  estimate  our  costs,  we could  suffer  losses on these  contracts. Increases  in the cost of raw  materials  could  have an  adverse  impact on our financial performance if we are not able to effectively forecast such increases. In  addition,  our  revenues  under these  contracts  are  recognized  under the percentage of completion method of accounting. This method requires considerable judgment and as a result the estimates derived at any point in time could differ significantly from the final results attained.  Our  ability to obtain  payment  and/or  performance  bonds is  critical  to our ability to conduct business. In the conduct of our business we are often  required by our customers to obtain payment and/or  performance  bonds. The majority of these bonds have been needed in the ISS and PS&J segments. Recently,  approximately 75% of ISS' work has come from jobs where payment and performance  bonds are required and for PS&J, 19% of its work has required payment and performance bonds. The Company's recent losses have made it more  challenging  for the Company to obtain the bonding  needed to procure  certain of its  projects.  As of  December  31,  2005,  the Company was required to provide  collateral  for two of its projects which it did by issuing bank letters of credit as collateral in the amount of approximately $5.5 million in total. If we are unable to obtain such bonds for any reason, or if the terms, particularly collateral requirements,  of the bonds are not within our financial means, it would significantly diminish our ability to secure new contracts,  and consequently  our  financial  performance  and  results  of  operations  may  be materially adversely affected.  If we are unable to design,  manufacture and market our products  offerings in a timely and efficient manner, we may not remain competitive. We offer a wide variety of products.  If the design,  manufacturing or marketing of a product or products is not  successful  and we must allocate more resources to ensure the products' success, it could lower the profitability of the product or products  and affect  customer  perceptions  as to the quality of products we produce.  In addition,  all four  segments of our business face  considerable  competition from large and small companies.  We compete  primarily on a price basis with our competitors and because of the bid and request for proposal process, we often do not have access to the underlying  assumptions that resulted in our competitor's bids,  and  therefore,  other  than  price we cannot  determine  why our bid was successful or unsuccessful for particular  projects.  This creates difficulty in accurately  projecting  the success of future  bids. A decrease in the amount of successful  bids and  subsequent  projects  could have an adverse  effect on our business.  If we are unable to develop and market new products in a timely  manner,  we may not remain competitive. Some of our markets are characterized by continuing  technological  advancement, changes in customer requirements, and evolving product standards. In particular, our PS&J segment  specializes in the development,  implementation and support of complex,   integrated  software  systems,   and  accordingly,   PS&J  devotes  a substantial amount of resources to product development. To compete successfully, PS&J must  develop and market new  products  that  provide  increasingly  higher levels of performance and reliability.  Product  development is highly uncertain and there can be no assurance  that we will  successfully  develop new products. Our  inability  to develop  and market  these  products  or to achieve  customer acceptance of these products could have an adverse effect on our business.  The  failure  to  obtain  U.S.  Government  contracts  in  connection  with  the Department of Homeland  Security's  Homeland Defense  initiative could adversely affect our business. We  currently  do not  have  any  U.S.  Government  contracts  derived  from the Department  of  Homeland  Security's  Homeland  Defense  initiative.  We may not receive  any  contracts  as a  result  of this  initiative  and the  size of any contracts  that we receive  may vary.  Our  failure to secure  Homeland  Defense contracts could give other companies in the public security market a competitive advantage and could have an adverse effect on our business.  We are subject to substantial  government  regulation that could cause delays in the  delivery of our products and services and may subject us to audits or other similar review processes. As a  contractor  with  agencies  of  the  U.S.  Government  and  various  state governments,  we are obligated to comply with a variety of regulations governing our operations and the workplace.  These  regulations  include those promulgated by,  among  others,  the  various  states  with  which  we  contract,  the  U.S. Departments  of  Commerce,  State,  Transportation  and the  U.S.  Environmental Protection Agency, the Occupational  Safety and Health  Administration,  and the U.S. Bureau of Alcohol, Tobacco and Firearms.  Certain of our contracts give the                                          6     contracting agency the right to conduct audits of our facilities and operations, including a review of our compliance with the prescribed procedures  established in connection with the government contract.  We may be subject to investigations as a result of an audit or for other  causes.  Government  contractors  that are found to have  violated the False  Claims Act, or are indicted or convicted  for violations  of other  federal  laws,  or are  considered  not to be  responsible contractors,  may be suspended or debarred from government  contracting for some period of time.  Such  convictions  could also  result in fines.  Suspension  or debarment could have a material adverse effect on the Company.  U.S.  Government contracts  may also contain  specific  delivery  requirements,  which if not met satisfactorily by us could result in penalties assessed against us and a loss of profits.  In addition,  changes in federal,  state and local laws may impact our ability to secure new  contracts  and  otherwise  affect the  operations  of our business.  Our inability to effectively  integrate  acquisitions could adversely affect our business. We have made a number of  acquisitions  in recent  years,  which require that we integrate  operations and systems and personnel from those  businesses  into our Company.  This process  requires,  among other things,  that we must continually evaluate our  operational  and financial  systems and controls and enhance those systems and controls as necessary.  If we are unable to  successfully  integrate these  acquisitions  it could  adversely  effect our  operating  results and our ability to comply fully with laws and regulations.  Our inability to or  successfully  complete our  restructuring  and simplify our structure could adversely affect our business. Our  Institutional  Security  Systems,  Attack  Protection and Public Safety and Justice  business  segments are undergoing  significant  organizational  expense restructuring.  In addition,  we are  evaluating  our  structure and strategy to determine if any less  decentralized,  or other  organizational  structure would result in lower selling,  general and administrative costs and we are evaluating our strategy to determine if we would benefit from  focusing on fewer  segments. If we are unable to  successfully  complete our current  organizational  expense restructuring,  or if we are unable to effectively  further change our structure in order to achieve lower selling,  general and  administrative  costs, it could adversely   affect  our  operating   results  and  detract  from  future  growth opportunities.  If we are unable to comply with  Sarbanes-Oxley  Act Section 404 ("Section 404") and the requirement to maintain adequate disclosure controls and procedures,  we may be adversely impacted. Section 404 requires that certain  companies  establish and maintain an adequate internal control structure and procedures for financial  reporting and assess on an on-going  basis,  the design and operating  effectiveness  of their  internal control  structure and procedures for financial  reporting.  Although we are not required to comply with Section 404 for 2005, we were required to comply in 2004 and we previously  disclosed that our internal control over financial  reporting as of December 2004 had material  weaknesses.  Although we have  remediated  the material weaknesses,  and currently are not required to comply with Section 404, we will be required to comply with Section 404 in 2007 and any future  inability to maintain an adequate internal control  structure and disclosure  controls and procedures  could result in our independent  registered  public  accounting firm issuing  an adverse  opinion  on our  internal  controls,  increased  regulatory scrutiny and possible  restatement of our financial  statements and delisting of our common  stock on the Nasdaq  market.  Compliance  with Section 404 will also result in substantial additional expenses.  We may need additional financing for bonding  requirements,  working capital and capital  expenditures  and  additional  financing  may not be available on terms acceptable to us. In order to operate our business, we may need to obtain additional surety bonds, maintain working capital and make significant capital  expenditures and may need additional  capital to do so. Our ability to operate and grow is dependent upon, and  may  be  limited  by,  among  other  things,   availability   of  financing arrangements.  Additional  funding sources may be needed, and we may not be able to obtain the  additional  capital  necessary to pursue new projects or maintain our  operations,  and if we can  obtain  additional  financing,  the  additional financing may not be on terms which are satisfactory to us.  Our failure to remain in compliance  with the terms of our credit facility could adversely affect our business. As of  September  30, 2004 we were not in  compliance  with the  "minimum  fixed charge  coverage  ratio" and as of December  31, 2004 we were not in  compliance with the "minimum  EBITDA"  covenant in our credit  facility.  The bank who is a party to our credit facility agreed to waive  compliance with these covenants in connection  with an amendment to our credit  facility dated October 29, 2004 and March 4, 2005, respectively.  On May 3, 2005, our bank confirmed in writing that there will not be any event of default under the various credit  agreements,  by virtue of our failure to timely file an Amendment  to our Annual  Report on Form 10-K for the year ended December 31, 2004. In the event that we were to breach a covenant under our credit facility in the future, there can be no guarantee that we could  secure a waiver for such  breach and we would be in default  under the credit  facility.  Our  failure  to remain in  compliance  with the terms of our credit  facility could have a material  adverse effect on our ability to conduct our business and to fulfill our obligations  under our Convertible  Subordinated Notes due 2011 ("2011 Notes").                                          7     Legal proceedings may adversely affect our business. We are a party to certain  legal actions and  inquiries  for  environmental  and other  matters  resulting  from  the  normal  course  of  business.  Some of our businesses,  especially  Institutional  Security  Systems,  involve working as a subcontractor  to a prime  contractor.  From time to time we make claims against the prime  contractor,  or the prime  contractor makes claims against us. At any point  in  time  we are  engaged  in a  number  of  claim  disputes  with  prime contractors, some of which may have a significant negative outcome. Although the total amount of liability  with respect to these matters  cannot be  ascertained given the nature of the  related  allegations,  we  presently  believe  that any resulting  liability would not have a material effect on our financial position, results of future  operations  or cash  flows.  In addition to claims with prime contractors,  we may also make claims  against  customers and customers may make claims against us.  We have been named in lawsuits  involving  asbestos  related personal injury and death  claims in which  CompuDyne  Corporation,  individually  and as an alleged successor, is a defendant. We have been named as a defendant in cases related to claims for asbestos exposure  allegedly due to asbestos  contained in certain of its predecessor's products. We have advised our insurers of each of these cases, and the insurers are providing a defense  pursuant to agreement with us, subject to reservation of rights by the insurers.  The insurers have advised that claims in such  litigation  for punitive  damages,  exemplary  damages,  malicious  and willful and wanton behavior and intentional conduct are not covered.  One of the carriers has given notice that asbestos related claims are excluded from certain of these  policies.  The insurers have  additional  coverage  defenses which are reserved,  including that claims may fall outside of a particular  policy period of coverage.  Litigation costs to date have not been significant and we have not paid any settlements from our own funds.  The Company  cannot  ascertain  the total  amount of  potential  liability  with respect to these legal  matters,  but does not believe  that any such  potential liability  should  have a  material  effect on its  financial  position,  future operations or future cash flows.  However,  litigation  is inherently  risky and unexpected results could have a material adverse effect on us.  We are exposed to potential liability to clients and others. Our  involvement  in the public  security  and  justice  business  exposes us to potential  liability  claims  from  our  clients.   Our  products  are  used  in applications  where their failure could result in serious personal  injuries and death. We have sought ways to minimize loss to our clients by obtaining  product liability and professional  liability insurance policies;  however, a successful claim could result in liability in excess of coverage limits or the cancellation of insurance coverage and have an adverse effect on our business and operations.  We are subject to various environmental laws that could subject us to unforeseen expenditures. Our operations are subject to various  environmental  statutes and  regulations, including laws and regulations  addressing  materials used in the manufacture of our products.  In addition,  certain of our  operations  are subject to federal, state and local  environmental  laws and regulations that impose  limitations on the discharge of pollutants  into the air and water and establish  standards for the treatment,  storage and disposal of solid and hazardous wastes.  Although we believe that we have made sufficient capital expenditures to maintain compliance with  existing laws and  regulations,  future  expenditures  may be necessary as compliance standards and technology change.  Unforeseen significant expenditures required to maintain such compliance,  including unforeseen  liabilities,  could have an adverse effect on our business and financial condition.  Our ability to generate  sufficient cash to make principal and interest payments on the 2011 Notes depends on many factors beyond our control. Our ability to make payments on and to  repurchase  the 2011 Notes upon maturity will depend on our ability to generate cash in the future.  Our business may not generate sufficient cash flow from operations, cost savings may not be realized, and future borrowings may not be available to us under credit arrangements in an amount  sufficient to enable us to make the  principal and interest  payments on the 2011 Notes.  We may need to refinance  all or a portion of our  indebtedness under the 2011 Notes on or before maturity.  We may not be able to refinance the 2011 Notes, if necessary, on commercially reasonable terms or at all.  Cautionary Statement Regarding Forward-Looking Information - ----------------------------------------------------------  Certain  statements  made  in  this  Form  10-K  with  regard  to the  Company's expectations as to future revenues,  expenses,  financial  position and industry conditions,  the Company's ability to secure new contracts, its goals for future operations,   implementation  of  business  strategy  and  other  future  events constitute  "forward-looking  statements"  within  the  meaning  of the  federal securities  laws.  When  used in this Form  10-K,  words  such as  "anticipate," "believe,"  "estimate,"  "expect,"  "intend"  and similar  expressions  identify forward-looking statements.  Although the Company makes such statements based on current  information and assumptions it believes to be reasonable,  there can be no assurance that actual results will not differ materially from those expressed or implied by such  forward-looking  statements.  Actual  results  could  differ                                          8     materially from those contemplated by the forward-looking statements as a result of certain  important  factors,  including but not limited to, capital  spending patterns  of the  security  market and the demand  for the  Company's  products, competitive  factors and pricing pressures,  changes in legislation,  regulatory requirements,  government  budget problems,  the Company's ability to secure new contracts,  the ability to remain in compliance with its bank covenants,  delays in  government  procurement  processes,  ability  to  obtain  bid,  payment  and performance bonds on various of the Company's projects,  technological change or difficulties,  the  ability  to  refinance  debt when it  becomes  due,  product development   risks,   commercialization   difficulties,   adverse   results  in litigation,  the level of product returns, the amount of remedial work needed to be  performed,  costs of compliance  with  Sarbanes-Oxley  requirements  and the impact of the failure to comply with such  requirements,  risks  associated with internal  control  weaknesses  identified  in  complying  with  Section  404  of Sarbanes-Oxley,  the Company's ability to realize anticipated cost savings,  the Company's ability to simplify its structure and modify its strategic objectives, and general economic  conditions.  Risks inherent in the Company's  business and with respect to future  uncertainties are further described in our other filings with the Securities and Exchange Commission.  Available Information - ---------------------  Our website is located at www.CompuDyne.com. The Company makes available free of charge  all of its SEC  filings  (including  its  annual  report  on Form  10-K, quarterly  reports on Form 10-Q,  current reports on Form 8-K and all amendments to these  reports)  on the  Company  website  and posts the  filings  as soon as reasonably  practicable after electronically filing or otherwise furnishing such material to the SEC.
The Company's principal  executive offices are in Annapolis,  Maryland where the Company leases approximately 4,358 square feet of office space.  At December 31, 2005 the  Institutional  Security Systems segment leased primary facilities for engineering,  assembly and  administration  including:  Alabama - 40,250  square feet,  California - 15,795  square feet,  Maryland - 9,500 square feet, Arizona - 8,369 square feet and North Carolina - 5,775 square feet.  At December 31, 2005 the Attack Protection  segment owned primary facilities for engineering,  manufacturing and administration in Alabama - 165,883 square feet. A portion of this space is used by the ISS segment for administrative  purposes. These  facilities  are  encumbered  by  Industrial  Revenue  Bonds.  The  Attack Protection segment also leases 31,372 square feet of  office/warehouse  space in Oregon.  At December 31, 2005 the Integrated  Electronic  Systems  segment leased primary facilities for  engineering,  assembly and  administration  in Maryland - 14,690 square feet.  At  December  31,  2005 the Public  Safety and Justice  segment  leased  primary facilities for  engineering  and  administration  including  California - 34,527 square feet,  Colorado - 10,432 square feet, Texas - 10,247 square feet,  United Kingdom - 6,663  square feet,  Oregon - 5,669  square feet,  Utah - 5,422 square feet,  Washington - 4,000 square feet,  Massachusetts  - 3,552 square feet,  and Wisconsin - 1,902 square feet.  The Company leases only those  properties  necessary to conduct its business and does not invest in real  estate or  interests  in real  estate on a  speculative basis. The Public Safety and Justice  segment's  California  office has signed a new lease  agreement  for 30,772  square  feet of office  space to  replace  the currently  used 32,050  square feet of office space  beginning on April 1, 2006. The lease has a term of six years and total future minimum rental payments under the lease are $4.2 million.  The Company believes that after this relocation the current  properties  will be suitable and  adequate for its current  operations. Additional space may be required to service contracts in other areas.
The Company is party to certain legal  actions and  inquiries for  environmental and other  matters  resulting  from the normal  course of business.  Some of the businesses,  especially  Institutional  Security  Systems,  involve working as a subcontractor to a prime contractor.  From time to time the Company makes claims against the prime  contractor,  or the prime contractor makes claims against the Company.  At any  point in time the  Company  is  engaged  in a number  of claim disputes with prime contractors,  some of which may have a significant  negative outcome.  Although the total amount of potential liability with respect to these matters can not be ascertained given the nature of the related allegations,  the Company presently believes that any resulting liability will not have a material effect on its financial position, results of future operations or cash flows.                                          9     In addition to claims with prime  contractors,  the Company may also make claims against customers and customers may make claims against the Company.  The Company has learned  that the National  Association  of  Securities  Dealers ("NASD") and other regulatory bodies are seeking sanctions against purchasers of the  Company's  common  stock in its 2001 PIPE  transaction.  In  addition,  the Company has learned that the placement agent for this  transaction is also being investigated  by the SEC,  NASD and other  regulatory  bodies.  The  Company  is investigating  these matters,  has filed lawsuits against certain purchasers and is evaluating its other options for recovery.  The Company  has been named in  lawsuits  involving  asbestos  related  personal injury and death claims in which CompuDyne  Corporation,  individually and as an alleged successor, is a defendant.  The Company has been named as a defendant in cases  related  to  claims  for  asbestos  exposure  allegedly  due to  asbestos contained in certain of its predecessor's  products. The Company has advised its insurers  of each of these  cases,  and the  insurers  are  providing  a defense pursuant to agreement with the Company,  subject to reservation of rights by the insurers.  The insurers have advised that claims in such litigation for punitive damages,  exemplary  damages,  malicious  and  willful and wanton  behavior  and intentional  conduct are not covered.  One of the carriers has given notice that asbestos  related  claims  are  excluded  from  certain of these  policies.  The insurers have additional coverage defenses,  which are reserved,  including that claims may fall outside of a particular  policy  period of coverage.  Litigation costs  to date  have  not  been  significant  and the  Company  has not paid any settlements from its own funds.  The Company  cannot  ascertain  the total  amount of  potential  liability  with respect to these legal  matters,  but does not believe  that any such  potential liability  should  have a  material  effect on its  financial  position,  future operations or future cash flows.  The Company,  as a government  contractor,  is from time to time subject to U.S. Government  investigations  relating to its operations.  Government  contractors that are found to have  violated  the  False  Claims  Act,  or are  indicted  or convicted for  violations of other  federal  laws, or are  considered  not to be responsible   contractors,   may  be  suspended  or  debarred  from   government contracting  for some  period of time.  Such  convictions  could also  result in fines.  Suspension  or  debarment  could have a material  adverse  effect on the Company. No such violations or conditions of debarment exist at this time.
None.                                          10                                          PART II
CompuDyne Common Stock is quoted on the Nasdaq National Market, under the symbol "CDCY." There were 1,907 common shareholders of record as of March 23, 2006.  The following table sets forth the high and low sales for CompuDyne Common Stock as quoted on the Nasdaq National Market.                                         2005                       2004                                        ----                       ---- Quarter Ended                    High         Low           High         Low - -------------                  -------------------        ------------------- March 31                       $ 7.80       $ 4.65        $13.19       $ 8.56 June 30                        $ 8.00       $ 5.03        $17.46       $ 8.55 September 30                   $ 9.40       $ 5.27        $11.61       $ 7.06 December 31                    $ 6.75       $ 4.74        $ 8.50       $ 6.10  The Company did not pay any dividends on its common stock during the years ended December 31, 2005 and 2004, and its bank covenants forbid paying dividends until satisfaction  in  full  of  the  obligations  and  termination  of  the  banking agreements. In addition, the Company's 2011 Notes restrict the Company's ability to declare or pay cash dividends.
The  following is a  consolidated  summary of  operations  of CompuDyne  and its subsidiaries  for the years ended December 31, 2005, 2004, 2003, 2002, and 2001. The  information  in the  table  below is based  upon the  audited  consolidated financial  statements of CompuDyne and its  subsidiaries for the years indicated appearing  elsewhere in this annual  report or in prior  annual  reports on Form 10-K  filed by the  Company  with the SEC,  and  should  be read in  conjunction therewith and the notes thereto.     (In thousands except per share data)                                For the years ended December 31                                                  -----------------------------------------------------------------------                                                        2005(b)         2004          2003        2002(a)           2001                                                   ------------  ------------  ------------  ------------  --------------       Net sales                                        $    141,650  $    142,782  $    193,263  $    155,556  $      127,394                                                   ============  ============  ============  ============  ============== Gross profit                                     $     42,539  $     37,678  $     46,396  $     34,816  $       25,280 Selling, general and administrative expenses           40,567        36,219        32,305        25,785          17,378 Research and development                                8,685         7,755         7,374         4,916              70 Impairment of goodwill and other intangibles                -         1,826             -             -               -                                                   ------------  ------------  ------------  ------------  -------------- Operating (loss) income                          $     (6,713) $     (8,122) $      6,717  $      4,115  $        7,832                                                   ============  ============  ============  ============  ============== Interest expense, net of interest income         $      2,233  $      2,289  $      1,051  $      1,394  $        2,540                                                   ============  ============  ============  ============  ============== Net (loss) income                                $     (8,691) $     (8,198) $      3,408  $      1,814  $        4,092                                                   ============  ============  ============  ============  ============== (Loss) earnings per share (c): Basic   (Loss) earnings per common share               $      (1.07) $      (1.01) $        .43  $        .24  $          .75                                                   ============  ============  ============  ============  ============== Weighted average number of common   shares outstanding                                    8,129         8,136         7,895         7,456           5,424                                                   ============  ============  ============  ============  ============== Diluted   (Loss) earnings per common share               $      (1.07) $      (1.01) $        .42  $        .23  $          .67                                                   ============  ============  ============  ============  ============== Weighted average number of common   shares and equivalents                                8,129         8,136         8,158         7,940           6,110                                                   ============  ============  ============  ============  ==============  Total assets                                     $    126,692  $    132,891  $    115,732  $    120,804  $       74,485                                                   ============  ============  ============  ============  ============== Long-term debt                                   $     42,870  $     43,123  $     17,658  $     27,510  $       15,162                                                   ============  ============  ============  ============  ============== Total shareholders' equity                       $     36,422  $     45,831  $     52,927  $     49,204  $       32,637                                                   ============  ============  ============  ============  ==============    Reclassifications - Certain prior year amounts have been reclassified to conform with the current year's presentation.  Notes:      (a)  Includes  operations of Tiburon,  Inc.  from May 2, 2002,  the date of           acquisition.      (b)  Includes  operations of Xanalys  Corporation from August 24, 2005, the           date of acquisition.      (c)  No dividends  have been paid on the Company's  Common Stock during the           above periods.                                          11
Introduction  Overview of CompuDyne Corporation  CompuDyne  Corporation was  reincorporated in Nevada in 1996. We were originally incorporated in 1952. We believe that we are a leading  provider of products and services to the public security markets.  We operate in four distinct  segments: Institutional  Security Systems ("ISS");  Attack Protection  ("AP");  Integrated Electronic Systems ("IES"); and Public Safety and Justice ("PS&J").  The  Institutional  Security  Systems  segment is  headquartered  in Montgomery, Alabama and operates under the trade name Norment  Security  Group  ("Norment"). This segment provides physical and electronic  security products and services to the corrections  industry  (prisons and jails) and to the courthouse,  municipal and commercial markets. ISS typically serves as a subcontractor, responsible for their portion of the installation work on larger projects. Installations involve hard-line   (steel  security  doors,   frames,   locking   devices,   etc.)  and sophisticated  electronic  security systems,  including  software,  electronics, touch-screens,  closed  circuit TV,  perimeter  alarm devices and other security monitoring controls.  ISS also developed a product called MaxWall.  MaxWall is a modular  steel,   concrete  filled   prefabricated  jail  cell.  It  allows  for construction  projects to use  considerably  less space and can save the project owner   significant   amounts  of  money.   ISS  provides  field  level  design, installation and maintenance of both physical and electronic security products.  Included in the  Institutional  Security  Systems  segment is the TrenTech  line which  manufactures  and  integrates   electronic  security  systems.   TrenTech integrates  generally  available products and software as well as developing its own  proprietary  systems.  TrenTech has developed a  sophisticated  proprietary video badging system,  with  approximately 250 systems installed at more than 70 facilities, most of which are military installations.  The Institutional  Security Systems segment also manufactures a complete line of locks and locking  devices  under the brand name  Airteq.  Airteq is an industry leader  in  pneumatic  and  electro-mechanical   locking  devices  used  in  the corrections industry.  The Attack Protection  segment is one of the country's largest  manufacturers of bullet,  blast and attack resistant windows and doors designed for high security applications such as embassies, courthouses, Federal buildings, banks, corporate headquarters  and other  facilities  that insist on having the highest  level of protection  currently  available.  We believe that we are a premier  provider of Underwriters  Laboratory  ballistic standard UL-752 Level 8 security windows and doors,  the highest rating level of commercial  ballistic  security  windows and doors.  Our attack  resistant  windows and doors are integrated and structurally secure  products with  specifically  designed  frames and  encasements  that are integral  parts of the structure in which they are installed.  Existing  product installations  number in the  thousands  and range from the  Middle  East to the White House. AP is a significant  supplier of bullet and blast resistant windows and doors to United  States  embassies  throughout  the world.  AP usually works under contracts from prime contractors who have direct contracts with the United States  Department of State,  the segment's  largest client.  Attack  Protection products  are also sold to drug stores and  convenience  stores to secure  drive through  facilities.   Other  commercial   applications  include  guard  booths, tollbooths,  cash drawers and other similar  items.  Additionally,  this segment designs and installs both fixed and pop-up  bollards and wedge barrier  security systems.  The Attack  Protection  segment also  manufactures a  sophisticated  fiber optic sensor system,  known as Fiber SenSys, used to detect physical  intrusion.  This application is designed to protect large perimeters  including such applications as Federal  facilities,  military  deployments  and bases,  oil fields,  airport tarmacs,  public utilities,  nuclear reactors and water systems. In addition, it has been  installed  to protect  the  perimeters  of private  estates  and other similar properties.  The Integrated  Electronic  Systems (formerly known as Federal Security Systems) segment consists of CompuDyne-Integrated Electronics Division, LLC. Its customer base  includes  the  military,   governmental  agencies,  and  state  and  local governmental  units. IES provides turnkey system  integration of public security and safety  systems.  This  segment  specializes  in a wide range of  customized access control and badging,  intrusion  detection,  surveillance and assessment, communications,  command and control,  fire and life safety,  and asset tracking systems.  IES provides  central  station  oversight  and control of multiple and separate  facilities  as well as security  and public  life  safety  systems and equipment.  This segment also designs and  manufactures  advanced digital signal processing products used in reconnaissance of foreign telecommunications signals designed for the United States Government and its foreign allies.                                          12     The Public Safety and Justice segment  consists of  CompuDyne-Public  Safety and Justice, Inc. (formerly Tiburon, Inc.),  CorrLogic,  LLC, the recently completed acquisition of Xanalys  Corporation and the acquired assets of 90 Degrees,  Inc. ("90 Degrees") and Copperfire Software Solutions,  Inc.  ("Copperfire").  PS&J's software  systems  are used in a wide  range of  applications  within the public safety and criminal  justice sectors of governmental  units,  including  police, fire and emergency medical services computer-aided dispatch systems, and police, fire, jail,  prosecution,  probation,  court records and  institutional  medical software   management   systems.   We  also   specialize  in  the   development, implementation  and support of complex,  integrated inmate  management  software systems, including inmate medical management systems that improve the efficiency and accuracy of correctional facility operations.  During the second half of 2004,  we expanded our  offerings in the Public Safety and Justice  segment by acquiring  the assets of 90 Degrees and  Copperfire.  90 Degrees  provides a web-based  fire records  management  system,  which is being integrated into our current PS&J product offerings. 90 Degrees'  enterprise-wide records management  solutions assist fire and Emergency Medical Service agencies in  managing  responses  to  emergency  situations.  We  anticipate  that  as we integrate 90 Degrees'  product  offerings into our PS&J product  offerings,  the open  web-based  technology  from 90 Degrees  will  advance our current fire and rescue product  offerings.  Copperfire  provides  customized  report writing and forms generation  software  designed  specifically for public safety and justice agencies. The software automates an agency's current business practices, turning hard copy  forms into  digital  images,  to create a  paperless  report  writing system.  Xanalys was acquired during the third quarter of 2005. Xanalys provides a  suite  of  investigative   management  and  analysis  solutions  that  enable investigators  to collect,  analyze and share  information  to solve  cases.  We believe that integration of Copperfire's and Xanalys'  products will enhance our total offerings in PS&J.  Management Outlook  We continue to find  ourselves in very  challenging  times.  We have three major areas of focus:       o    The first is increasing the amount of our backlog.      o    The second is  migrating to a business  model with a more  predictable           revenue stream.      o    The third is to improve our cost structure  (including  evaluating our           strategy  to  determine  if we would  benefit  from  focusing on fewer           segments), quality, and customer and employee satisfaction.  Our backlog is a key indicator of what our future  revenues will look like.  Our backlog peaked at December 31, 2002, at which time it exceeded $204 million. The December  31,  2005  quarter  is the  third  consecutive  quarter  in  which  we experienced a  quarter-over-quarter  increase.  Backlog was approximately $148.1 million at December 31, 2005, as shown in the following table:                                Institutional                   Integrated      Public                              Security         Attack      Electronics    Safety and     Backlog   (in thousands)             Systems        Protection      Systems        Justice        Total                           -----------------------------------------------------------------------       December 31, 2002          $ 99,527          $ 18,478       $ 11,440        $ 74,867      $204,312 December 31, 2003          $ 57,258          $ 10,043       $  8,326        $ 63,727      $139,354 December 31, 2004          $ 49,324          $ 20,803       $  8,299        $ 48,434      $126,860 March 31, 2005             $ 42,700          $ 20,139       $  8,395        $ 44,488      $115,722 June 30, 2005              $ 56,492          $ 19,466       $  9,105        $ 46,045      $131,108 September 30, 2005         $ 52,557          $ 16,210       $  8,146        $ 58,270      $135,183 December 31, 2005          $ 58,128          $ 28,802       $  7,503        $ 53,705      $148,138    Historically,  approximately  93% of our revenues  were  generated  from sources where the ultimate client is a federal,  state or local government unit.  During the last few  years,  due to the  general  economic  slowdown,  state  and local budgets, which we are dependent on for approximately 69% of our revenue sources, have  come  under  intense  pressure.  Most  states  were  running  in a deficit situation, as were many local governments. This caused many of them to delay and in some  cases  cancel  many  infrastructure  projects  until such time as their economic  fortunes rebound.  In recent months,  tax revenues have been improving resulting  in  increased  activity  preparatory  to the  issuance  of  bids  and ultimately  the awarding of new  projects.  In addition,  we have  increased our sales and  marketing  efforts  with a specific  objective  of  marketing  to the commercial  sector  which  inherently   offers  faster  project   implementation schedules.  Our second area of focus is the  reengineering  of our business model so that it contains  a  greater  percentage  of  recurring  revenue.  As  indicated  in the following table,  approximately  15.4% of the revenue in 2005 was generated from recurring revenue sources (primarily maintenance revenues),  and the majority of these  revenues  occurred in our Public  Safety and Justice  segment.  We define one-time revenue as revenue derived from discrete projects, from which we do not expect to generate  incremental  revenue upon the completion of the project.  We                                          13     define  recurring  revenue  as  sources  of  revenue  from  which we  anticipate receiving revenue in the current, as well as future periods,  for example annual renewable maintenance contracts.                                                                   Year Ended December 31, 2005                                                               ----------------------------           (in thousands)             One-time Revenue    %     Recurring Revenue  %           Total                                    -------------------------------------------------------------------       Institutional Security Systems      $      56,035      39.6    $      4,617      3.3    $      60,652 Attack Protection                          27,017      19.1               -        -           27,017 Integrated Electronic Systems               7,786       5.5           2,324      1.6           10,110 Public Safety and Justice                  28,987      20.4          14,884     10.5           43,871                                      -----------------------    ---------------------    -------------      Total                          $     119,825      84.6    $     21,825     15.4    $     141,650                                      =======================    =====================    =============    Since the majority of our revenues are one-time revenues and are  non-recurring, we must reinvent our book of business on a continual  basis.  This makes it very difficult  for us to project  our future  revenue  stream and thus makes it very difficult for us to project our earnings as well as our business  outlook.  Over the next five years,  we intend to modify our  business  model to rely less upon one-time sources of revenue and more on recurring sources of revenue.  Our third focus area is to improve our cost structure,  quality,  and client and employee satisfaction.  Our Institutional Security Systems and Attack Protection business  segments  are  undergoing   significant   organizational  and  expense restructuring,  including a partial consolidation of regional office efforts and an increased focus on centralized  performance of the most complicated  security projects. This initiative began by ensuring our organization is properly aligned with our  clients'  needs.  Many  changes  have  been made and  initial  results indicate  that  our  cost,  our  quality,  our  clients  and our  employees  are responding  favorably to the changes implemented thus far. We have much room for improvement  as  we  move  toward  a  more  client-oriented  organization.   The organization  re-alignment is critical to strengthening  our future as it allows us to deploy the Six Sigma and Lean Manufacturing  methodologies  across all our business segments more efficiently.  The Six Sigma methodology focuses on defect elimination,  which will have a direct impact on our cost,  quality,  and client satisfaction.  Lean  Manufacturing  also  focuses  on  reduction  of  costs  and elimination of waste. In addition,  in light of the escalating selling,  general and  administrative  costs  associated  with the current  heightened  regulatory environment, we are evaluating our structure and strategy to determine if a less decentralized,  or other organizational structure would result in lower selling, general and administrative costs and we are evaluating our strategy to determine if we would benefit from focusing on fewer segments.  We believe that if we address and implement  successfully  the above three areas of focus, we will significantly enhance our future growth opportunities and will provide for more predictable financial results.  During the second half of 2004,  we expanded our  offerings in the Public Safety and Justice  segment by acquiring  the assets of 90 Degrees and  Copperfire.  90 Degrees  provides a web-based  fire records  management  system,  which is being integrated into our current PS&J product offerings. 90 Degrees'  enterprise-wide records management  solutions assist fire and emergency medical service agencies in  managing  responses  to  emergency  situations.  We  anticipate  that  as we integrate 90 Degrees'  product  offerings into our PS&J product  offerings,  the open  web-based  technology  from 90 Degrees  will  advance our current fire and rescue product  offerings.  Copperfire  provides  customized  report writing and forms generation  software  designed  specifically for public safety and justice agencies. The software automates an agency's current business practices, turning hard copy  forms into  digital  images,  to create a  paperless  report  writing system.  Xanalys was acquired during the third quarter of 2005. Xanalys provides a  suite  of  investigative   management  and  analysis  solutions  that  enable investigators  to collect,  analyze and share  information  to solve  cases.  We believe that integration of Copperfire's and Xanalys'  products will enhance our total offerings in PS&J.  On May 2, 2005, we filed a Form 8-K disclosing that the we failed to timely file an amendment to our Annual  Report on Form 10-K for the year ended  December 31, 2004 to provide management's report on internal control over financial reporting as of December  31, 2004 and the related  report of our  independent  registered public  accounting  firm on  management's  assessment  of the  effectiveness  of internal control over financial reporting (together,  the "404 Report") required by Section 404 of the Sarbanes-Oxley Act of 2002.  On May 4, 2005, we received a notice from the Listing Qualifications  Department of The Nasdaq  Stock  Market  stating that due to our failure to timely file the 404 Report, we were no longer in compliance with the requirements of Marketplace Rule 4310(c)(14). The Rule requires us to file with Nasdaq copies of all reports required to be filed with the  Securities  and Exchange  Commission on or before the date they are required to be filed with the SEC.                                          14     On June 27, 2005,  the Company filed its Form 10-K/A with the SEC containing the 404 Report.  On June 30, 2005, the Nasdaq Listing  Qualifications  Panel advised CompuDyne  that  CompuDyne had remedied its filing  delinquency  and was in full compliance with Nasdaq Market Place Rules.  On December 21, 2005 the Securities and Exchange  Commission  issued Release No. 33-8644 "Revisions to Accelerated Filer Definition and Accelerated Deadlines For Filing Periodic Reports" (the "Release").  The Release revised the definition of "accelerated filer" to make it simpler for accelerated filers whose public float falls below the $50 million threshold on the measurement date of June 30 to exit accelerated  filer status.  Under the new rules,  an accelerated  filer that has voting and non-voting  equity held by non-affiliates of less than $50 million at the end of its second  fiscal  quarter is  permitted to exit  accelerated  filer status at the end of that year and to file its  annual  report for that year and subsequent periodic reports on a non-accelerated basis. Accelerated filer status affects an issuer's  deadlines for filing its periodic  reports with the SEC and complying  with the  requirements  of Section 404 of the  Sarbanes-Oxley  Act of 2002. A  non-accelerated  filer must begin to comply with the  internal  control over financial  reporting  requirements  including the  attestation  report of a registered  public  accounting firm for its first fiscal year ending on or after July 15, 2007.  The Company exited  accelerated  filer status as of December 31, 2005.  The aggregate worldwide market value of CompuDyne  Corporation's  equity held by non-affiliates as of June 30, 2005, the last business day of CompuDyne's  second fiscal quarter, was less than $50 million. As a result, as of December 31, 2005, CompuDyne exited accelerated filer status.  Prior to the Release CompuDyne was classified as an "accelerated  filer" and was required to comply with the  requirements  of Section 404 of the  Sarbanes-Oxley Act of 2002. In light of the Release,  CompuDyne,  as a non-accelerated filer as of December  31,  2005,  is not required to comply with Section 404 for the year ended December 31, 2005.  Results of Operations  YEARS ENDED DECEMBER 31, 2005 AND 2004  Revenues.  The Company had revenues of $141.6 million and $142.8 million for the years ended December 31, 2005 and December 31, 2004, respectively,  representing a decrease of $1.13 million or 0.8%. As discussed below,  the decrease  occurred primarily from our IES and PS&J segments offset by increases from our ISS and AP segments.  Revenues from the Institutional  Security Systems segment were $60.7 million for the year ended  December 31, 2005,  an increase  from $54.0 million for the year 2004  representing  an  increase  of $6.7  million or 12.4%.  The  Institutional Security Systems segment is largely a construction driven business.  Much of its revenue is obtained by working on new and retrofit  construction projects in the corrections  industry,  as opposed to sources of recurring revenue. As such, the increase in revenue  experienced by this segment is largely  attributable to our working on more projects than we did in the previous  year.  Backlog for ISS had decreased  from $99.5  million at December 31, 2002 to $57.3 million at December 31, 2003.  Backlog was $49.3  million and $58.1 million at December 31, 2004 and December  31,  2005,  respectively.  The years  2003 and 2004 were slow  bidding periods for the Company.  Although the gross amount of construction  spending in the corrections  area remained  relatively flat between 2003 and 2004, the types of projects  that the Company  solicits,  namely  large-scale  medium to maximum security installations,  declined significantly in 2003 and 2004. This situation was  further  compounded  by the  general  state and local  governmental  budget deficits  which  caused  these  governmental  units to rethink and delay many of their  pending  corrections  projects.  Beginning  in early 2005,  ISS is seeing significant,  heightened  bidding activity,  particularly in the market space it serves,  namely large-scale  medium to maximum security prisons.  This increased bidding  activity is expected to result in securing more projects,  which should result in  increased  revenue.  During the last  three  quarters  of 2005,  ISS' backlog increased significantly providing the segment with a greater opportunity to generate revenue during the second half of 2005.  Revenues  from the Attack  Protection  segment  were $27.0  million for the year ended  December 31, 2005,  an increase from $25.2 million for the same period of 2004  representing  an  increase  of $1.9  million or 7.4%.  In 2002 the Company purchased  an  existing  75,000  square foot  factory for the Attack  Protection segment  on 20 acres of land in  close  proximity  to its  existing  factory  in Montgomery,  Alabama. This capacity increase was largely driven by the Company's expectation that the demands for its products,  principally its bullet and blast resistant windows and doors would accelerate significantly in the post September 11, 2001 world.  Throughout 2002,  2003, and 2004 this  anticipated  increase in demand did not materialize leaving the segment with significant excess capacity. This segment is composed of two chief product offerings, namely Norshield, which encompasses bullet and blast resistant windows and doors and ancillary products, and Fiber SenSys, which encompasses fiber optic intrusion detection systems. For the year ended December 31, 2005 the Norshield line experienced a 14.6% increase in revenues as compared to the year ended  December 31, 2004,  whereas the Fiber                                          15     SenSys line experienced a 10.8% decrease in revenues for the comparable  period. The increase in revenue of $2.6 million in the Norshield line is a direct result of the award of a major contract won in the fourth quarter of 2005. Execution on this contract began  immediately upon award.  Fiber SenSys' revenue decline is a result of the rollout of its next generation product, which until its testing is completed,  expected  in the first  quarter of 2006,  has and will  continue  to negatively  impact  revenues.  The slow-down in the government  building process experienced  during 2002 and 2003 has reversed.  Projects are now being released for  construction,  and thus  the  Attack  Protection  segment  is  experiencing increased bidding activity for its products.  During 2003, the Company furnished bids to supply its products for eight new embassy  projects.  At the time,  this was the largest  number of embassy  projects bid in a single  calendar  year for this  segment.  The Company was awarded four of these  embassy  projects,  for a total  CompuDyne  contract  value of $7.0 million,  and lost the remaining  four embassy project bids to competitors.  During 2004, we bid on fifteen new embassy projects.  Through  December  31, 2005 the  Company  was awarded  seven of these embassy  projects for a total  contract  value of $9.6  million,  and lost seven embassy project bids to  competitors,  with one project still awaiting award. In 2005, twenty-eight embassy projects were planned. We believe that this increased level of new embassy  construction  will  continue for the next  several  years. Through  December 31, 2005 the Company had been awarded three of these projects, one of which was for a total of $14.3 million, and lost one project and one bulk bid embassy project  comprising  eight  embassies to  competitors,  with sixteen projects still awaiting award.  Revenues  from  Integrated  Electronic  Systems were $10.1  million for the year ended  December 31, 2005, a decrease  from $14.3  million for the same period of 2004 representing a decrease of $4.2 million or 29.3%. A significant  portion of this segment's revenue is backlog driven.  Backlog at both December 31, 2003 and December  31, 2004 was $8.3  million.  IES'  revenue  decline was largely due to certain  government  clients,  for which the segment  receives repeat  business, having had their  budgets  significantly  reduced.  This  decrease was partially offset by a new $2.0  million  project.  The first half of 2005 was a  difficult time for IES,  with a downturn in revenues  and gross  profit,  ensuing  from: a delay  in  a  large-scale   installation  contract,   pending  the  government's completion of the building to house the system's  Command and Control Center;  a reduction in an ongoing  governmental  integration  program,  resulting from the Department of Defense's base  relocation and closure (BRAC)  program;  delays in several  significant  awards,  because  funding had been  redirected  to the war efforts in Iraq and  Afghanistan;  and a delay in the start-up of a 5-year,  $25 million  security  contract,   due  to  an  award  protest  by  the  predecessor contractor.  Revenues from the Public  Safety and Justice  segment were $43.9 million for the year ended  December 31, 2005, a decrease from $49.4 million for the same period of 2004  representing  a decrease  of $5.5  million or 11.2%.  The  decline  was primarily the result of lower backlogs and an increased  focus on developing our next  generation  product  which  resulted in more hours  worked on research and development and less hours worked on revenue-generating  projects. Revenues were also  impacted by  relatively  low  contract  signing  rates in early 2005,  low billing rates and difficult  performance  requirements  on some  contracts.  The lower levels of backlog did, however,  start to improve late in the year. During the fourth  quarter of 2005 PS&J  redeployed a portion of its  technical  staff, typically  deployed in the research and  development  area, to work on projects, resulting in increased  revenue.  It should be noted that although we made three acquisitions in this segment, two in 2004 (90 Degrees and Copperfire) and one in August 2005 (Xanalys), these acquisitions had little impact on Public Safety and Justice's revenues due to their relatively small size.  Expenses.  Cost of sales of $99.1  million for the year ended  December 31, 2005 were down $6.0  million or 5.7% from  $105.1  million  during the same period of 2004.  The smaller  percentage  decrease in sales as compared to the  percentage decrease in cost of goods sold resulted in an increased gross profit  percentage of 30.0% for the year ended  December 31, 2005 as compared to 26.4% in 2004.  In 2004,  the  windows  and  door  component  of  the  Attack  Protection   segment experienced  significant  operating   inefficiencies  and  difficulties.   These inefficiencies  and difficulties,  which did not recur in 2005, reduced the 2004 gross profit percentage.  Cost of  goods  sold in the  Institutional  Security  Systems  segment  of $50.8 million for the year ended  December  31, 2005 were up $3.2 million or 6.8% from $47.5  million  during the same period of 2004.  This increase was less than the related sales increase of this segment of 12.4%, resulting in a 4.4% increase in the gross profit  percentage to 16.3% from 11.9% for the year ended December 31, 2004. This increase in gross profit percentage  resulted mainly from one of this segment's customers  terminating its contract for convenience,  resulting in the recognition  of $1.3 million in gross  margin.  Starting in 2002 and  continuing through 2004,  Institutional  Security  Systems'  senior  management  identified managerial  problems at its West Coast  operations and determined  that numerous problems  existed there,  including that the costs to complete its projects were going to be significantly higher than was previously projected. This resulted in significant cost overruns on many of these projects. As the work on the projects progressed,  the Institutional  Security Systems segment  identified  additional cost  overruns  which caused the costs to complete  these  projects to increase. Although the problem projects identified in 2002 are substantially all complete, the  problems in the ISS West Coast  operations  continued  into 2003,  2004 and 2005. The West Coast office continues to be affected by one final contract which requires ISS to install a  proprietary  duress  system which has been  validated through an independent consultant and the manufacturer of the equipment but will not  function as  required  by the  contract  specifications.  ISS has  incurred                                          16     significant costs trying to make the equipment function as desired. The customer is  working  with ISS to  develop  a level of  acceptance,  and both ISS and the customer  are  cooperating  to close out the project in an amicable  manner.  We believe that all future costs on these projects have been  adequately  accounted for through  December 31, 2005.  Senior  management at the West Coast operations has been replaced as well as certain project  management and engineering  staff. It should be noted that the West Coast office has been  downsized to a sales and support  office,  consolidating  the  estimating,  electronics  engineering  and electronics  fabrication  functions into the Montgomery home office. The project management  and  hardline  engineering  staff has been  upgraded to  experienced professional  personnel,  and this office  only  manages  projects  specifically suited to their  expertise  or as  required by the local  marketplace.  The West Coast office  realized  eleven  consecutive  months of positive gross margins on such projects in 2005.  Despite these  positive  gross  margins,  the West Coast office  experienced  high legal and overhead  costs  closing out many of the old projects.  While this  resulted in an overall loss at the West Coast  operation, the office was also able to  significantly  reduce  aged  receivables  and filed multiple  claims  for  possible  future  upside  recovery.  The office is in the process of moving its  facilities to a smaller,  more cost  effective  facility, which will further reduce overhead costs in the future.  The West Coast problems,  including project overruns, resulted in pre-tax losses recorded in the following periods, in thousands:           Second Half of 2002                    $  2,698          Full Year 2003                            4,087          Full Year 2004                            6,092          First Quarter of 2005                       740          Second Quarter of 2005                      472          Third Quarter of 2005                       399          Fourth Quarter of 2005                      417                                                 --------                  Total West Coast Losses        $ 14,905                                                 ========  To  address  this  situation,  the  Company  has  implemented  more  centralized controls,  replaced  certain  personnel  at its West  Coast  operations  and its Alabama headquarters, and has reorganized the function of the West Coast office.  Cost of goods sold in the Attack  Protection  segment of $20.9  million  for the year ended  December 31, 2005 decreased $2.7 million or 11.4% from $23.6 million during the same period of 2004. This decrease was not proportional when compared to the  relative  sales  increase,  resulting  in a 16.4%  increase in the gross profit  percentage  to 22.6% from 6.2% during the year ended  December 31, 2004. Significant  factors  contributing to this increase in gross profit included the fact that in 2004,  significant  operating  inefficiencies and difficulties were experienced  by the  windows  and  doors  components  of the  Attack  Protection segment.  These  inefficiencies and difficulties  amounted to approximately $1.9 million, which contributed to the reduction of the 2004 gross profit percentage. They did not recur in 2005 due to new senior  management  hired in January  2005 that has reduced  manufacturing  and overhead  costs.  In addition,  one of this segment's  customers  terminated its contracts for convenience  during the first quarter of 2005 resulting in the recognition of $0.2 million in gross margin due to contract closeout activities.  Cost of goods sold in the Integrated  Electronic Systems segment of $8.5 million for the year ended  December 31, 2005 decreased $3.8 million or 30.9% from $12.3 million during the same period of 2004.  This decrease was  consistent  with the related sales decrease of this segment of 29.3%, resulting in a 2.0% increase in the gross profit  percentage to 16.1% from 14.1% in the year ended  December 31, 2004.  Substantially  all of the  projects  awarded in this segment are discrete projects.  Cost of goods sold in the Public Safety and Justice segment of $19.0 million for the year  ended  December  31,  2005 was down $2.7  million  or 12.7% from $21.7 million  during 2004.  This decrease was more than the related sales decrease of this  segment  of  11.2%,  resulting  in a 0.8%  increase  in the  gross  profit percentage   to  56.8%  from  56.0%  in  the  year  ended   December  31,  2004. Substantially all of the projects awarded in this segment are discrete projects.  Selling,  general and  administrative  expenses  were $40.6 million for the year ended December 31, 2005, an increase of $4.3 million or 12.0% from $36.2 million for the same  period of 2004.  Much of this  increase  is related to  additional costs  incurred  by the  Company  related to  compliance  with new  requirements mandated  by  the   Sarbanes-Oxley   Act  and  the  SEC.  The  Company  expended approximately  $0.4  million to perform its 2003 audit,  which did not require a SOX 404 report.  This was paid to our independent  registered  public accounting firm for audit and audit  related  services.  For the 2004  audit,  the  Company expended $3.2 million for external  third party costs to complete its 2004 audit and its SOX 404 report. Of this amount,  approximately  $2.5 million was paid to our independent  registered  public  accounting firm for audit and audit related services  with the  balance  paid to  various  consultants  and  others who have assisted the Company in the 404 process.  Expenses  related to audit and SOX 404 of $2.1 million and $1.9 million were recorded  during the years ended  December                                          17     31, 2005 and 2004,  respectively,  for  services  provided or accrued for during these periods. In addition,  AP's selling,  general and administrative  expenses increased by $1.2  million or 24.8%  during the year ended  December 31, 2005 as compared to the year ended  December  31,  2004.  This  increase was largely the result of increased legal costs  associated  with ongoing claims  resolutions in actions both as plaintiff and  defendant and for increased  selling and training costs as the  segment is trying to expand its  presence  into new  marketplaces. PS&J's selling, general and administrative expenses increased by $1.8 million or 10.3%  during the year ended  December  31,  2005 as  compared to the year ended December 31, 2004.  This increase was largely the result of increased  headcount and related costs from the three  acquisitions made by PS&J in 2004 and 2005. In addition,  the Xanalys  acquisition  contributed  approximately $600 thousand to this increase.  In conjunction  with the  acquisition of the assets of 90 Degrees and Copperfire and  the  stock  of  Xanalys  and in  compliance  with  Statement  of  Financial Accounting  Standards  No. 141 (SFAS 141)  Business  Combinations,  the  Company determined the fair value of the following  identifiable assets and assigned the indicated lives for the purposes of amortization and depreciation.                                                 Amount                                            (in thousands)    Life (in years)                                            --------------    --------------- Software                                       $ 2,434               5 Non Compete Agreements                             130               3 Tradename                                           60              15                                                -------                                                $ 2,624  The  amortization  of  the  above  assets  resulted  in  the  Company  recording amortization  expense related to these assets of $582 thousand and $178 thousand for the years ended December 31, 2005 and 2004, respectively,  which is included in operating expenses.  In an effort to further  reduce costs,  during 2005 the Company  eliminated  the position of Chief  Operating  Officer  and had its  division  Presidents  report directly to the Company's CEO.  Research and development  expenses were $8.7 million for the year ended December 31,  2005,  an increase of $0.9  million or 12.0% from $7.8 million for the same period of 2004.  Being a  technology-driven  enterprise,  the  Company's  Public Safety and  Justice  segment  continually  updates  and  enhances  its  software offerings,  thus incurring  significant  research and development costs.  During 2005 Public Safety and Justice started investing in its Next Generation products and  expended  $884  thousand  for this  project,  and is expected to spend $2.5 million and $1.0 million in 2006 and 2007, respectively.  Interest  expense  was $3.1  million for the year ended  December  31,  2005,  a decrease of $0.2  million or 7.1% from $3.3 million for the same period of 2004. The following table compares the weighted average of the Company's twelve months ended December 31, 2005 and 2004 interest bearing borrowings,  in thousands, and the related rates charged thereon:                                    Monthly Weighted           Monthly Weighted                                    Average - 2005             Average - 2004                                  Amount        Rate          Amount        Rate                                  ------        ----          ------        ---- Bank borrowings                  $      -       -%         $    617       4.2% Industrial revenue bonds         $  3,722     3.7%         $  4,162       3.1% Subordinated borrowings          $ 40,250     6.2%         $ 40,250       6.2% Swap hedge agreement             $  1,015     1.4%         $  3,721       3.6%  In addition the Company recorded the following  non-cash  interest  expense,  in thousands:  Amortization and write-off   of deferred financing charges  $   283                   $   600  Taxes on Income. The effective tax rate was a benefit of 2.4% for the year ended December 31, 2005 and the effective tax benefit rate was approximately 21.4% for the year ended  December 31, 2004. The Company's tax benefit of $2.2 million for the year ended December 31, 2004 was primarily a result of the Company's ability to carryback the loss incurred in 2004 to prior years,  resulting in Federal and State tax receivables.  Since all available tax loss prior year receivables were used via the 2004  carrybacks,  no such receivables were available to offset the December 31, 2005 losses generated by the Company.  The tax benefit for the year ended  December  31,  2005 is  primarily  a result of $500  thousand  previously recorded as a reserve for  uncertain tax  positions  which is no longer  needed, partially  offset by state tax  expenses.  The  Company has decided to provide a valuation  allowance  against its deferred tax assets, as it has determined that                                          18     due to the Company's  recent operating losses there is uncertainty as to whether more likely than not the assets will be realized.  The Company had net operating loss carryforwards for financial accounting purposes of $8.9 million at December 31, 2005.  Net Loss.  The  Company  reported a net loss of $8.7  million for the year ended December 31, 2005 and a net loss of $8.2 million for the year ended December 31, 2004. Diluted loss per share was a loss of $1.07 for the year ended December 31, 2005 and a loss of $1.01 for the year ended  December  31,  2004.  The  weighted average number of common shares  outstanding and  equivalents  used in computing EPS was 8.1 million in both 2005 and 2004.  YEARS ENDED DECEMBER 31, 2004 AND 2003  Revenues.  The Company had revenues of $142.8 million and $193.3 million for the years ended December 31, 2004 and December 31, 2003, respectively,  representing a decrease of $50.5 million or 26.1%. As discussed  below,  most of this decline occurred  in our ISS  segment  due to  delayed  projects  at the state and local levels,  largely caused by significant  budget deficits many governmental  units are currently experiencing.  Revenues from the Institutional  Security Systems segment were $54.0 million for the year ended  December 31, 2004,  a decrease  from $98.7  million for the same period  of  2003  representing  a  decrease  of  $44.7  million  or  45.3%.  The Institutional   Security  Systems  segment  is  largely  a  construction  driven business.  Much of its  revenue  is  obtained  by  working  on new and  retrofit construction  projects  in the  corrections  industry,  as opposed to sources of recurring revenue.  As such, the decrease in revenue experienced by this segment is  largely  attributable  to our  working on less  projects  than we did in the previous  year.  The  principal  reason for the decline was that its backlog had decreased  from $99.5  million at December 31, 2002 to $57.3 million at December 31, 2003 thus resulting in less work available to be performed in the year ended December 31, 2004 as compared to the year ended  December  31, 2003.  Backlog at December 31, 2004 had declined further to $49.3 million. The years 2003 and 2004 have been slow  bidding  periods for the  Company.  Although the gross amount of construction  spending in the corrections area remained  relatively flat between 2002,  2003 and 2004,  the types of projects that the Company  solicits,  namely large-scale medium to maximum security installations, declined in 2003 and 2004. This   situation  was  further   compounded  by  the  general  state  and  local governmental  budget  deficits  which are causing  these  governmental  units to rethink and delay many of their pending corrections projects.  Revenues  from the Attack  Protection  segment  were $25.2  million for the year ended  December 31, 2004, a decrease  from $28.4  million for the same period of 2003  representing  a decrease  of $3.2  million or 11.3%.  In 2002 the  Company purchased  an  existing  75,000  square foot  factory for the Attack  Protection segment  on 20 acres of land in  close  proximity  to its  existing  factory  in Montgomery,  Alabama. This capacity increase was largely driven by the Company's expectation that the demands for its products,  principally its bullet and blast resistant windows and doors would accelerate significantly in the post September 11, 2001 world.  Throughout  2002,  2003 and 2004 this  anticipated  increase in demand did not materialize leaving the segment with significant excess capacity. This segment is composed of two chief product offerings, namely Norshield, which encompasses bullet and blast resistant windows and doors and ancillary products, and Fiber SenSys, which encompasses fiber optic intrusion detection systems. For the year ended December 31, 2004 the Norshield line  experienced a 22.7% decline in revenues as compared to the year ended  December 31, 2003,  whereas the Fiber SenSys line experienced a 40.5% increase in revenues for the comparable  period. The Company  continues to see heightened  interest for its Fiber SenSys products and expects sales for these items to continue to experience  sustainable growth. The slow-down in the government  building  process  experienced  during 2002 and 2003 appears to have stabilized. It appears that projects are being released for construction,  and thus the Attack Protection segment is experiencing  increased bidding  activity for its products.  During 2003 the Company  furnished  bids to supply its products for eight new embassy  projects.  At the time,  this was the largest  number  of  embassy  projects  bid in a single  calendar  year for this segment.  Through  December  31,  2004,  the Company  was awarded  four of these embassy projects, for a total CompuDyne contract value of $7.0 million, and lost the remaining four embassy projects.  During 2004, we bid on fifteen new embassy projects.  Through  March 2005 the  Company  was  awarded  six of these  embassy projects for a total  contract  value of $8.6  million,  and lost seven  embassy projects to  competitors,  with two  projects  still  awaiting  award.  In 2005, preliminary  indications  show eighteen  embassy  projects will be available for bid. It appears to us that this increased level of new embassy construction will continue for the next several years.  Revenues from the Integrated  Electronic  Systems segment were $14.3 million for the year ended  December 31, 2004,  a decrease  from $16.4  million for the same period of 2003  representing  a decrease of $2.1 million or 13.1%. A significant portion of this segment's revenue is backlog driven.  The Integrated  Electronic Systems  segment  ended 2002 with a backlog level of $11.4  million.  Backlog at December  31,  2003 was $8.3  million  and at  December  31,  2004 was also $8.3 million.  Revenues from the Public  Safety and Justice  segment were $49.4 million for the year ended  December 31, 2004, a decrease from $49.8 million for the same period of 2003  representing  a decrease of $0.4 million or 0.8%. In 2003,  the Company                                          19     recognized  approximately  $5.5 million of revenue related to hardware  supplied under a contract with one of its  customers.  Minimal  margin was earned on this hardware.  Although  PS&J ships  certain  hardware  components  to clients on an occasional basis,  shipments of this magnitude of hardware,  done to accommodate our client, is an unusual and non-routine event. In addition, it should be noted that although we made two  acquisitions  in this segment in 2004 (90 Degrees and Copperfire), these acquisitions had little impact on Public Safety and Justice's revenues due to their  relatively  small size and due to their  occurring in the later part of the year.  Expenses.  Cost of goods sold of $105.1  million for the year ended December 31, 2004 were down $41.8 million or 28.4% from $146.9 million during the same period of 2003.  This  decrease was a result of decreased  costs of goods sold of $36.9 million at the Institutional  Security Systems segment,  largely attributable to the decreased sales of this segment. The smaller percentage decrease in sales as compared  to the  percentage  decrease  in cost of  goods  sold  resulted  in an increased gross profit  percentage of 26.4% for the year ended December 31, 2004 as compared to 24.0% in 2003.  Cost of  goods  sold in the  Institutional  Security  Systems  segment  of $47.5 million for the year ended  December  31, 2004 were down $36.9  million or 43.7% from $84.4 million  during the same period of 2003.  This decrease was less than the  related  sales  decrease  of this  segment  of 45.3%,  resulting  in a 2.5% decrease in the gross  profit  percentage  to 11.9% from 14.4% in the year ended December 31, 2003.  Starting in 2002 and continuing through 2004,  Institutional Security Systems' senior management  identified  managerial problems at its West Coast  operations and determined that numerous  problems existed there including that the costs to complete its projects  were going to be  significantly  higher than was previously projected. This was a result of significant cost overruns on many  of  these  projects.   As  the  work  on  the  projects  progressed,   the Institutional Security Systems segment identified additional cost overruns which would cause the costs to complete  these projects to increase as a result of the changes in the estimates to complete.  Although the problem projects  identified in 2002 are  substantially  all  complete,  the  problems  in the ISS West Coast operations continued into 2003 and 2004. We realized that the management changes made in 2002 did not adequately address the root problems  identified,  and as a result, projects started after 2002 continued to experience cost overruns due to a lack  of  appropriate  oversight.  Staff  and  management  changes  in ISS are ongoing.  We have revised our estimates to complete  these  projects and believe that all future costs on these projects have been adequately  considered through December 31, 2004.  The West Coast problems, including project overruns, resulted in losses recorded in the following periods:                                          (in thousands)     Second Half of 2002                   $ 2,698     First Half of 2003                      1,674     Third Quarter of 2003                     541     Fourth Quarter of 2003                  1,872     First Quarter of 2004                   1,271     Second Quarter of 2004                  1,139     Third Quarter of 2004                   1,516     Fourth Quarter of 2004                  2,166                                           -------             Total West Coast Losses       $12,877                                           =======  To  address  this  situation,  the  Company  is  implementing  more  centralized controls,  replaced  certain  personnel  at its West  Coast  operations  and its Alabama headquarters, and hired a Chief Operating Officer.  Cost of goods sold in the Attack  Protection  segment of $23.6  million  for the year ended  December 31, 2004  increased $0.9 million or 4.1% from $22.7 million during  the same  period of 2003.  This  increase  occurred  in spite of a sales decrease of this segment of 11.3%,  resulting  in a 13.9%  decrease in the gross profit percentage to 6.2% from 20.1% during the year ended December 31, 2003. We are  actively  working to better  utilize  the 75,000  square  foot  factory the Company purchased in Montgomery,  Alabama. The Airteq manufacturing operation in Oregon was  relocated  in the  latter  part of 2003 and  consolidated  into this facility.  This was done in an effort to enhance  the  utilization  of our owned facilities in Alabama and thus absorb some of our excess manufacturing capacity. Although not the primary contributor,  this did result in further utilization of approximately  12,000 square feet of previously  unused  manufacturing  space in this plant in Alabama.  In  addition,  we  identified,  in late 2003,  a quality problem  with the  windows  and doors being  installed  on a project  ultimately completed in the fourth quarter of 2004. As a result of this identified problem, we took  remedial  action in the field to repair  this  defect.  During the year ended December 31, 2004 we increased our estimated cost to complete this project by $2.0 million thus causing this project to become a negative  margin  project. Cumulative write-downs on this project amount to $2.3 million.                                          20     Cost of goods sold in the Integrated Electronic Systems segment of $12.3 million for the year ended  December 31, 2004 decreased $1.6 million or 11.3% from $13.8 million during the same period of 2003.  This decrease was less than the related sales  decrease of this segment of 13.1%,  resulting  in a 1.8%  decrease in the gross profit percentage to 14.1% from 15.9% in the year ended December 31, 2003. Substantially all of the projects awarded in this segment are discrete projects.  Cost of goods sold in the Public Safety and Justice segment of $21.7 million for the year  ended  December  31,  2004 was down $4.2  million  or 16.2% from $25.9 million  during 2003.  This decrease was more than the related sales decrease of this  segment  of  0.8%,  resulting  in an 8.0%  increase  in the  gross  profit percentage to 56.0% from 48.0% in the year ended  December 31, 2003.  During the fourth  quarter  of 2003,  our  Public  Safety and  Justice  segment  received a complaint  alleging  that we breached  our  contract to provide a public  safety software  system to a client.  As a result,  we recorded a $1.6 million  pre-tax charge,  of which $600  thousand was recorded as a reduction of revenue and $1.0 million was recorded as a charge to cost of sales.  During the second quarter of 2004 this matter was  settled,  resulting  in a reversal of $0.3  million of the accrued charge,  which was reflected as a reduction of cost of sales. The net of this  activity  contributed  $1.9  million  of the  $3.8  million  gross  profit improvement in 2004 compared to 2003.  Selling,  general and  administrative  expenses  were $36.2 million for the year ended December 31, 2004, an increase of $3.9 million or 12.1% from $32.3 million for the same  period of 2003.  Much of this  increase  is related to  additional costs  incurred  by the  Company  related  to  legal  fees  in  connection  with responding  to and settling the  complaint  filed by a Public Safety and Justice segment  client,  expenses  incurred in  connection  with  evaluating  potential acquisitions,  recruiting  fees incurred to fill the recently hired COO position and other senior  management  positions and expenses  related to compliance with new requirements mandated by the Sarbanes-Oxley Act and the SEC.  During the fourth  quarter of 2004 the  Company  concluded  that the  continuing decline in the backlog in its ISS segment  constituted a triggering  event which caused the Company to conclude it was necessary to reassess and ultimately write off goodwill in the amount of $0.7 million and certain other  intangibles in the amount of $1.1 million. Those amounts appear as a separate line item in the 2004 statement of operations.  In conjunction  with the  acquisition of the assets of 90 Degrees and Copperfire and in compliance with Statement of Financial Accounting Standards No. 141 (SFAS 141) Business Combinations,  the Company preliminarily determined the fair value of the following  identifiable  assets and assigned the indicated  lives for the purposes of amortization and depreciation.                                         Amount                                    (in thousands)    Life (in years)                                    --------------    --------------- Software                              $ 2,800                 5 Employment Contracts                      120                1-3                                       --------                                       $ 2,920  The  amortization  of  the  above  assets  resulted  in  the  Company  recording amortization  expense related to these assets of $178 thousand in 2004, which is included in operating expenses.  Research and development  expenses were $7.8 million for the year ended December 31,  2004,  an increase of $0.4  million or 5.1% from $7.4  million for the same period of 2003.  Being a  technology-driven  enterprise,  the  Company's  Public Safety and  Justice  segment  continually  updates  and  enhances  its  software offerings, thus incurring significant research and development costs.  Interest expense  increased to $3.3 million for the year ended December 31, 2004 from $1.4  million  for the year ended  December  31, 2003 due to an increase in borrowings and overall higher interest  rates.  The following table compares the weighted average of the Company's years ended December 31, 2004 and December 31, 2003 interest bearing borrowings and the related rates charged thereon.                                            Monthly Weighted               Monthly Weighted                                         Average - 2004                 Average - 2003                                        Amount        Rate             Amount        Rate                                   ----------------  --------     ----------------  --------                                    (in thousands)                 (in thousands)      Bank borrowings                   $           617       4.2%     $        16,208       3.6% Industrial revenue bonds          $         4,162       3.1%     $         4,675       3.7% Subordinated borrowings           $        40,250       6.3%                   -         - Swap hedge agreement              $         3,721       3.6%     $         6,103       4.0%                                            21     In addition the Company recorded the following non-cash interest expense:  Amortization and write-off   of deferred financing charges  $           600                 $           250  Taxes on Income.  The effective tax benefit was  approximately  21% for the year ended December 31, 2004 and the effective tax rate was approximately 41% for the year ended December 31, 2003. The difference in rates is largely attributable to the losses experienced in 2004 and the related valuation  allowance  established for  substantially  all of the  Company's net deferred tax assets as of December 31, 2004.  Net (Loss) Income.  The Company reported net (loss) income of ($8.2) million and $3.4 million for the years ended December 31, 2004 and 2003,  respectively.  The reason for the loss in 2004 was the significant  decline in revenues.  While the Company was able to  significantly  reduce its cost of goods sold,  its selling, general and administrative  expenses increased while its revenues  significantly decreased,  contributing to the loss.  Diluted earnings per share decreased to a loss of ($1.01) in the year ended December 31, 2004 from a profit of $.42 in the year ended  December 31,  2003.  The weighted  average  number of common  shares outstanding  and  equivalents  used in computing EPS was 8.1 million in 2004 and 8.2 million in 2003.  Liquidity and Capital Resources  The  Company  funds  its  operations  through  cash  flows  generated  from  its operations,  bank and public  financings,  and the sale of its common stock. The Company's  liquidity  requirements  arise  from  cash  necessary  to  carry  its inventories and billed and unbilled receivables,  for capital  expenditures,  to repurchase  shares of its common stock under its share repurchase  program,  for payments  of  principal  and  interest  on  outstanding   indebtedness  and  for acquisitions.  The ultimate clients of the Company are primarily federal,  state and local  governmental  units.  In the event the funding of these  governmental units is reduced for any reason,  including budgetary reductions due to economic conditions, there is a risk that the demand for the Company's goods and services would decrease which would reduce the availability of funds to the Company.  As of December  31,  2005,  the Company  had  working  capital of $35.3  million compared with $44.0 million as of December 31, 2004.  Net cash used in operating  activities  was $3.6  million  during the year ended December 31, 2005 versus $4.5 million  provided by operating  activities  during the year ended  December  31,  2004.  This  decrease  was largely  caused by the decline in revenues and the $8.9 million loss  experienced  by the Company.  The largest  component  of cash used in  operating  activities  was an  increase  in accounts receivable of $5.2 million, which was partially offset by a decrease in cost in excess of  billings of $2.3  million and a decrease in prepaid  expenses and other current assets of $3.0 million.  Net cash  provided by investing  activities  was $6.5 million for the year ended December 31, 2005  compared to net cash used of $26.8  million in the year ended December 31, 2004.  In the year ended  December 31, 2005,  the net of marketable securities  bought and redeemed was an increase of cash of $8.0 million.  In the year ended December 31, 2004 the net purchase of marketable securities was $19.5 million.  Net cash used in  financing  activities  amounted  to $1.1  million for the year ended  December  31,  2005  compared  with  a net  cash  provided  by  financing activities of $25.6 million in the year ended  December 31, 2004.  The amount in 2004 was primarily  provided  through the issuance of the 2011 Notes,  offset by the repayment of $13.7 million of bank borrowings.  The following table summarizes contractual obligations consisting of total notes payable,  non-cancelable operating lease obligations and related interest of the Company as of December 31, 2005 and the payments due by period, in thousands.                                        Non-Cancelable          Interest on                                       --------------          -----------                     Notes Payable    Operating Leases   Contractual Obligations                     -------------    ----------------   -----------------------   December 31:       2006              $   440           $ 2,497          $    2,636       2007                  440             2,551               2,620       2008                  440             1,885               2,604       2009                  440             1,544               2,588       2010                  440             1,313               2,571   Thereafter             41,615             1,120                 856                         -------        ----------             --------   Totals                $43,815        $   10,910             $13,875                         =======        ==========             =======                                          22    In addition,  the Company enters into purchase  obligations to procure equipment and services,  including  subcontractor  contracts,  in the  performance  of the day-to-day  operations of its business.  Substantially  all of these obligations are covered by our existing backlog and the revenues generated by these backlogs are expected to be sufficient  to meet any payment  obligations  resulting  from these purchase commitments.  On January 22, 2004, the Company  completed the offering of the 2011 Notes.  The offering was for $40.25 million principal  amount.  The 2011 Notes bear interest at the rate of 6.25% per annum, payable semi-annually,  and are convertible into shares of common stock at a conversion  price of $13.89 per share.  The proceeds from the  2011  Notes  were  used to repay  substantially  all of the  Company's outstanding bank borrowings.  During  January 2004, the Company repaid  substantially  all of its  outstanding bank borrowings from the proceeds of the issuance of its 2011 Notes. The Company did not prepay any of its  Industrial  Revenue  Bond  ("IRB")  borrowings  as it determined that there are certain favorable tax treatments  afforded the Company when it  entered  into  these  IRBs,  which it  would  lose in the  event  these borrowings were prepaid.  On October 29, 2004 and March 4, 2005,  the  Company and its bank  entered  into amendments  to its  credit  agreement  pursuant  to which  the bank  waived  the Company's  non-compliance  with its fixed charge  coverage  ratio covenant as of September 30, 2004 and  non-compliance  with its minimum  EBITDA  covenant as of December 31, 2004,  respectively.  In addition, the Company and its bank amended the credit  agreement to  eliminate  the $15.0  million line of credit  maturing March 2005 and to require  borrowings  under its $10.0 million line of credit to be  secured by pledged  marketable  securities  equal to 111.11% of the value of such  borrowings  or cash  equal to the  value of such  borrowings.  The  credit agreement was also amended to permanently eliminate the quarterly minimum EBITDA covenant effective as of the Company's first quarter ended March 31, 2005 and to provide that the minimum fixed charge coverage ratio  covenant,  maximum debt to EBITDA ratio covenant and the minimum  consolidated  tangible net worth covenant were not to become effective until March 31, 2006. On May 3, 2005, the Company's bank  confirmed in writing that there will not be any event of default under the various credit agreements,  by virtue of the Company's failure to timely file an amendment to its Annual Report on Form 10-K for the year ended December 31, 2004 (the "2004  10-K") to  provide  management's  report on  internal  control  over financial  reporting  as of  December  31,  2004 and the  related  report of the Company's   independent   registered  public  accounting  firm  on  management's assessment of the  effectiveness  of internal  control over financial  reporting (together,  the "404 Report") required by Section 404 of the  Sarbanes-Oxley Act of 2002.  The 404 Report was filed with the SEC on Form 10-K/A on June 27, 2005. On  November  17,  2005,  the Company and its bank  entered  into an  additional amendment to the credit agreement  pursuant to which the bank agreed to increase its  commitment  to lend  under the  Company's  revolving  line of  credit  from $10,000,000 to $13,000,000,  to increase the letter of credit  subfacility  from $8,000,000 to $13,000,000 and to terminate the swing line subfacility.  On December 19, 2005, the Company and its bank entered into a Second Amended and Restated  Revolving  Credit and Security  Agreement (the "Second Restated Credit Agreement").  The Second  Restated  Credit  Agreement  amended and  restated the Company's Amended and Restated Credit Agreement dated March 31, 2004.  In connection with the execution of the Second Restated  Credit  Agreement,  the Company  provided  the bank  with  collateral  that  includes  all  receivables, equipment,  general intangibles,  inventory,  investment property, real property and a  security  interest  in  subsidiary  stock.  The  Second  Restated  Credit Agreement allows the Company to obtain revolving  advances in a principle amount of up to $20,000,000. Revolving advances are limited by a borrowing base formula based upon the value of the Company's receivables, inventory, fixed assets, real property and issued and  outstanding  letters of credit.  The maximum  aggregate face  amount of letters of credit  that may be drawn  under the Second  Restated Credit Agreement is limited to $18,000,000. The Second Restated Credit Agreement matures on December 18, 2008.  Revolving advances under the Second Restated Credit Agreement bear interest,  at the  election of the Company,  at a variable  rate equal to the  alternate  base rate, a prime interest based rate, or the Eurodollar  rate plus two and one half percent.  For letters of credit,  the Company  shall pay an amount  equal to the average daily face amount of each outstanding letter of credit multiplied by two and one half percent per annum, and a fronting fee of one quarter of one percent per annum, together with other administrative fees and charges. The Company paid its bank a closing fee of $50,000 in connection with the execution of the Second Restated  Credit  Agreement.  The  Company is also  required  to pay the bank an unused  fee equal to  three-eighths  of one  percent  per annum of the amount by which  $20,000,000  exceeds the average  daily unpaid  balance of the  revolving advances and undrawn amount of any outstanding  letters of credit.  In addition, the Company is required to pay a collateral  monitoring  fee equal to $1,000 per month and a collateral evaluation fee as required.  The Second Restated Credit Agreement  contains various  affirmative and negative covenants  including financial  covenants.  On the closing date, the Company was required to have undrawn availability of at least $10,000,000 and thereafter the                                          23     Company  is  required  to  maintain  an  unrestricted   undrawn  borrowing  base availability of at least  $5,000,000.  Commencing with the fiscal quarter ending June 30, 2006, the Company is required to maintain a fixed charge coverage ratio of at least 1.1 to 1.0.  The  Company's  total  outstanding  borrowings  at December 31, 2005 amounted to approximately  $42.9  million,  net of broker's  discounts in the amount of $0.9 million.  The 2011 Notes accounted for $39.3 million, net of broker's discounts, of  these  borrowings.  The  remaining  amount  of $3.6  million  resulted  from borrowings  at variable  rates and  consisted of two  industrial  revenue  bonds outstanding  in the  amounts  of $1.3  million  and $2.3  million.  The  average interest  rate  charged to the Company at December  31, 2005 for its  industrial revenue  bonds  was  3.7%.  The  variable  interest  rate for  these  borrowings fluctuated  between 1.6% and 3.7% during the year ended  December 31, 2005 based on weekly  market  conditions.  These  bonds are  fully  collateralized  by bank letters of credit issued under the Company's bank agreement.  The Company's bank considers  letters of credit as  outstanding  borrowings  when  considering  the amount of availability the Company has remaining under its line of credit.  Other than the Company's  letters of credit,  which amounted to $15.5 million at December  31,  2005,  the  Company  has no  other  material  off  balance  sheet liabilities.  At December 31, 2005 the Company had $3.6 million of unused availability.  The Company  anticipates  that cash generated from  operations and its currently available  cash will enable the Company to meet its liquidity,  working  capital and capital  expenditure  requirements  during the next 12 months.  The Company, however, may require additional  financing to pursue  acquisitions,  and to meet its long-term liquidity,  working capital and capital expenditure  requirements. If  such  financing  is  required,  there  are no  assurances  that  it  will be available,  or if available,  that it can be obtained on terms  favorable to the Company.  From time to time, the Company may be party to one or more non-binding letters of intent regarding material acquisitions, which, if consummated, may be paid for with cash or through the issuance of a significant  number of shares of the Company's common stock.  The Company has not been profitable and in fact has recorded  significant losses over the previous two years. We recognize that the return to  profitability is a critical  objective which the Company must attain. The Company continues to have a significant  amount of cash and marketable  securities on its balance sheet at December 31, 2005,  however,  the Company must return to profitability  prior to depleting its current cash and marketable securities.  On May 2, 2005, we filed a Form 8-K disclosing  that we failed to timely file an amendment to our Annual Report on Form 10-K for the year ended December 31, 2004 to provide  management's  report on internal control over financial reporting as of December 31, 2004 and the related report of our independent registered public accounting  firm on  management's  assessment of the  effectiveness  of internal control  over  financial  reporting  (together,  the "404  Report")  required by Section 404 of the  Sarbanes-Oxley  Act of 2002.  On May 3, 2005,  the Company's bank  confirmed in writing that there will not be any event of default under the various credit agreements, by virtue of the Company's failure to file its report required by Section 404 of Sarbanes-Oxley in a timely manner.  On May 4, 2005, we received a notice from the Listing Qualifications  Department of The Nasdaq  Stock  Market  stating that due to our failure to timely file the 404 Report, we were no longer in compliance with the requirements of Marketplace Rule 4310(c)(14). The Rule requires us to file with Nasdaq copies of all reports required to be filed with the  Securities  and Exchange  Commission on or before the date they are required to be filed with the SEC.  On June 27, 2005,  the Company filed its Form 10-K/A with the SEC containing the 404 Report.  On June 30, 2005, the Nasdaq Listing  Qualifications  Panel advised CompuDyne  that  CompuDyne had remedied its filing  delinquency  and was in full compliance with Nasdaq Market Place Rules.  Another  consequence of not filing the 404 Report timely as noted above includes our  inability to use a shorter form  registration  document for one year in the event we were to engage in an  offering  of our  securities.  This could have an adverse impact on our ability to raise capital and the cost of raising capital.  Additional Considerations  Bid Bonds and Payment and Performance Bonds Historically,  certain of the Company's projects have required bid bonds at time of proposal submission and payment and/or performance bonds upon contract award. The  majority  of these  bonds  have been  needed in the ISS and PS&J  segments. Recently,  approximately  75% of ISS' work has come from jobs where  payment and                                          24     performance  bonds  are  required  and for  PS&J,  19% of its work has  required payment and  performance  bonds.  The Company's  recent losses have made it more challenging  for the Company to attain the bonding needed to procure  certain of its  projects.  As of December  31,  2005,  the Company was  required to provide collateral  for two of its  projects  which it did by  issuing  bank  letters of credit as collateral in the amount of  approximately  $5.5 million in total.  In the  event the  Company  is unable to  obtain  bonds,  or if the  terms,  namely additional  collateral,  of the bonds are not within the financial  means of the Company,  the  amount  of work  the  Company  is able to  contract  for  will be negatively impacted.  Cost Containment Due to current economic conditions, the Company's losses, and in light of a very strong  competitive  environment,  the  Company  recognizes  that its ability to increase the prices it charges its clients is limited. In addition,  in light of escalating selling, general and administrative costs associated with the current heightened regulatory  environment,  we are evaluating our strategy to determine if a revised strategy would result in lower selling,  general and administrative costs.  As a result,  in order to enhance our  profitability,  the Company  will continue to seek ways to reduce its costs.  Total Backlog CompuDyne's backlog amounted to $148.1 million at December 31, 2005. This was an increase  of 16.8%  from the  Company's  December  31,  2004  backlog  of $126.9 million.  The break down of the Company's  backlog by segment is as follows,  in thousands:                                                        December 31,                                              --------------------------------                                                  2005               2004                                              -------------      -------------           Institutional Security Systems         $ 58,128           $ 49,324          Attack Protection                        28,802             20,803          Integrated Electronic Systems             7,503              8,299          Public Safety and Justice                53,705             48,434                                              -------------      -------------                   Total                         $148,138           $126,860                                              =============      =============  Included in the backlog of the ISS, AP and PS&J segments at December 31, 2005 is $11.9 million, $0.8 million and $5.4 million, respectively,  representing awards received by the segment for which the clients  have not yet entered  into signed contracts. These awards are expected to result in signed contracts over the next twelve months.  Corporate Reorganization As part of the Company's  efforts to better  manage its costs,  during the first quarter of 2005 the Company  implemented a corporate  reorganization  whereby it converted several corporate entities into LLCs (Limited Liability Corporations). This activity was designed to improve the Company's tax reporting  structure and should  help  better  manage the  Company's  state  income tax  obligations.  In conjunction  with this  reorganization,  our  Federal  Security  Systems  group, formerly   known   as   Quanta   Systems    Corporation,    was   re-formed   as CompuDyne-Integrated  Electronics  Division,  LLC,  and our  Public  Safety  and Justice group,  formerly known as Tiburon, was renamed  CompuDyne-Public  Safety and Justice, Inc. In addition,  CorrLogic,  Inc. was converted to CorrLogic, LLC and Fiber SenSys,  Inc. was  converted to Fiber SenSys,  LLC. The impact of this reorganization  is not  expected  to have a material  effect on  operations.  In addition,  in light of  escalating  selling,  general and  administrative  costs associated with the current heightened regulatory environment, we are evaluating our structure to determine if another  organizational  structure would result in lower selling, general and administrative costs.  Critical Accounting Policies and Estimates Percentage of Completion  Accounting and Revenue Recognition.  Approximately 60% of the Company's revenues are derived from long-term  contracts where revenue is recognized  under  the  percentage  of  completion  method  of  accounting.  The Company's  software related  contracts utilize labor hours incurred to date on a project, divided by the total expected project hours to determine the completion percentage.  The Company's construction contracts utilize costs incurred to date on a project,  divided by the total  expected  project  costs to  determine  the completion percentage.  Both of these methods require considerable judgment and, as such, the estimates  derived at any point in time could differ  significantly from actual  results.  These  estimates  affect  many of the  balance  sheet and statement  of  operations  accounts  including  net sales,  cost of goods  sold, accounts receivable, contract costs in excess of billings and billings in excess of contract costs incurred.  Revenues for support and  maintenance  contracts  are  deferred  and  recognized ratably over the life of the contract.  Sales of products  unrelated to contract revenue are  recognized as revenue when all of the  following  criteria are met: persuasive evidence of an arrangement exists;  delivery has occurred or services have been rendered;  the seller's  price to the buyer is fixed or  determinable; and collectibility is reasonably assured.                                          25     Provisions for estimated  losses on uncompleted  contracts are recognized in the period such losses are determined.  Inventories  are  stated at the  lower of cost or  market,  using the  First-in, First-out  (FIFO) method.  Costs  included in inventories  consist of materials, labor,  and  manufacturing  overhead,  which are  related  to the  purchase  and production of inventories.  Warranty  reserves  are  estimated  and  made at the time  products  are sold or services are rendered.  They are established using historical information on the nature,  frequency  and average cost of warranty  claims.  The Company  warrants numerous  products,  the terms of which vary  widely.  In  general,  the Company warrants its products against defect and specific non-performance.  Accounts  receivable are expected to be substantially  collected within one year except  for a  portion  of the  receivables  recorded  as  retainage.  Retainage expected to be collected in over one year is reflected as a current  asset as it will be collected within the operating cycle under the related contract.  Tax valuation  allowances are  established  when the Company  believes it is not "more  likely than not" that the Company will be able to receive tax benefits in the future.  The  federal  income tax benefit  recorded in 2005  represents  the reduction of a liability  maintained  for uncertain  tax positions  which was no longer required.  Goodwill and Intangible Assets. The Company  reviews the carrying  value of goodwill and  intangible  assets not subject to  amortization  annually during the fourth quarter of the year or when events or changes in  circumstances  indicate that the carrying value may not be recoverable,  utilizing a  discounted  cash flow model.  Changes in estimates of future cash flows caused by items such as unforeseen events or changes in market conditions could negatively affect the Company's reporting units' fair value and result in an impairment  charge.  The carrying  value of goodwill and intangible assets not subject to amortization totaled  approximately $26.8 million and $5.6 million,  respectively,  and intangible  assets subject to amortization  totaled approximately  $2.6  million,  net, at December  31,  2005.  The Company  cannot predict the occurrence of events that might adversely affect these values.  Stock Compensation Policy. The Company accounts for its stock-based  compensation using the intrinsic value method and in accordance with the recognition and measurement  principles of APB Opinion  No.  25,  "Accounting  for Stock  Issued  to  Employees,"  and  related interpretations.  No stock-based employee  compensation cost is reflected in net income,  as all options  granted had an exercise  price equal to the fair market value of the underlying common stock on the date of the grant.  Economic  Conditions  and the After Effect of the September  11, 2001  Terrorist Attacks Much of the work CompuDyne performs is for state and local  governmental  units. These  entities were severely  impacted by recent  economic  conditions  and the resulting  contraction of the tax bases of these  governmental  units.  This has caused these  governmental  units to carefully  evaluate their budgets and defer expenses and projects where possible.  Much of the work of the Company's  Public Safety and Justice and  Institutional  Security  Systems  segments is contracted with these state and local governmental units. As a result,  these segments have seen delays in new work  available  to be bid and worked on. In  addition,  even work that had been  contracted  for was sometimes  deferred by the customer into the future. In recent months, it appears the state and local government revenues have been improving, resulting in increased activity preparatory to the issuance of requests for new bids and ultimately, the Company expects the awarding of new projects.  It  appears  to us that we are in the  early  stages  of an  economic recovery.  After the  occurrence of the tragic  events of the September 11, 2001  terrorist attacks,  there was a general perception that our Integrated  Electronic Systems and Attack Protection  segments would see a significant  increase in order flow. To the  contrary,  in the  months  subsequent  to the  terrorist  attacks  these segments saw a slowing in new work opportunities as the various federal agencies and other  customers  that are the usual source of their  business  slowed their procurement  processes waiting for definitive  direction as to how to proceed in the post September 11 world.  Now further  complicated by the military action in Iraq,  the Company's  clients are  reevaluating  priorities  and budgets and are funding only their most  pressing  demands while also making key decisions as to which projects can be deferred.  As a result of the above  factors,  during the last four years the  Company  has experienced a more  challenging  marketplace  than it  experienced  in the years prior to September 11, 2001.  Market Risk The Company is exposed to market risk related to changes in interest rates.  The Company  entered into a 4.9% fixed rate interest rate swap agreement on June 26, 2001 in the initial  notional  amount of $11.5 million.  The notional  amount of                                          26     this swap  agreement  declined by $676  thousand  on a quarterly  basis until it matured on September  30, 2005. In January 2004 the interest rate swap ceased to be a  highly-effective  cash  flow  hedge  when the  related  debt  was  repaid. Consequently,  the amounts previously recorded in other comprehensive  income as changes in fair value of the interest rate swap were  recognized in earnings for the  year  ended   December  31,   2004.   Upon   determination   of  the  hedge ineffectiveness, the cumulative loss on the fair value of the interest rate swap was $155 thousand,  which was  recognized in other  expense.  The change in fair value of the interest rate swap for the year ended  December 31, 2005 was a gain of $21 thousand.  On January 22,  2004,  the  Company  completed  an  offering  of $40.25  million principal  amount of the 2011 Notes. The 2011 Notes bear interest at the rate of 6.25% per annum,  payable  semi-annually,  and are  convertible  into  shares of common  stock at a  conversion  price of $13.89 per share.  The  Company  used a portion of the proceeds of this note offering to pay down outstanding borrowings under its variable rate bank notes. Subsequent to the pay-down of its bank notes the only variable rate borrowing  remaining  outstanding at December 31, 2005 is approximately  $3.6 million of industrial  revenue  bonds.  Since this borrowing bears  interest at variable  rates,  and in the event  interest  rates  increase dramatically,  the increase in interest expense to the Company could be material to the results of operations of the Company.  Recent Accounting Pronouncements In  May  2005,  the  FASB  issued  SFAS  154,   "Accounting  Changes  and  Error Corrections" (SFAS 154) which replaces APB Opinion No. 20, "Accounting  Changes" and SFAS 3, "Reporting  Accounting  Changes in Interim  Financial  Statements-An Amendment of APB Opinion No. 28." SFAS 154 provides  guidance on the  accounting for and reporting of accounting  changes and error  corrections.  It establishes retrospective  application,  or the latest  practicable  date,  as the  required method for  reporting a change in  accounting  principle  and the reporting of a correction  of an  error.  SFAS 154 is  effective  for  accounting  changes  and corrections  of errors made in fiscal years  beginning  after December 15, 2005. The  adoption  of SFAS 154 is not  expected  to have a  material  impact  on our consolidated financial position, results of operations or cash flows.  In December  2004, the FASB issued  Statement No. 153,  Exchanges of Nonmonetary Assets,  an  amendment  of APB  Opinion  No. 29.  Statement  153  addresses  the measurement  of  exchanges  of  nonmonetary  assets and  redefines  the scope of transactions  that  should be  measured  based on the fair  value of the  assets exchanged.  Statement 153 is effective for nonmonetary asset exchanges occurring in fiscal periods  beginning  after June 15, 2005. The adoption of Statement 153 has not had a material effect on our consolidated financial position, results of operations or cash flows.  In December 2004, the FASB issued FASB Staff Position No. 109-1,  Application of FASB  Statement  No. 109 (SFAS 109),  Accounting  for Income  Taxes,  to the Tax Deduction  on Qualified  Production  Activities  Provided by the  American  Jobs Creation Act of 2004 (FSP 109-1).  FSP 109-1  clarifies that the  manufacturer's deduction  provided  for under the  American  Jobs  Creation  Act of 2004 (AJCA) should be accounted for as a special  deduction in accordance  with SFAS 109 and not as a tax rate  reduction.  The  adoption  of FSP  109-1 had no impact on the Company's  results of  operations  or  financial  position  for fiscal year 2005 because the  manufacturer's  deduction is not available due to the Company's net loss carryforwards. The Company is evaluating the effect that the manufacturer's deduction will have in subsequent years.  In  December  2004,  the FASB  issued SFAS No.  123R,  "Share-Based  Payment," a revision  of  SFAS  No.  123,  "Accounting  for  Stock-Based  Compensation"  and superseding APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS No. 123R requires the Company to expense  grants made under its stock option and employee  stock purchase plan  programs.  That cost will be recognized  over the vesting  period of the options.  SFAS No. 123R is effective for the first annual period  beginning  after June 15, 2005.  The Company has not yet  determined the method of adoption or the effect of adopting SFAS 123R,  and has not  determined whether the adoption  will result in amounts that are similar to the current pro forma  disclosures  under SFAS 123. The Company is evaluating  the  alternatives allowed under the standard,  which the Company is required to adopt beginning in the first quarter of 2006.  In November 2004, the FASB issued SFAS No. 151,  "Inventory Costs," an amendment to ARB No. 43, Chapter 4, "Inventory  Pricing," to clarify that abnormal amounts of  idle  facility  expenses,  freight,  handling  costs  and  wasted  materials (spoilage) should be recognized as current-period  charges. In addition, FAS 151 requires that allocation of fixed production overhead to the costs of conversion be based on the normal  capacity of the production  facilities.  SFAS No. 151 is effective for inventory  costs incurred during fiscal years beginning after June 15, 2005. There has been no material effect on the financial  position,  results of operations, or cash flows of the Company upon adoption of this statement.                                          27
Interest Rate Risk CompuDyne  has fixed and variable rate notes  payable.  These  on-balance  sheet financial instruments expose the Company to interest rate risk, with the primary interest  rate  exposure  resulting  from  changes  in the bond  market  used to determine the interest rate applicable to the borrowings under the Company's IRB borrowings.  The following information  summarizes our sensitivity to market risks associated with  fluctuations in interest rates as of December 31, 2005. To the extent that the Company's  financial  instruments  expose the Company to interest rate risk, they are presented in the table below.  The table presents  principal cash flows and related  interest  rates by year of maturity of the Company's  notes payable with variable rates of interest in effect at December 31, 2005.  On January 22,  2004,  the  Company  completed  an  offering  of $40.25  million principal  amount of 6.25%  Convertible  Subordinated  Notes due on January  15, 2011.  The 2011  Notes  bear  interest  at a rate of 6.25%  per  annum,  payable semi-annually,  and are convertible  into shares of common stock at a conversion price of $13.89 per share.  The  Company  used a portion of the  proceeds of the 2011  Notes to pay down its  variable  bank notes  payable.  The pay down of its variable borrowings reduced the Company's interest rate risk.  Financial Instruments by Expected Maturity Date   Notes Payable       Variable                        Fixed   Year Ending        Rate ($)    Average Variable    Rate ($)     Average Fixed    December 31    (in thousands)  Interest Rate   (in thousands)  Interest Rate - --------------------------------------------------------------------------------      2006          $       440        3.67%    $          -              -      2007                  440        3.67%               -              -      2008                  440        3.67%               -              -      2009                  440        3.67%               -              -      2010                  440        3.67%               -              -     Thereafter           1,365        3.67%          40,250           6.25%                     -----------                 ------------     Total          $     3,565        3.67%    $     40,250           6.25%     Fair Value     $     3,565        3.67%    $     26,162          11.73%                                          28
The following consolidated financial statements of the Corporation and its subsidiaries are included herein as indicated below:       Report of Independent Registered Public Accounting Firm - Aronson & Company      Report   of   Independent    Registered    Public    Accounting    Firm   -      PricewaterhouseCoopers LLP      Report of Independent Registered Public Accounting Firm - Deloitte & Touche      LLP      Consolidated Balance Sheets at December 31, 2005 and 2004      Consolidated  Statements  of  Operations  for the years ended  December 31,      2005, 2004 and 2003      Consolidated  Statement  of Changes in  Shareholders'  Equity for the years      ended December 31, 2005, 2004 and 2003      Consolidated  Statements  of Cash Flows for the years  ended  December  31,      2005, 2004 and 2003      Notes to Consolidated Financial Statements                                          29     REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM  To the Board of Directors and Shareholders of CompuDyne Corporation Annapolis, Maryland  We have  audited  the  accompanying  Consolidated  Balance  Sheet  of  CompuDyne Corporation   and   Subsidiaries  as  of  December  31,  2005  and  the  related Consolidated  Statements of Operations,  Stockholders' Equity and Cash Flows for the year then ended.  Our audit also included the financial  statement  schedule for the year ended December 31, 2005, listed in the index at Item 15a(2).  These financial  statements and financial statement schedule are the responsibility of the  Corporation's  management.  Our  responsibility is to express an opinion on these financial statements and financial statement schedule based on our audit.  We conducted  our audit in accordance  with the standards of the Public  Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes 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 also 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 audit provides a reasonable basis for our opinion.  In our opinion,  the financial  statements  referred to above present fairly, in all  material  respects,   the  consolidated  financial  position  of  CompuDyne Corporation  and  Subsidiaries as of December 31, 2005, and the results of their operations  and their  cash  flows for the year then  ended in  conformity  with accounting principles generally accepted in the United States of America.  Also, in our  opinion,  the related  financial  statement  schedule for the year ended December 31, 2005, when considered in relation to the basic financial statements taken as a whole,  presents fairly in all material  respects the information set forth therein.  ARONSON & COMPANY  Rockville, Maryland March 10, 2006                                          30     REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM  To the Board of Directors and Shareholders of CompuDyne Corporation Annapolis, Maryland  In our opinion,  the  accompanying  consolidated  balance  sheet and the related consolidated  statement of operations,  changes in shareholders' equity and cash flows  present  fairly,  in all material  respects,  the  financial  position of CompuDyne  Corporation and its subsidiaries at December 31, 2004 and the results of its  operations  and its cash flows for the year ended  December  31, 2004 in conformity with accounting principles generally accepted in the United States of America. In addition,  in our opinion,  the financial statement schedule for the year ended December 31, 2004 listed in the index  appearing  under Item 15(a)(2) presents  fairly,  in all material  respects,  the information set forth therein when read in conjunction  with the related  consolidated  financial  statements. These   financial   statements   and  financial   statement   schedule  are  the responsibility of the Company's management.  Our responsibility is to express an opinion on these financial  statements and financial statement schedule based on our audit.  We conducted our audit of these  statements  in accordance  with the standards of the Public  Company  Accounting  Oversight  Board (United  States). Those standards  require that we plan and perform the audit to obtain reasonable assurance   about  whether  the  financial   statements  are  free  of  material misstatement.  An audit includes examining, on a test basis, evidence supporting the  amounts  and  disclosures  in  the  financial  statements,   assessing  the accounting  principles  used and significant  estimates made by management,  and evaluating the overall  financial  statement  presentation.  We believe that our audit provides a reasonable basis for our opinion.  PRICEWATERHOUSECOOPERS LLP  Baltimore, Maryland March 31, 2005                                          31     REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM  To the Board of Directors and Shareholders of CompuDyne Corporation Annapolis, Maryland  We  have  audited  the  accompanying   consolidated  statements  of  operations, shareholders' equity, and cash flows of CompuDyne Corporation for the year ended December 31, 2003. Our audit  also included the financial statement schedule for the year ended  December  31, 2003,  listed in the Index at Item  15a(2).  These financial  statements and financial statement schedule are the responsibility of the Corporation's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audit.  We conducted our audit  in accordance  with the standards of the Public  Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes 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 also 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 audit provides a reasonable basis for our opinion.  In our opinion,  such consolidated  financial  statements present fairly, in all material respects, the results of CompuDyne  Corporation's  operations and their cash flows for the year ended December 31, 2003, in conformity  with  accounting principles  generally  accepted in the United  States of America.  Also,  in our opinion,  such financial statement schedule,  when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.  DELOITTE & TOUCHE LLP  Baltimore, Maryland March 8, 2004                                          32                          COMPUDYNE CORPORATION AND SUBSIDIARIES                            CONSOLIDATED BALANCE SHEETS                                                                             December 31,      December 31,                                    ASSETS                                  2005              2004                                                                       ---------------   ---------------                                                                              (dollars in thousands) Current Assets         Cash and cash equivalents                                       $         6,938   $         5,198      Marketable securities                                                    11,429            19,577      Accounts receivable, net                                                 39,625            34,291      Contract costs in excess of       billings                                                                13,764            16,087      Inventories                                                               6,195             5,165      Prepaid expenses and other                                                2,809             5,412                                                                       ---------------   ---------------         Total Current Assets                                                  80,760            85,730  Property, plant and equipment, net                                             9,962            12,094 Goodwill                                                                      26,846            25,894 Other intangible assets, net                                                   8,221             8,460 Other                                                                            903               713                                                                       ---------------   ---------------         Total Assets                                                 $       126,692   $       132,891                                                                       ===============   ===============                        LIABILITIES AND SHAREHOLDERS' EQUITY  Current Liabilities      Accounts payable and accrued liabilities                        $        23,030  $        21,771      Billings in excess of contract costs incurred                            13,847           13,497      Deferred revenue                                                          8,094            5,998      Current portion of notes payable                                            440              440                                                                       ---------------  ---------------         Total Current Liabilities                                             45,411           41,706  Notes payable                                                                  3,125            3,565 Convertible subordinated notes payable, net                                   39,305           39,118 Deferred tax liabilities                                                       2,060            2,072 Other                                                                            369              599                                                                       ---------------  ---------------         Total Liabilities                                                     90,270           87,060                                                                       ---------------  ---------------  Commitments and Contingencies  Shareholders' Equity      Preferred stock, 2,000,000 shares authorized and unissued                     -                -      Common stock, par value $.75 per share:  50,000,000 shares        authorized at December 31, 2005 and December 31, 2004;        8,950,356 and 8,943,856 shares issued at December 31,        2005 and December 31, 2004, respectively                                6,712            6,707      Additional paid-in-capital                                               44,388           44,368      Accumulated deficit                                                      (8,963)            (272)      Accumulated other comprehensive (loss) income                               (39)              14      Treasury stock, at cost; 831,777 and 721,077 shares        at December 31, 2005 and December 31, 2004, respectively               (5,676)          (4,986)                                                                       ---------------  ---------------         Total Shareholders' Equity                                            36,422           45,831                                                                       ---------------  ---------------         Total Liabilities and Shareholders' Equity                   $       126,692  $       132,891                                                                       ===============  ===============       The accompanying notes are an integral part of these financial statements.                                          33                          COMPUDYNE CORPORATION AND SUBSIDIARIES                       CONSOLIDATED STATEMENTS OF OPERATIONS                                                                        Year Ended December 31,                                                              2005             2004             2003                                                        ---------------  ---------------  ---------------                                                               (in thousands, except per share data) Revenues:      Contract revenues earned                             $       106,512  $       114,899  $       160,709  Other revenues                                                35,138           27,883           32,554                                                        ---------------  ---------------  ---------------   Total revenue                                               141,650          142,782          193,263  Cost of  Sales                                                 99,111          105,104          146,867                                                        ---------------  ---------------  ---------------  Gross profit                                                   42,539           37,678           46,396  Selling, general and administrative expenses                   40,567           36,219           32,305 Research and development                                        8,685            7,755            7,374 Impairment of goodwill and other intangibles                        -            1,826                -                                                        ---------------  ---------------  --------------- (Loss) income from operations                                  (6,713)          (8,122)           6,717                                                        ---------------  ---------------  ---------------  Other expense (income)  Interest expense                                               3,065            3,298            1,389  Interest income                                                 (832)          (1,009)            (338)  Other (income) expense                                           (40)              19              (90)                                                        ---------------  ---------------  ---------------   Total other expense                                           2,193            2,308              961                                                        ---------------  ---------------  ---------------  (Loss) income before income taxes                              (8,906)         (10,430)           5,756 Income taxes (benefit) expense                                   (215)          (2,232)           2,348                                                        ---------------  ---------------  --------------- Net (loss) income                                     $        (8,691) $        (8,198) $         3,408                                                        ===============  ===============  ===============  Earnings (loss) per share: Basic earnings (loss) per common share                $         (1.07) $         (1.01) $           .43                                                        ===============  ===============  ===============  Weighted average number of common shares outstanding                                              8,129            8,136            7,895                                                        ===============  ===============  ===============  Diluted earnings (loss) per common share              $         (1.07) $         (1.01) $           .42                                                        ===============  ===============  ===============  Weighted average number of common shares and equivalents                                          8,129            8,136            8,158                                                        ===============  ===============  ===============       The accompanying notes are an integral part of these financial statements.                                          34                          COMPUDYNE CORPORATION AND SUBSIDIARIES            CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY                                  (in thousands)                                                                                     Accumulated                                                          Additional  Retained     Other                                         Common Stock      Paid-in   Earnings   Comprehensive     Treasury Stock                                       Shares     Amount   Capital   (Deficit)   Income (Loss)  Shares   Amount     Total                                     ---------- --------- ---------- ----------  ------------  ------- ---------- ---------          Balance at December 31, 2002            8,392   $  6,294  $  42,508 $    4,518  $      (196)     574   $ (3,920) $ 49,204  Tax benefit from the exercise of stock options                                                127                                                   127 Acquisition of Tiburon Purchase price adjustment                                      (370)                                                 (370) Stock options exercised                   128         96        360                                                   456 Warrants exercised                         48         36        130                               21       (166)        - Purchase of treasury shares                                                                        -         (1)       (1)                                     -----------------------------------------------------------------   --------  --------  Subtotal                               8,568      6,426     42,755      4,518         (196)     595     (4,087)   49,416 Comprehensive income:  Net income                                                              3,408                                      3,408 Other comprehensive income, net of tax:  Gain on interest rate   swap agreement                                                                        110                           110 Translation adjustment                                                                   (7)                           (7)                                                                                                                   -------- Comprehensive income (loss)                                                                                         3,511                                     ----------------------------------------------------------------------------  -------- Balance at December 31, 2003            8,568      6,426     42,755      7,926          (93)     595     (4,087)   52,927  Common stock issued in connection with acquisition                72         54        585                                                   639 Stock options exercised                   304        227      1,028                                                 1,255 Purchase of treasury shares                                                                      126       (899)     (899)                                     -----------------------------------------------------------------   --------  --------  Subtotal                               8,944      6,707     44,368      7,926          (93)     721     (4,986)   53,922 Comprehensive income:  Net loss                                                               (8,198)                                    (8,198) Other comprehensive income, net of tax:  Gain on interest rate swap   agreement                                                                              93                            93 Unrealized gain on available for sale marketable securities                                                               14                            14                                                                                                                   -------- Comprehensive income (loss)                                                                                        (8,091)                                     ----------------------------------------------------------------------------  -------- Balance at December 31, 2004            8,944      6,707     44,368       (272)          14      721     (4,986)   45,831  Stock options exercised                     6          5         20                                                    25 Purchase of treasury shares                                                                      111       (690)     (690)                                     -----------------------------------------------------------------   --------  --------  Subtotal                               8,950      6,712     44,388       (272)          14      832     (5,676)   45,166 Comprehensive income:  Net loss                                                               (8,691)                                    (8,691) Other comprehensive loss, net of tax: Unrealized loss on available for sale marketable securities                                                              (53)                          (53)                                                                                                                   -------- Comprehensive loss                                                                                                 (8,744)                                     ----------------------------------------------------------------------------  -------- Balance at December 31, 2005            8,950   $  6,712  $  44,388 $   (8,963) $       (39)     832   $ (5,676) $ 36,422                                     ==========   ========  ========= ==========  ====================   ========  ========       The accompanying notes are an integral part of these financial statements.                                          35                          COMPUDYNE CORPORATION AND SUBSIDIARIES                       CONSOLIDATED STATEMENTS OF CASH FLOWS                                                                                        Year Ended December 31,                                                                                 2005            2004            2003                                                                        --------------  --------------  --------------                                                                                        (in thousands)     Cash flows from operating activities: Net (loss) income                                                     $       (8,691) $       (8,198) $        3,408  Adjustments to reconcile net (loss) income to  net cash provided by (used in) operations:      Depreciation and amortization                                             3,393           2,921           2,988      Deferred income tax (benefit) expense                                       (12)           (219)            245      (Gain) loss from disposition of property, plant and equipment                (5)              2               -      Impairment of goodwill and other intangibles                                  -           1,826               -      Amortization of debt discount                                               187             176               -      Amortization of discounts of marketable securities                           11             (18)              -      Unrealized loss on interest rate swap                                         -              21               -  Changes in assets and liabilities:      Accounts receivable                                                      (5,244)          7,507           3,388      Contract costs in excess of billings                                      2,323           1,481           1,305      Inventories                                                              (1,028)          1,539            (303)      Prepaid expenses and other current assets                                 3,018          (3,160)            188      Other assets                                                               (190)            191            (237)      Accounts payable and accrued liabilities                                    885             616            (830)      Billings in excess of contract costs incurred                               350             (54)            (51)      Deferred revenue                                                          1,606             (38)            224      Other liabilities                                                          (230)            (66)            665                                                                        --------------  --------------  -------------- Net cash flows (used in) provided by  operating activities                    (3,627)          4,527          10,990                                                                        --------------  --------------  --------------  Cash flows from investing activities:      Purchase of marketable securities                                       (14,610)        (42,361)              -      Redemption of marketable securities                                      22,660          22,824               -      Additions to property, plant and equipment                               (1,252)         (1,784)         (1,068)      Proceeds from sale of property, plant and equipment                           7               4              14      Cash acquired from acquisition                                              363               -               -      Net payment for acquisitions                                               (696)         (5,526)            (71)                                                                        --------------  --------------  -------------- Net cash flows provided by (used in) investing activities                      6,472         (26,843)         (1,125)                                                                        --------------  --------------  --------------  Cash flows from financing activities:      Warrants exercised                                                            -               -             166      Stock options exercised                                                      25           1,255             583      Purchase of treasury stock                                                 (690)           (899)           (167)      Repayment of bank notes and lines of credit                                (440)        (13,653)         (9,852)      Borrowings of convertible subordinated notes payable                          -          38,942               -                                                                        --------------  --------------  -------------- Net cash flows (used in) provided by financing activities                     (1,105)         25,645          (9,270)                                                                        --------------  --------------  --------------  Net change in cash and cash equivalents                                        1,740           3,329             595 Cash and cash equivalents at the beginning of the year                         5,198           1,869           1,274                                                                        --------------  --------------  -------------- Cash and cash equivalents at the end of the year                      $        6,938  $        5,198  $        1,869                                                                        ==============  ==============  ==============  Supplemental disclosures of cash flow information:   Cash paid during the year for:      Interest                                                         $        2,690  $        1,573  $        1,087      Income taxes, net of refunds                                     $           88  $          771  $        1,873   Common stock issued in connection with acquisition                  $            -  $          639  $            -       The accompanying notes are an integral part of these financial statements.                                          36                          COMPUDYNE CORPORATION AND SUBSIDIARIES                    NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  1.   NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES  Nature of Operations CompuDyne  Corporation,  a Nevada  corporation,  operates in four sectors of the security industry - Institutional  Security Systems,  Attack Protection,  Public Safety and Justice, and Integrated Electronic Systems.  The  Institutional  Security  Systems segment  provides  physical and electronic security products and services to the corrections  industry (jails and prisons), and to the courthouse, municipal and commercial markets.  The Attack Protection segment  manufactures  bullet,  blast and attack resistant windows  and  doors  designed  for  high-end  security  applications,  including embassies,   courthouses,   Federal  Reserve   buildings  and  banks;  and  also manufactures  fiber optic  systems used to detect  physical  intrusion,  protect large  perimeters  and for the physical  protection of data lines;  and,  fixed, removable, semi-automatic vehicle bollards and wedge barrier security systems.  The Integrated  Electronic  Systems segment provides the United States military, governmental  agencies and state and local units with specialty  engineering and security services, often of a classified nature.  The Public  Safety and  Justice  segment  provides a fully  integrated  suite of products including computer assisted dispatching,  records management, court and probation  software  systems,   and  inmate  management  software  for  the  law enforcement, fire and rescue, corrections and justice environments.  Summary of Significant Accounting Policies The  consolidated   financial  statements  of  CompuDyne   Corporation  and  its subsidiaries  have  been  prepared  in  accordance  with  accounting  principles generally accepted in the United States of America.  Principles of Consolidation The  consolidated   financial  statements  include  the  accounts  of  CompuDyne Corporation and its subsidiaries (collectively "CompuDyne" or "the Company").  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  of assets and liabilities  and disclosure of contingent  assets and liabilities at the date of the  financial  statements  and the  reported  amounts of revenues  and expenses during the reporting period. These include estimates of percentage-completion on long-term contracts and valuation allowances for contracts, accounts receivable, inventories  and deferred  tax assets.  Actual  results  could differ from those estimates.  Revenue Recognition Much of the  Company's  revenues  are derived  from  long-term  contracts  where revenue is recognized  under the percentage of completion  method of accounting. Revenues and the associated  costs from software  products and related  hardware installations,  as well as computer programming and systems engineering services delivered  as part of the  Company's  delivery  of its  software  products,  are recognized using the percentage-of-completion  method using labor hours incurred relative to total  estimated  contract hours as the measure of progress  towards completion.  The Company's construction contracts utilize costs incurred to date on a project  divided  by the total  expected  project  costs to  determine  the completion  percentage.  Revenue under cost reimbursable contracts is recognized to the extent of costs incurred to date plus a  proportionate  amount of the fee earned.  Revenue under time and materials  contracts is recognized to the extent of billable rates times hours incurred plus materials expense incurred.  Revenue from fixed price  construction  contracts is recognized  under the percentage of completion  method,  whereby a portion of the total contract price is recognized based on the amount of costs incurred to date as a percentage of total estimated costs.  Changes in revenue,  costs,  and profit  estimates  occurring during the course of a contract are  recognized  in the period in which the  revisions  are determined.  Revenues  for support and  maintenance  contracts  are deferred and recognized  ratably  over the life of the  service  contract.  Sales of products unrelated  to  contract  revenue  are  recognized  as  revenue  when  all of the following  criteria  are met:  persuasive  evidence  of an  arrangement  exists; delivery has occurred or services have been rendered;  the seller's price to the buyer  is fixed or  determinable;  and  collectibility  is  reasonably  assured. Provisions for estimated  losses on uncompleted  contracts are recognized in the period such losses are  determined.  Costs and  estimated  earnings in excess of billings on  uncompleted  contracts  represent  the excess of contract  revenues recognized  to date over  billings  to date on certain  contracts.  Billings  in                                          37     excess of costs and estimated  earnings on uncompleted  contracts  represent the excess of  billings  to date over the  amount of revenue  recognized  to date on certain contracts.  Research and Development Expenditures for research and development are charged to operations as incurred.  Goodwill Goodwill represents the cost in excess of the fair value of net assets acquired. In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial  Accounting  Standards  No. 142 ("SFAS  142"),  "Goodwill and Other Intangible  Assets",  which was  effective  January 1, 2002.  SFAS 142 requires, among other things,  the discontinuance of goodwill  amortization.  In addition, the standard includes  provisions for the  reclassification  of certain existing recognized intangibles as goodwill, reassessment of the useful lives of existing recognized   intangibles,   reclassification   of  certain  intangibles  out  of previously  reported  goodwill and the  identification  of  reporting  units for purposes of assessing  potential future  impairments of goodwill.  SFAS 142 also requires the Company to complete a  transitional  goodwill  impairment  test six months from the date of adoption.  The result of this impairment test identified that as of January 1, 2002 there were no  impairments  of goodwill or intangible assets. CompuDyne will continue to conduct impairment assessments annually as of October 1 of each  fiscal year or when events  indicate a  triggering  event has occurred.  During the fourth  quarter of 2004,  the Company  concluded  that the continuing  decline in the backlog in its ISS segment  constituted  a triggering event. The Company  performed its interim  impairment test of the reporting unit as of December 31, 2004 and based on its valuation concluded it was necessary to write off the value of the  segment's  goodwill in the amount of $739  thousand. This  write-off is included in impairment of goodwill and other  intangibles  in the 2004 statement of operations.  As of October 1 and December 31, 2005,  there were no other impairments of goodwill.  Cash and Cash Equivalents The  Company  considers  all  highly  liquid  investments  with an  original  or remaining  maturity of three months or less to be cash equivalents.  The Company deposits  cash  and  cash  equivalents   with  high  credit  quality   financial institutions. These deposits may exceed the federally insured limits.  Marketable Securities The  Company's  marketable  securities  are  categorized  as  available-for-sale securities,  as defined by Statement of Financial  Accounting Standards No. 115, "Accounting  for Certain  Investments in Debt and Equity  Securities,"  and as a result, were reported at fair value. Unrealized gains and losses are reported as a component of accumulated other comprehensive  income in shareholders'  equity. The  amortized  costs of debt  securities is adjusted for accretion of discounts from the date of purchase to  maturity.  The  accretion  is included in interest income on the  investments.  The cost for  marketable  securities was determined using  the  specific  identification  method.  The  fair  values  of  marketable securities are estimated based on the quoted market price for these securities.  Allowance for Doubtful Accounts An  allowance  for  doubtful  accounts is estimated  based on a  combination  of write-off history, aging analysis and any specific, known troubled accounts.  Property, Plant, and Equipment Property, plant and equipment are stated at cost less accumulated  depreciation. Depreciation of plant and equipment is computed principally by the straight-line method based upon the estimated  useful lives of the various  classes of assets. Leasehold  improvements are amortized over their useful lives or the term of the underlying lease, whichever is shorter. Maintenance and repair costs are charged to operations as incurred;  major renewals and betterments are capitalized.  Any gain or loss from the  retirement  or sale of an asset is credited or charged to operations.  Inventories Inventories  are  stated at the  lower of cost or  market,  using the  First-in, First-out  (FIFO) method.  Costs  included in inventories  consist of materials, labor,  and  overhead,  which are  related to the  purchase  and  production  of inventories.  Warranty Reserves In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure  Requirements for Guarantees,  Including  Indirect  Guarantees of Indebtedness  of  Others"  ("FIN  45").  FIN  45  requires  the  recognition  of liabilities  for guarantees  that are issued or modified  subsequent to December 31, 2002. The liabilities  should reflect the fair value,  at inception,  of the guarantors'  obligations  to  stand  ready to  perform,  in the  event  that the specified  triggering  events or conditions occur. The adoption of this standard did not have a material effect on the financial position,  results of operations or cash flows of  CompuDyne.  The  Interpretation  also  requires  disclosure of accounting policies and methodologies with respect to warranty accruals, as well                                          38     as a  reconciliation  of the change in these accruals for the reporting  period. Refer to Note 12, "Product  Warranties," in the Notes to Consolidated  Financial Statements for additional information.  Deferred Revenue The Company provides  ongoing  maintenance and service for many of its completed projects.  Much of this work is performed  pursuant to  maintenance  agreements, which  typically  cover such  services  for a twelve month  period.  The Company recognizes  revenue under these contracts ratably over the term of the contract. Any revenue not yet earned under the contract is recorded as deferred revenue in the accompanying financial statements.  Fair Value and Hedging The  Company  hedged  the cash  flows  of some of its  long-term  debt  using an interest rate swap. The Company entered into this derivative  contract to manage its exposure to interest  rate  movements by achieving a desired  proportion  of fixed rate versus  variable rate debt.  In the interest  rate swap,  the Company agreed to exchange the difference  between a variable interest rate and either a fixed or another  variable  interest  rate,  multiplied by a notional  principal amount.  The Company's  hedge matured on September 30, 2005 at which time it was no longer in force.  Income Taxes The Company follows  Statement of Financial  Accounting  Standards  ("SFAS") No. 109,  "Accounting  for Income Taxes." Under SFAS 109,  deferred income taxes are recognized for the future tax  consequences of differences  between tax bases of assets and liabilities and financial  reporting amounts,  based upon enacted tax laws and statutory tax rates  applicable to the periods in which the differences are  expected  to affect  taxable  income.  The Company has decided to provide a valuation  allowance  against its deferred tax assets, as it has determined that due to the Company's  recent operating losses there is uncertainty as to whether it is more likely than not that these assets will be realized.  Comprehensive Income (Loss) The following table shows the components of comprehensive  income (loss), net of income taxes, for the years ended December 31, 2005 and 2004, in thousands.                                                                 For the Year                                                             Ended December 31,                                                            2005         2004                                                         -----------  -----------  Net loss                                                 $ (8,691)    $ (8,198) Unrealized (loss) gain on available-for-sale securities       (53)          14 Ineffectiveness of interest rate swap agreement                 -           93                                                         -----------  ----------- Comprehensive loss                                       $ (8,744)    $ (8,091)                                                         ===========  ===========  Stock-Based Compensation As of December 31, 2005,  the Company  continues to account for its  stock-based compensation  plans, using the intrinsic value method and in accordance with the recognition  and measurement  principles of APB Opinion No. 25,  "Accounting for Stock Issued to Employees," and related interpretations. No stock-based employee compensation  cost is  reflected  in the results of  operations,  as all options granted had an exercise  price equal to or greater than the fair market value of the  underlying  common  stock  on  the  date  of  grant.  The  following  table illustrates,  in accordance with the provisions of SFAS No. 148, "Accounting for Stock-Based  Compensation  - Transition and  Disclosure,"  the effect on the net loss and loss per share if the Company  had  applied the fair value  recognition provisions  of SFAS No.  123,  "Accounting  for  Stock-Based  Compensation,"  to stock-based employee compensation.                                                 For the Year Ended December 31,                                                 2005       2004         2003                                             ---------- ------------  ----------                                            (in thousands, except per share data) Net (loss) income, as reported             $   (8,691)$     (8,198) $    3,408 Deduct:  Total stock-based employee compensation expense determined under fair value based method for all awards net of related tax effects           2,678        1,040       1,117                                             ---------- ------------  ---------- Pro forma net (loss) income                $  (11,369)$     (9,238) $    2,291                                             ========== ============  ==========  (Loss) earnings per share: Basic - as reported                        $    (1.07)$      (1.01) $      .43 Basic - pro forma                          $    (1.40)$      (1.14) $      .29  Diluted - as reported                      $    (1.07)$      (1.01) $      .42 Diluted - pro forma                        $    (1.40)$      (1.14) $      .28                                          39     On December  27,  2005 the  Compensation  Committee  of the  Company's  Board of Directors approved the acceleration of option vesting terms for 166,600 unvested out of the  money  employee  stock  options,  including  executive  officers  in accordance  with the provisions of the Company's  1996 and 2005 Stock  Incentive Plans for Employees. Stock options which had been awarded under the Non-employee directors plans were not included in such acceleration. This accelerated vesting included all options with a grant price of $9.00 and above.  The exercise prices of the affected  stock options were above the  Company's  closing stock price on the  date  of  acceleration.  As a  result  of the  accelerated  vesting  terms, approximately $954 thousand has been included in pro forma compensation  expense for the twelve  months ended  December 31, 2005.  The  accelerated  options have exercise  prices  ranging from $9.19 to $14.09 and a weighted  average  exercise price of $11.45. The total number of accelerated options includes 20,200 options held by executive  officers of the Company,  with exercise  prices  ranging from $9.19 to $12.21 and a weighted average exercise price of $10.11.  The primary purpose of accelerating the vesting of these options is to eliminate the recognition of non-cash  compensation  expense associated with these options that  the  Company   would  have  been  required  to  recognize  in  its  future consolidated  statements  of  operations  upon  its  adoption  of  Statement  of Financial  Accounting  Standards  No. 123 (revised  2004),  Share-Based  Payment ("SFAS  123R").  SFAS 123R will  generally  require  that the fair  value of all share-based payments to employees,  including stock option awards, be recognized as compensation expense in the Company's  statements of operations.  The Company will be  required  to adopt  the  expense  recognition  provisions  of SFAS 123R effective January 1, 2006.  The fair value of the  Company's  stock-based  option  awards to  employees  was estimated using the Black-Scholes  model assuming no expected  dividends and the following weighted-average assumptions:                                          For the Year Ended December 31,                                            2005      2004       2003                                           -----     -----      -----          Expected life in years             4.8       5.4       6.6          Risk-free interest rate            4.0%      3.4%      2.9%          Expected volatility               81.5%     75.3%     79.5%  On May 27, 2005, the Company's shareholders approved amendments to the CompuDyne Corporation  1996  Stock  Incentive  Compensation  Plan  for  Employees  and the CompuDyne  Corporation 1996 Stock Option Plan for  Non-Employee  Directors ("the 1996 Plans") to provide  primarily for a definition of a change in control.  The Company  does not believe  the  amendments  have a material  impact on the stock awards issued under the 1996 Plans.  On May 27, 2005, the Company's  shareholders  approved the CompuDyne Corporation 2005  Stock  Incentive   Compensation  Plan  for  Employees  and  the  CompuDyne Corporation 2005 Stock Option Plan for Non-Employee Directors ("the 2005 Plans") and authorized awards exercisable for up to 4,000,000 and 400,000 common shares, respectively,  under the 2005 Plans.  The 2005 Plans are intended to replace the 1996 Plans, which expire in March 2006, and contain similar provisions. The 2005 Plans permit the  issuance of either  incentive  stock  awards or  non-qualified stock awards.  Corporate Reorganization As part of the Company's  efforts to better  manage its costs,  during the first quarter of 2005 the Company  implemented a corporate  reorganization  whereby it converted several corporate entities into LLCs (Limited Liability Corporations). This activity was designed to improve the Company's tax reporting  structure and should  help  better  manage the  Company's  state  income tax  obligations.  In conjunction  with this  reorganization,  our  Federal  Security  Systems  group, formerly   known   as   Quanta   Systems    Corporation,    was   re-formed   as CompuDyne-Integrated  Electronics  Division,  LLC,  and our  Public  Safety  and Justice group,  formerly known as Tiburon, was renamed  CompuDyne-Public  Safety and Justice, Inc. In addition,  CorrLogic,  Inc. was converted to CorrLogic, LLC and Fiber SenSys,  Inc. was  converted to Fiber SenSys,  LLC. The impact of this reorganization  is not  expected  to have a material  effect on  operations.  In addition,  in light of the escalating selling,  general and administrative costs associated with the current heightened regulatory environment, we are evaluating our structure to determine if another  organizational  structure would result in lower selling, general and administrative costs.  Other Recently Issued Accounting Pronouncements In  May  2005,  the  FASB  issued  SFAS  154,   "Accounting  Changes  and  Error Corrections" (SFAS 154) which replaces APB Opinion No. 20, "Accounting  Changes" and SFAS 3, "Reporting  Accounting  Changes in Interim  Financial  Statements-An Amendment of APB Opinion No. 28." SFAS 154 provides  guidance on the  accounting for and reporting of accounting  changes and error  corrections.  It establishes retrospective  application,  or the latest  practicable  date,  as the  required method for  reporting a change in  accounting  principle  and the reporting of a correction  of an  error.  SFAS 154 is  effective  for  accounting  changes  and corrections  of errors made in fiscal years  beginning  after December 15, 2005. The  adoption  of SFAS 154 is not  expected  to have a  material  impact  on our consolidated financial position, results of operations or cash flows.                                          40     In December  2004, the FASB issued  Statement No. 153,  Exchanges of Nonmonetary Assets,  an  amendment  of APB  Opinion  No. 29.  Statement  153  addresses  the measurement  of  exchanges  of  nonmonetary  assets and  redefines  the scope of transactions  that  should be  measured  based on the fair  value of the  assets exchanged.  Statement 153 is effective for nonmonetary asset exchanges occurring in fiscal periods  beginning  after June 15, 2005. The adoption of Statement 153 has not had a material effect on our consolidated financial position, results of operations or cash flows.  In December 2004, the FASB issued FASB Staff Position No. 109-1,  Application of FASB  Statement  No. 109 (SFAS 109),  Accounting  for Income  Taxes,  to the Tax Deduction  on Qualified  Production  Activities  Provided by the  American  Jobs Creation Act of 2004 (FSP 109-1).  FSP 109-1  clarifies that the  manufacturer's deduction  provided  for under the  American  Jobs  Creation  Act of 2004 (AJCA) should be accounted for as a special  deduction in accordance  with SFAS 109 and not as a tax rate  reduction.  The  adoption  of FSP  109-1 had no impact on the Company's  results of  operations  or  financial  position  for fiscal year 2005 because the  manufacturer's  deduction is not available due to the Company's net loss carryforwards. The Company is evaluating the effect that the manufacturer's deduction will have in subsequent years.  In  December  2004,  the FASB  issued SFAS No.  123R,  "Share-Based  Payment," a revision  of  SFAS  No.  123,  "Accounting  for  Stock-Based  Compensation"  and superseding APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS No. 123R requires the Company to expense  grants made under its stock option and employee  stock purchase plan  programs.  That cost will be recognized  over the vesting  period of the options.  SFAS No. 123R is effective for the first annual period  beginning  after June 15, 2005.  The Company has not yet  determined the method of adoption or the effect of adopting SFAS 123R,  and has not  determined whether the adoption  will result in amounts that are similar to the current pro forma  disclosures  under SFAS 123. The Company is evaluating  the  alternatives allowed under the standard,  which the Company is required to adopt beginning in the first quarter of 2006.  In November 2004, the FASB issued SFAS No. 151,  "Inventory Costs," an amendment to ARB No. 43, Chapter 4, "Inventory  Pricing," to clarify that abnormal amounts of  idle  facility  expenses,  freight,  handling  costs  and  wasted  materials (spoilage) should be recognized as current-period  charges. In addition, FAS 151 requires that allocation of fixed production overhead to the costs of conversion be based on the normal  capacity of the production  facilities.  SFAS No. 151 is effective for inventory  costs incurred during fiscal years beginning after June 15, 2005. There has been no material effect on the financial  position,  results of operations, or cash flows of the Company upon adoption of this statement.  Reclassifications - Certain prior year amounts have been reclassified to conform with the current year's presentation.  2.   EARNINGS PER SHARE  Earnings per share are presented in accordance with SFAS No. 128,  "Earnings Per Share." This Statement  requires dual presentation of basic and diluted earnings per share on the face of the statement of  operations.  Basic earnings per share is computed using the weighted average number of shares  outstanding  during the period and excludes any dilutive  effects of options,  warrants,  or convertible securities.  Diluted  earnings per share is computed using the weighted  average number of common and  common  stock  equivalent  shares  outstanding  during the period;  common stock  equivalent  shares are excluded from the  computation  if their effect is antidilutive.  Stock options and warrants to purchase  1,257,133  shares,  729,800 shares,  and 901,770  shares  for  the  years  ended  December  31,  2005,   2004  and  2003, respectively,  were  not  dilutive  and,  therefore,  were not  included  in the computation of diluted  earnings per common share.  Additionally,  the 2,897,768 shares issuable upon conversion of the 6.25% Convertible  Subordinated Notes due January 15, 2011 (the "2011  Notes") are excluded  for the years ended  December 31, 2005 and 2004 as the effect is antidilutive.  The  computations of the Company's  basic and diluted  earnings per common share amounts were as follows:                                          41                                                          2005          2004          2003                                                 -----------------------------------------                                                       (in thousands, except per share data) Net (loss)  income                             $     (8,691) $     (8,198) $       3,408                                                 ============  ============  =============  Weighted average common shares outstanding            8,129         8,136          7,895 Effect of dilutive stock options and warrants             -             -            263                                                 ------------  ------------  ------------- Diluted weighted average common shares  outstanding                                   $      8,129  $      8,136  $       8,158                                                 ============  ============  ============= Net earnings (loss) per common share Basic                                          $      (1.07) $      (1.01) $         .43 Diluted                                        $      (1.07) $      (1.01) $         .42    In March 2004, the EITF reached a final consensus on Issue 03-6,  "Participating Securities and the Two-Class  Method under FASB Statement No. 128,  Earnings Per Share" ("Issue 03-6"),  effective June 30, 2004.  Issue 03-6 requires the use of the  two-class  method to compute  earnings  per share for  companies  that have issued securities other than common stock that contractually  entitle the holder to participate in dividends and earnings of the Company ("participation rights") when, and if, it declares dividends on its common stock.  The 2011 Notes contain contingent participation rights. The participation rights are contingent  upon the ability,  based on the  undistributed  earnings for the period, of the Company to declare and distribute dividends per share equal to or in  excess  of the per share  fair  value of the  Company's  common  stock.  The contingency  was not met for  the  years  ended  December  31,  2005  and  2004. Accordingly, no undistributed earnings have been allocated to the 2011 Notes. At each reporting  period,  the Company assesses  whether the contingency  criteria have been met and consequently if undistributed  earnings should be allocated to participating securities.  3.   INVESTMENTS IN MARKETABLE SECURITIES  The  Company's  marketable  securities  are  categorized  as  available-for-sale securities,  as defined by SFAS No. 115,  "Accounting for Certain Investments in Debt and Equity  Securities."  At December 31, 2005 and December 31, 2004 all of the  Company's   investments  in  marketable   securities   were  classified  as available-for-sale,  and as a result,  were  reported at fair value.  Unrealized gains and losses are reported as a component of accumulated other  comprehensive income  in  shareholders'   equity.  The  cost  for  marketable  securities  was determined using the specific  identification  method and adjusted for accretion of discounts from the date of purchase to maturity. The accretion is included in interest income. The fair values of marketable securities are estimated based on the quoted market price for these securities.  Marketable  securities  at  December  31,  2005  and  2004  are  summarized,  in thousands, as follows:                                                               2005                                         2004                                     ---------------------------------------------------- -----------------------------------                                                        Gross Unrealized                         Gross Unrealized                                                   --------------------------    Fair             ---------------     Fair                                           Cost         Gains      Losses        Value      Cost    Gains Losses      Value                                     ----------------------------------------------------------------------------------------          Collateralized mortgage obligations (CMO's) consisting of securities issued by Fannie Mae and Freddie Mac          $      11,494 $         - $          65 $    11,429 $ 19,554 $    23  $   - $    19,577    The cost and estimated fair value of current  marketable  securities at December 31, 2005, by contractual  maturity,  are shown below.  Expected  maturities will differ from  contractual  maturities  because the issuers of the securities have the right to repay obligations without prepayment penalties. It is the Company's policy to classify  available-for-sale  securities that are available for use in current operations as a current asset.                                                               Estimated (in thousands)                             Cost             Fair Value                                          --------           ---------- Due after one year and beyond            $ 11,494            $ 11,429                                          --------            -------- Total debt securities                    $ 11,494            $ 11,429                                          ========            ========                                          42     4.   ACCOUNTS RECEIVABLE  Accounts receivable consist of the following, in thousands:                                                          December 31,                                              -----------------------------------                                                    2005               2004                                               ---------------    ---------------    U.S. Government Contracts        Billed                                $         1,926    $         6,181        Unbilled                                          424                384                                               ---------------    ---------------                                                        2,350              6,565                                               ---------------    ---------------    Commercial        Billed                                         33,954             23,760        Retainage                                       5,642              5,885                                               ---------------    ---------------                                                       39,596             29,645                                               ---------------    ---------------    Total accounts receivable                          41,946             36,210    Less: allowance for doubtful accounts              (2,321)            (1,919)                                               ---------------    ---------------    Accounts receivable, net                  $        39,625    $        34,291                                               ===============    ===============  The Company expects to collect  substantially  all  receivables  within one year except  for a  portion  of the  receivables  recorded  as  retainage.  Retainage expected to be collected in over one year amounts to $2.2 million, or 39% of the total retainage amount at December 31, 2005, and is reflected as a current asset as it will be collected  within the operating cycle under the related  contract. Substantially  all of the U.S.  Government billed  receivables  result from cost reimbursable or time-and-material contracts. Direct sales to the U.S. Government for the years ended  December 31, 2005,  2004 and 2003 were  approximately  $9.4 million, $9.9 million and $12.6 million,  respectively,  or 6.7%, 7.0%, and 6.5% of the Company's total net sales for the respective years. The sales to the U.S. Government were in the  Institutional  Security  Systems,  Attack Protection and Integrated Electronic Systems segments. No single customer accounted for greater than 10% of the Company's net sales. Contract costs for services provided to the U.S.  Government,  including  indirect  expenses,  are  subject  to audit by the Defense  Contract Audit Agency ("DCAA").  All contract  revenues are recorded in amounts  expected  to be  realized  upon  final  settlement.  In the  opinion of management, adequate provisions have been made for adjustments, if any, that may result from the government  audits.  The Company  received final approval on its indirect  costs billed to the U. S.  Government for 2000 from DCAA in April 2004 and final approval on its indirect costs billed to the U.S.  Government for 2001 from DCAA in August 2004.  No  significant  payments or billings  were made as a result of the approval of the 2000 and 2001 rates.  The years 2002,  2003,  2004 and 2005 are still open and subject to audit.  The  Company  does not expect the audit of these  years to have a material  effect on its  financial  position  or results of operations.  5.   CONTRACTS IN PROCESS  Amounts included in the financial statements,  which relate to recoverable costs and accrued  profits not yet billed on contracts in process,  are  classified as current assets. Billings on uncompleted contracts in excess of incurred cost and accrued  profits are classified as current  liabilities.  The Company expects to bill and collect  substantially all costs in excess of billings within one year. Summarized below are the components of the amounts:                                                                                 December 31,                                                                   ---------------------------------                                                                             2005              2004                                                                   ---------------   ---------------                                                                            (in thousands)        Costs and estimated earnings on uncompleted contracts        $       277,048   $       286,041     Less customer progress payments                                      285,225           289,449                                                                   ---------------   ---------------                                                                  $        (8,177)  $        (3,408)                                                                   ===============   ===============     Included in the consolidated balance sheets:     Costs and estimated earnings in excess of billings       on uncompleted contracts                                   $        13,764   $        16,087     Billings in excess of contract costs and estimated       on uncompleted contracts                                           (13,847)          (13,497)     Deferred revenue                                                      (8,094)           (5,998)                                                                   ---------------   ---------------                                                                  $        (8,177)  $        (3,408)                                                                   ===============   ===============                                           43     6.   INVENTORIES  Inventories consist of the following, in thousands:                                                                                 December 31,                                                                   --------------------------------                                                                             2005              2004                                                                   ---------------   ---------------        Raw materials                                                $         3,984   $         4,241     Work in progress                                                       3,342             1,890     Finished goods                                                           240               396                                                                   ---------------   ---------------     Total inventory                                                        7,566             6,527     Reserve for excess and obsolete inventory                             (1,371)           (1,362)                                                                   ---------------   ---------------     Inventories, net                                             $         6,195   $         5,165                                                                   ===============   ===============    7.   PROPERTY, PLANT AND EQUIPMENT  Property, plant and equipment consist of the following, in thousands:                                                                                  December 31,             Estimated                                                                   ---------------------------------   Useful Life                                                                             2005              2004     In Years                                                                   ---------------   ---------------  ------------         Land                                                         $           435   $           435     Buildings and leasehold improvements                                   4,889             4,897          7-39     Machinery and equipment                                                7,170             7,050          3-10     Furniture and fixtures                                                 1,238             1,191          3-10     Automobiles                                                              396               458           3-7     Software                                                               8,734             9,027           3-7     Construction in progress                                                 966               605                                                                   ---------------   ---------------                                                                           23,828            23,663         Less: accumulated depreciation and amortization                  (13,866)          (11,569)                                                                   ---------------   ---------------                                                                  $         9,962   $        12,094                                                                   ===============   ===============    The Company  acquired  software as a result of its  purchase of the assets of 90 Degrees and Copperfire of $2.2 million and $0.2 million, respectively.  Depreciation  expense for the years ended December 31, 2005,  2004, and 2003 was $3.1 million, $2.6 million and $2.6 million, respectively.  8.   GOODWILL  The December 31, 2005 and December 31, 2004  consolidated  financial  statements include the fair market value of the assets acquired and liabilities assumed and the related  allocations of the purchase price related to the acquisition of the assets of 90 Degrees on August 11,  2004.  Goodwill  recorded for the 90 Degrees asset acquisition was approximately $2.0 million.  The December 31, 2005 and December 31, 2004  consolidated  financial  statements also  include  the fair  market  value of the assets  acquired  and  liabilities assumed  and the  related  allocations  of the  purchase  price  related  to the acquisition of the assets of Copperfire on December 15, 2004.  Goodwill recorded for the Copperfire asset acquisition was approximately $2.3 million.  The Company  reviews the carrying value of goodwill  annually  during the fourth quarter of the year or whenever events or changes in circumstances indicate that the carrying  value may not be  recoverable,  utilizing a  discounted  cash flow model.  Changes  in  estimates  of future  cash  flows  caused by items  such as unforeseen  events or changes in market  conditions could negatively  affect the reporting  unit's  fair value and result in an  impairment  charge.  The Company cannot predict the occurrence of events that might adversely affect the reported value of goodwill of approximately $26.9 million at December 31, 2005.                                          44     Goodwill, by segment, consists of the following, in thousands:                                    Institutional                        Public                                  Security          Attack          Safety &                                  Systems         Protection         Justice            Total                               ---------------  ---------------  ---------------  ---------------      December 21, 2003            $           739  $           728  $        21,883  $        23,350    Goodwill impairment                  (739)               -                -             (739)    Acquisitions                            -                -            3,283            3,283                               ---------------  ---------------  ---------------  --------------- December 31, 2004                          -              728           25,166           25,894    Acquisitions                            -                -              952              952                               ---------------  ---------------  ---------------  --------------- December 31, 2005            $             -  $           728  $        26,118  $        26,846                               ===============  ===============  ===============  ===============    The change in Public Safety & Justice's goodwill balance at December 31, 2005 as compared  to  December  31,  2004  is  primarily  a  result  of the  adjustments necessitated  by  recording  the final  appraisal  of the  assets  received  and liabilities assumed for the recent acquisitions.  9.   INTANGIBLE ASSETS  The December 31, 2005 and December 31, 2004  consolidated  financial  statements include the fair market value of the assets acquired and liabilities assumed and the related  allocations of the purchase price related to the acquisition of the assets of 90 Degrees on August 11,  2004.  Intangible  assets for the 90 Degrees asset acquisition are approximately $60 thousand at December 31, 2005.  The December 31, 2005 and December 31, 2004  consolidated  financial  statements include the fair market value of the assets acquired and liabilities assumed and the related  allocations of the purchase price related to the acquisition of the assets of Copperfire on December 15, 2004.  Intangible assets for the Copperfire asset acquisition are approximately $130 thousand at December 31, 2005.  The weighted average life for purposes of amortization of identified  intangible assets  acquired in 2005 was three years for non  compete  agreements  and trade names.  Intangible  assets include the trade name,  customer  relationships  and backlog from the acquisition of Tiburon,  Inc. in 2002. Other intangibles  include trade names,  Department  of State  Certifications,  Underwriters  Laboratories,  Inc. listings,  and  patents  related to the  acquisition  of Norment in 1998 and its other recent  acquisitions.  With the exception of the Norment and Tiburon trade names,  which have indefinite  lives, the intangible  assets are being amortized using the straight-line method.  Intangible assets consist of the following, in thousands:                                              December 31,                               ---------------------------------    Amortizable                                          2005             2004        Lives                                ---------------  ---------------  -------------- Cost                                                                (in years)  Trade names                  $         5,673  $         5,673   15 - Indefinite  Customer relationships                 2,500            2,500              14  Other                                  1,255            1,305            1-20                                ---------------  ---------------                                         9,428            9,478 Accumulated Amortization  Trade names                               (4)               -  Customer relationships                  (655)            (476)  Other                                   (548)            (542)                                ---------------  ---------------  Net Cost                      $         8,221  $         8,460                                ===============  ===============  Amortization  expense for the  Company's  intangible  assets for the years ended December  31, 2005 and December  31, 2004 was $309  thousand  and $358  thousand respectively. The following schedule lists the expected amortization expense for each of the next five years ending December 31, in thousands:                                          45                            Year                        ----                        2006                         $  263                        2007                            254                        2008                            243                        2009                            243                        2010                            229                        Thereafter                    1,357                                                    -------                        Total                       $ 2,589                                                    =======  10.  ACCOUNTS PAYABLE AND ACCRUED LIABILITIES  Accounts payable and accrued liabilities consist of the following, in thousands:                                                              December 31,                                                         ----------------------                                                         2005           2004                                                         --------      -------- Accounts payable                                        $ 15,461      $  9,406 Liability for marketable security purchased                    -         4,336 Accrued payroll costs                                      3,558         3,323 Income taxes payable                                         206           707 Other accrued expenses                                     3,805         3,999                                                         --------      --------                                                         $ 23,030      $ 21,771                                                         ========      ========  11.  NOTES PAYABLE AND LINE OF CREDIT                                                                                        December 31,                                                                          --------------------------------                                                                                2005           2004                                                                          --------------------------------                                                                                  (in thousands)    Industrial revenue bond, interest payable monthly at a variable rate of 1.65% to 3.71% (3.71% at December 31, 2005)  principal payable in quarterly installments of $35,000.  The bond is fully collateralized by a $1.4 million letter of credit and a bond guarantee agreement.      $         1,260  $         1,400  Industrial revenue bond, interest payable monthly at a variable rate of 1.62% to 3.65% (3.65% at December 31, 2005)  principal payable in annual installments of $300,000 until 2013 when the annual installments become $100,000.  The bond is fully collateralized by a $2.3 million letter of credit and a bond guarantee agreement.                   2,305            2,605  6.25% Convertible Subordinated Notes due January 15, 2011. The notes bear interest at a rate of 6.25% per annum, payable semi-annually, and are convertible into shares of common stock at a conversion price of $13.89 per share.  These notes are subordinated to all other liabilities of the Company.                        40,250           40,250                                                                          ---------------  ---------------         Total notes payable                                                       43,815           44,255        Less convertible subordinated notes discount                                 945            1,132                                                                          ---------------  ---------------         Subtotal                                                                 42,870           43,123        Less amount due within one year                                              440              440                                                                          ---------------  ---------------                                                                         $        42,430  $        42,683                                                                          ===============  ===============    Maturities of notes payable are as follows, in thousands:                 Year Ending December 31,         Amount                ------------------------       ---------                         2006                  $    440                         2007                       440                         2008                       440                         2009                       440                         2010                       440                         Thereafter              41,615                                               ---------                                               $ 43,815                                          46     On January 22,  2004,  the  Company  completed  an  offering  of $40.25  million principal  amount of the 2011 Notes.  The 2011 Notes bear  interest at a rate of 6.25% per annum,  payable  semi-annually,  and are  convertible  into  shares of common stock at a conversion price of $13.89 per share,  subject to adjustments. The 2011 Notes are  subordinated  to all other  liabilities of the Company.  The December 31, 2005 carrying value is listed below, in thousands.  Face value                              $40,250 Underwriters discounts, net                                             945                                         -------                                         $39,305                                         =======  The 2011 Notes can be converted into the Company's common stock at the option of the holder at any time at a  conversion  price of $13.89  per share,  subject to adjustments for stock splits, stock dividends, the issuance of certain rights or warrants to the existing  holders of the Company's common stock and common stock cash dividends in excess of a stated threshold.  The 2011 Notes are  redeemable  at the option of the Company  after  January 15, 2009, at a premium of two percent of the face value plus accrued interest unless a change in control event,  as defined in the indenture  dated as of January 15, 2004 between the Company and U.S. Bank,  relating to the 2011 Notes,  occurs. If such an event does occur, the Company may redeem the 2011 Notes in whole but not in part at face value plus a premium.  If a change in control  event  occurs and the Company does not elect to redeem the 2011 Notes, the holders can require the Company to repurchase the 2011 Notes at face value plus accrued interest.  The debt issuance  costs for the 2011 Notes are recorded as  non-current  assets and are amortized on a straight-line  basis to interest expense over the term of the 2011 Notes. In addition,  underwriters'  discounts  totaled $1.3 million and are amortized on a straight-line  basis to interest expense over the term of the 2011  Notes.  Interest  expense  recorded  for the  total of the  deferred  debt issuance  costs and  underwriters'  discounts  on the 2011  Notes  totaled  $251 thousand  and $245  thousand  for the years  ended  December  31, 2005 and 2004, respectively.  On March 31, 2004, the Company signed an Amended and Restated  Credit  Agreement for a $25.0  million  secured  working  capital line of credit.  This  agreement provided for borrowings against eligible accounts receivable and inventories and contained various financial  covenants,  including among other things, a minimum fixed charge coverage ratio,  maximum debt to earnings before  interest,  taxes, depreciation  and amortization  ("EBITDA")  ratio,  minimum EBITDA  covenant,  a minimum  consolidated  tangible net worth covenant,  a maximum permitted capital expenditures covenant,  and a covenant restricting the payment of dividends.  Of this  line of  credit,  $10.0  million  was to mature on March 1, 2007 and $15.0 million was to mature on March 1, 2005.  On October 29, 2004 and March 4, 2005,  the  Company and its bank  entered  into amendments  to its  credit  agreement  pursuant  to which  the bank  waived  the Company's  non-compliance  with its fixed charge  coverage  ratio covenant as of September 30, 2004 and  non-compliance  with its minimum  EBITDA  covenant as of December 31, 2004,  respectively.  In addition, the Company and its bank amended the credit  agreement to  eliminate  the $15.0  million line of credit  maturing March 2005 and to require  borrowings  under its $10.0 million line of credit to be  secured by pledged  marketable  securities  equal to 111.11% of the value of such  borrowings  or cash  equal to the  value of such  borrowings.  The  credit agreement was also amended to permanently eliminate the quarterly minimum EBITDA covenant effective as of the Company's first quarter ended March 31, 2005 and to provide that the minimum fixed charge coverage ratio  covenant,  maximum debt to EBITDA ratio covenant and the minimum  consolidated  tangible net worth covenant were not to become effective until March 31, 2006. On May 3, 2005, the Company's bank  confirmed in writing that there will not be any event of default under the various credit agreements,  by virtue of the Company's failure to timely file an amendment to its Annual Report on Form 10-K for the year ended December 31, 2004 (the "2004  10-K") to  provide  management's  report on  internal  control  over financial  reporting  as of  December  31,  2004 and the  related  report of the Company's   independent   registered  public  accounting  firm  on  management's assessment of the  effectiveness  of internal  control over financial  reporting (together,  the "404 Report") required by Section 404 of the  Sarbanes-Oxley Act of 2002.  The 404 Report was filed with the SEC on Form 10-K/A on June 27, 2005. On  November  17,  2005,  the Company and its bank  entered  into an  additional amendment to the credit agreement  pursuant to which the bank agreed to increase its  commitment  to lend  under the  Company's  revolving  line of  credit  from $10,000,000 to $13,000,000,  to increase the letter of credit  subfacility  from $8,000,000 to $13,000,000 and to terminate the swing line subfacility.  On December 19, 2005, the Company and its bank entered into a Second Amended and Restated  Revolving  Credit and Security  Agreement (the "Second Restated Credit Agreement").  The Second  Restated  Credit  Agreement  amended and  restated the Company's Amended and Restated Credit Agreement dated March 31, 2004.                                          47     In connection with the execution of the Second Restated  Credit  Agreement,  the Company  provided  the bank  with  collateral  that  includes  all  receivables, equipment,  general intangibles,  inventory,  investment property, real property and a  security  interest  in  subsidiary  stock.  The  Second  Restated  Credit Agreement allows the Company to obtain revolving  advances in a principle amount of up to $20,000,000. Revolving advances are limited by a borrowing base formula based upon the value of the Company's receivables, inventory, fixed assets, real property and issued and  outstanding  letters of credit.  The maximum  aggregate face  amount of letters of credit  that may be drawn  under the Second  Restated Credit Agreement is limited to $18,000,000. The Second Restated Credit Agreement matures on December 18, 2008.  Revolving advances under the Second Restated Credit Agreement bear interest,  at the  election of the Company,  at a variable  rate equal to the  alternate  base rate, a prime interest based rate, or the Eurodollar  rate plus two and one half percent.  For letters of credit,  the Company  shall pay an amount  equal to the average daily face amount of each outstanding letter of credit multiplied by two and one half percent per annum, and a fronting fee of one quarter of one percent per annum, together with other administrative fees and charges. The Company paid its bank a closing fee of $50,000 in connection with the execution of the Second Restated  Credit  Agreement.  The  Company is also  required  to pay the bank an unused  fee equal to  three-eighths  of one  percent  per annum of the amount by which  $20,000,000  exceeds the average  daily unpaid  balance of the  revolving advances and undrawn amount of any outstanding  letters of credit.  In addition, the Company is required to pay a collateral  monitoring  fee equal to $1,000 per month and a collateral evaluation fee as required.  The Second Restated Credit Agreement  contains various  affirmative and negative covenants including financial covenants.  The Company is required to maintain an unrestricted  undrawn  borrowing  base  availability  of  at  least  $5,000,000. Commencing with the fiscal quarter ending June 30, 2006, the Company is required to maintain a fixed charge coverage ratio of at least 1.1 to 1.0.  In January  2004,  the interest rate swap ceased to be a  highly-effective  cash flow  hedge  when  the  related  debt  was  repaid.  Consequently,  the  amounts previously  recorded in other  comprehensive  income as changes in fair value of the interest rate swap were  recognized in earnings for the year ended  December 31, 2004. Upon determination of the hedge ineffectiveness the cumulative loss on the fair value of the interest rate swap was $155 thousand, which was recognized in other  expense.  The change in fair value of the  interest  rate swap for the year ended December 31, 2005 was a gain of $21 thousand.  The interest rate swap matured on September 30, 2005.  12.  PRODUCT WARRANTIES  Included in accounts  payable and accrued  liabilities  are  estimated  expenses related  to  warranties  made at the  time  products  are sold or  services  are rendered.  These accruals are established  using  historical  information on the nature,  frequency,  and average cost of warranty  claims.  The Company warrants numerous  products,  the terms of which vary  widely.  In  general,  the Company warrants its products against defect and specific  non-performance.  The changes in the product  warranty  liability  are displayed in the  following  table,  in thousands:                                                December 31,                                      --------------------------------                                           2005             2004                                      ---------------  --------------- Beginning balance at January 1      $           359  $           517 Plus:  accruals for product  warranties                                     375              280 Less:  warranty charges/claims                 (346)            (438)                                      ---------------  --------------- Ending balance at December 31       $           388  $           359                                      ===============  ===============  13.   FAIR VALUE OF FINANCIAL INSTRUMENTS  The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:  Cash and Cash Equivalents,  Accounts Receivable and Accounts Payable and Accrued Expenses - The carrying  amounts  reported in the balance sheets for these items approximate  fair value due to the  short-term  maturities  of these  assets and liabilities.  Long-Term Debt - The carrying amounts reported in the balance sheet  approximate fair value as the  amounts  are at  floating  rates and terms  available  to the Company at December 31, 2005 and 2004 for borrowings  for similar  transactions. The Company's 2011 Notes are at a fixed rate of 6.25%.                                          48     Interest Rate Swap Agreements - The Company used an interest rate swap agreement to manage  exposure to fluctuations in interest rates. At December 31, 2004, the Company had an unleveraged swap agreement with a bank with a notional  principal amount of $2.0 million.  This agreement was placed on June 26, 2001 with a fixed rate of 4.9% and is settled in cash on a quarterly  basis.  The termination date was September 30, 2005.  In prior years the Company  hedged the cash flows of some of its long-term  debt using an interest rate swap. The Company entered into this  derivative  contract to manage its  exposure  to  interest  rate  movements  by  achieving  a desired proportion  of fixed rate versus  variable  rate debt. In an interest rate swap, the Company agreed to exchange the difference  between a variable  interest rate and either a fixed or another variable  interest rate,  multiplied by a notional principal amount.  As of December 31, 2003, the Company  recognized the cash flow hedge at its fair value  of  $155  thousand  in  accounts  payable  and  accrued  expenses  on the consolidated  balance  sheet.  As of December  31, 2003 the  interest  rate swap qualified for cash flow hedge  accounting,  therefore an unrealized loss of $155 thousand ($93 thousand net of tax),  representing  the effective  portion of the change in its fair value, was reported in other comprehensive loss. For the year ended December 31, 2004, the interest rate swap was determined to be ineffective and the changes in fair value were recognized in earnings.  14.  INCOME TAXES  The  components  of the  income  tax  provision  (benefit)  are as  follows,  in thousands:                             For the years ended December 31,                    ------------------------------------------------                              2005            2004             2003                     --------------  --------------  --------------- Current            $         (203) $       (2,013) $         2,103 Deferred                      (12)           (219)             245                     --------------  --------------  ---------------                    $         (215) $       (2,232) $         2,348                     ==============  ==============  ===============  The  tax  effects  of the  primary  temporary  differences  giving  rise  to the Company's net deferred tax assets and  liabilities at December 31, 2005 and 2004 are summarized as follows, in thousands:                                                                       December 31,                                                          --------------------------------                                                                2005             2004                                                          --------------- ----------------       Deferred tax assets:        Accrued expenses and deferred compensation       $           204 $            566        Tax operating loss carryforward                            4,349            1,064        Book reserves in excess of tax                             1,762            1,093        Tax depreciation and amortization in excess         of book depreciation and amortization                       821              440        Other                                                         25               84                                                          --------------- ----------------        Total deferred tax assets                                  7,161            3,247                                                          --------------- ----------------    Deferred tax liabilities:        Price risk management activities                              (9)              (9)        Purchased intangibles                                     (3,086)          (3,452)                                                          --------------- ----------------        Total deferred tax liabilities                            (3,095)          (3,461)        Valuation allowance                                       (6,126)          (1,858)                                                          --------------- ----------------    Net deferred tax (liability) asset                   $        (2,060)$         (2,072)                                                          =============== ================    In the third  quarter of 2005 the  Company  reversed  $500  thousand  previously recorded as a reserve for uncertain tax positions which was no longer needed.  At December 31, 2005 and 2004 the Company  established a valuation  allowance to reserve  substantially  all of its net deferred tax assets,  because the Company believes  that it is not "more  likely than not" that it will be able to realize the deferred tax assets in the future.  Deferred tax assets at December 31, 2005 include  $1.0  million  of state net  operating  losses  for  which a  valuation allowance  has  been  established.  This  deferred  tax  asset  and its  related valuation  allowance were not included in prior years as it was determined  that the assets were unlikely to be realized in future years.  The company  completed an  organizational  restructuring  during  the year  ended  December  31,  2005, creating a state tax structure  that may result in  realization of the state net operating loss in future years if the Company returns to profitability.  At  December  31,  2005,  the  Company  and its  subsidiaries  have  Federal net operating  loss  carryforwards  available  to offset  future  taxable  income of approximately  $8.4  million,  of which  $500  thousand  is  subject  to  severe limitations.  The limited tax loss  carryforwards  are limited to  approximately $235 thousand each year as a result of an ownership  change,  which  occurred in                                          49     1995.  Approximately  $7.9  million is available  for use on an unlimited  basis through 2025. The balance of these carryforwards expires between 2006 and 2010.  At December 31, 2005, the Company and its subsidiaries  have $32.5 million state net  operating  loss  carryforwards  available to offset  future  taxable  state income.  The  difference  between the statutory tax rate and the Company's  effective tax rate is summarized as follows:                                               For the years ended December 31,                                            ------------------------------------                                                   2005        2004        2003                                            ------------------------------------ Statutory federal income tax rate               (34.0)%     (34.0)%       34.0% State income taxes, net of   Federal benefit                                 (4.6)       (0.3)        6.2 Change in valuation allowance                     38.7        14.8           - Tax effect of non-deductible items                 0.7         0.5         1.1 Foreign income exclusion                          (1.4)       (1.9)       (2.4) Other                                             (1.8)       (0.5)        1.9                                            ------------------------------------ Effective tax rate                               (2.4)%     (21.4)%       40.8%                                            ====================================  At December 31, 2004, the Company and its subsidiaries recorded a tax receivable representing  net operating losses carried back to its 2003 and 2002 Federal and State tax returns.  The value of these carrybacks is approximately  $2.5 million and was recorded  within prepaid  expenses and other current  liabilities in the accompanying  balance sheet as of December 31, 2004.  Such amounts were received in 2005.  15.  SHAREHOLDERS' EQUITY  Warrants for Common  Stock.  In connection  with a Private  Investment in Public Equity  ("PIPE")  transaction  the Company  entered  into in October  2001,  the Company  granted  its  underwriter  an option to purchase  40,000  shares of the Company's  common stock at $12.00 per share,  the price at which the shares were sold in the PIPE.  These  options were granted on October 29, 2001 and expire on October  29,  2006.  The  shares   underlying   these  warrants  have  piggyback registration rights. At the underwriter's  option, these piggyback  registration rights may either convert to demand  registration  rights, with any fees related to the registration of these warrants and underlying shares paid by the Company, or the  Company  may  grant the  underwriter  a put  option  to sell the  shares underlying the warrants back to the Company at a predetermined price.  In connection  with the Company's  acquisition  of Tiburon in 2002,  the Company exchanged warrants and convertible securities to purchase shares of Tiburon into warrants to purchase  shares of the Company.  On May 2, 2002, the Company issued 90,962 warrants to purchase  shares of CompuDyne  common stock at prices ranging from  $3.75 to $6.71  per  share.  During  2002,  11,909  of the  warrants  were exercised.  During 2003,  44,417 of the  warrants  were  exercised  resulting in 34,636  of such  warrants  remaining  outstanding  at  December  31,  2005.  The following shows the exercise price and expiration date of the remaining warrants outstanding:          Number of Warrants       Exercise Price             Expiration Date         ------------------       --------------             ---------------             23,000                  $   5.37                December, 2006             11,636                  $   6.71                December, 2006  Stock Option  Plans.  The Company has various  stock option  plans.  Under these plans,  5,778,358 options to purchase common stock may be granted until December 8, 2015.  Options  generally  are  granted at fair  market  value at the date of grant,  typically  vest over 1 to 5 years from the date of grant,  and expire 10 years after the date of grant. The plans permit the issuance of either incentive stock  options or  non-qualified  stock  options.  Under all  plans,  there were 4,325,000  shares of common stock  reserved for future grants as of December 31, 2005. Transactions for stock options and warrants are summarized as follows:                                          Year                         Year                        Year                                      Ended        Weighted        Ended      Weighted         Ended        Weighted                                  December 31,      Average     December 31,   Average       December 31,    Average                                      2005           Price         2004          Price          2003          Price                                 ---------------------------------------------------------------------------------------        Outstanding, Beginning of Year       1,671,958 $        9.418   1,414,556 $        8.587      1,489,653 $        8.324        Granted                         287,000 $        6.983     675,000 $        9.145        271,500 $        8.131        Exercised                         6,500 $        3.906     303,898 $        4.131        172,497 $        3.610        Expired or Cancelled            499,100 $       10.004     113,700 $       11.590        174,100 $       10.554                                 --------------- -------------------------- ----------------------------- -------------- Outstanding, End of Year             1,453,358 $        8.755   1,671,958 $        9.418      1,414,556 $        8.587                                 --------------- -------------------------- ----------------------------- -------------- Exercisable, End of Year               843,308 $        9.587     492,861 $        9.226        616,365 $        6.625                                 =============== ========================== ============================= ==============                                            50     Summarized  information  about stock  options  and  warrants  outstanding  as of December 31, 2005 is as follows:                                 Options and Warrants Outstanding     Options and Warrants Exercisable                           ------------------------------------   --------------------------------                                          Weighted     Average                    Weighted                                          Average     Remaining                    Average                                          Exercise       Life                     Exercise Exercise Price Range        Number        Price     (In years)       Number        Price - --------------------      --------      --------    ----------       ------      ---------              $1.625  -   6.035     171,225       $5.1065      6.61           66,225       $3.8657      $6.250  -   7.125     148,836       $6.8423      7.88           33,736       $6.8247      $7.375  -   7.615     151,000       $7.5126      8.12           41,700       $7.5165      $7.640  -   8.075     267,000       $7.8950      7.03          139,800       $7.9931      $8.105  -   8.960     194,597       $8.6043      6.99          106,147       $8.5988       $9.190  - 10.420     206,700      $10.0675      7.34          141,700      $10.0278      $10.460  - 12.000     155,500      $11.2459      6.29          155,500      $11.2459      $12.070  - 13.890     145,500      $13.0218      6.22          145,500      $13.0218      $14.090  - 16.330      11,500      $14.3822      5.81           11,500      $14.3822      $16.630  - 16.630       1,500      $16.6300      5.74            1,500      $16.6300                           1,453,358       $8.7550      7.05          843,308       $9.5867                          =========                                  =======    As of December 31, 2005,  the Company  continues to account for its  stock-based compensation  plans using the intrinsic  value method and in accordance with the recognition  and measurement  principles of APB Opinion No. 25,  "Accounting for Stock Issued to Employees," and related Interpretations. No stock-based employee compensation  cost is reflected in the statement of  operations,  as all options granted had an  exercise  price  equal to fair  market  value of the  underlying common stock on the date of grant.  The Company has provided the additional disclosures specified in SFAS No. 123 as amended by SFAS No. 148 (see Note 1).  The weighted average fair value calculated utilizing the Black-Scholes method at the date of grant for  options  granted  during  2005,  2004 and 2003 was $4.15, $5.95, and $5.80 per option, respectively.  16.  COMMITMENTS AND CONTINGENCIES  Operating  Leases.  The Company  leases office space,  equipment,  distribution, manufacturing and storage facilities under non-cancelable  operating leases with various  expiration  dates through  December 2012.  Total rental expense for the years ended December  2005,  2004 and 2003 was $3.2 million,  $3.2 million,  and $3.2 million, respectively.  As of December 31, 2005,  future  minimum  rental  payments  required  under all non-cancelable operating leases are as follows, in thousands:  Year Ending December 31,                     Total - ------------                   ---------   2006                         $  2,497   2007                            2,551   2008                            1,885   2009                            1,544   2010                            1,313   Thereafter                      1,120                                --------                                $ 10,910  Interest on Contractual Obligations.  As of December 31, 2005, the Company has a $40.25  million note  outstanding  at a fixed rate of 6.25%.  In addition it has industrial  revenue bonds in the amount of $3.6 million  outstanding  which have variable interest rates and decreasing principal balances until maturity. Future interest on contractual obligations is as follows, in thousands:  Year Ending December 31,                    Total - ------------                  ---------   2006                        $ 2,636   2007                          2,620   2008                          2,604   2009                          2,588   2010                          2,571   Thereafter                                   856                               --------                               $13,875                                          51     Purchase  Obligations.  The Company enters into purchase  obligations to procure equipment and services, including subcontractor contracts, in the performance of the  day-to-day   operations  of  its  business.   Substantially  all  of  these obligations  are covered by our existing  backlog and the revenues  generated by these  backlogs are expected to be  sufficient  to meet any payment  obligations resulting from these purchase commitments.  Legal  Matters.  The Company is party to certain legal actions and inquiries for environmental  and other matters  resulting  from the normal course of business. Some of the  businesses,  especially  Institutional  Security  Systems,  involve working as a subcontractor to a prime contractor.  From time to time the Company makes claims against the prime contractor,  or the prime contractor makes claims against the Company.  At any point in time the Company is engaged in a number of claim  disputes  with prime  contractors,  some of which may have a  significant negative outcome.  Although the total amount of potential liability with respect to  these  matters  can not be  ascertained  given  the  nature  of the  related allegations,  the Company presently  believes that any resulting  liability will not  have a  material  effect  on its  financial  position,  results  of  future operations or cash flows.  In addition to claims with prime  contractors,  the Company may also make claims against customers and customers may make claims against the Company.  The Company has learned  that the National  Association  of  Securities  Dealers ("NASD") and other regulatory bodies are seeking sanctions against purchasers of the  Company's  common  stock in its 2001 PIPE  transaction.  In  addition,  the Company has learned that the placement agent for this  transaction is also being investigated  by the SEC,  NASD and other  regulatory  bodies.  The  Company  is investigating  these matters,  has filed lawsuits against certain purchasers and is evaluating its other options for recovery.  The Company  has been named in  lawsuits  involving  asbestos  related  personal injury and death claims in which CompuDyne  Corporation,  individually and as an alleged successor, is a defendant.  The Company has been named as a defendant in cases  related  to  claims  for  asbestos  exposure  allegedly  due to  asbestos contained in certain of its predecessor's  products. The Company has advised its insurers  of each of these  cases,  and the  insurers  are  providing  a defense pursuant to agreement with the Company,  subject to reservation of rights by the insurers.  The insurers have advised that claims in such litigation for punitive damages,  exemplary  damages,  malicious  and  willful and wanton  behavior  and intentional  conduct are not covered.  One of the carriers has given notice that asbestos  related  claims  are  excluded  from  certain of these  policies.  The insurers have additional coverage defenses,  which are reserved,  including that claims may fall outside of a particular  policy  period of coverage.  Litigation costs  to date  have  not  been  significant  and the  Company  has not paid any settlements from its own funds.  The Company  cannot  ascertain  the total  amount of  potential  liability  with respect to these legal  matters,  but does not believe  that any such  potential liability  should  have a  material  effect on its  financial  position,  future operations or future cash flows.  The Company,  as a government  contractor,  is from time to time subject to U.S. Government  investigations  relating to its operations.  Government  contractors that are found to have  violated  the  False  Claims  Act,  or are  indicted  or convicted for  violations of other  federal  laws, or are  considered  not to be responsible   contractors,   may  be  suspended  or  debarred  from   government contracting  for some  period of time.  Such  convictions  could also  result in fines.  Suspension  or  debarment  could have a material  adverse  effect on the Company. No such violations or conditions of debarment exist at this time.  17.  RELATED PARTY TRANSACTION  During 2005 and 2004 the Company's  Integrated  Electronic Systems unit recorded revenue of  approximately  $255 thousand and $200 thousand,  respectively,  from sales to a  company  of which  one of  CompuDyne's  Directors  is a senior  vice president  and  member of its board of  directors.  Included  in the  Integrated Electronic  Systems unit at December 31, 2005 and 2004 related to the company at which this  Director is employed was $351  thousand and $29 thousand of accounts receivables,  respectively,  and $9 thousand and $171 thousand of contract costs in excess of billings, respectively.  18.  EMPLOYEE BENEFIT PLANS  The Company established a non-qualified  Employee Stock Purchase Plan in October 1999,  the  terms of  which  allow  for  qualified  employees  (as  defined)  to participate in the purchase of shares of the Company's common stock. The Company matches at a rate of 15% of the  employee  purchase  at the market  value of the common stock for the monthly purchase period. The Company purchases stock on the open  market  and  distributes  the  shares  monthly  to  employees'  individual accounts.  Expense for matching  contributions to the plan was $33 thousand, $33 thousand, and $34 thousand for 2005, 2004, and 2003 respectively.                                          52     The Company has 401(k)  retirement  savings plans  covering all  employees.  All employees are eligible to  participate  in a plan after  completing  one year of service (as defined by the plan). Participants may make before tax contributions subject to Internal Revenue Service limitations.  CompuDyne currently matches up to 2.5% of  employee  contributions  up to a  maximum  of  $5,000.  Expense  for matching  contributions  to the Plan was $783  thousand,  $694 thousand and $712 thousand for 2005, 2004, and 2003, respectively.  The Company entered into the CompuDyne  Corporation  Retention Plan for Selected Employees (the "Retention Plan") effective June 28, 2005 with certain employees. The Retention Plan provides for cash bonuses and  acceleration of vesting of all unexercised unvested stock awards upon the occurrence of a change in control, as defined in the Retention Plan, for eligible  employees.  A change in control, as defined in the Retention  Plan, did not occur during the year ended December 31, 2005  and  therefore,  the  Company  did  not  record  a  liability  or  related compensation expense for the Retention Plan.  19.  OPERATING SEGMENT INFORMATION  Segment  information  has been  prepared in  accordance  with the  Statement  of Financial  Accounting Standards (SFAS) No. 131, "Disclosure about Segments of an Enterprise  and  Related  Information"  ("SFAS No.  131").  SFAS No. 131 defines "operating  segments" to be those  components of a business about which separate financial  information is available that is regularly evaluated by management in deciding how to allocate  resources and in assessing  performance.  SFAS No. 131 further requires that the segment  information  presented be consistent with the basis and manner in which management  internally evaluates financial information for the purpose of assisting in making internal operating decisions.  The following segment information includes operating information for CompuDyne's four operating  segments,  Institutional  Security Systems,  Attack  Protection, Integrated  Electronic  Systems  and Public  Safety and  Justice in  addition to Corporate  activities  for each of the years ended  December 31, 2005,  2004 and 2003.                                          53                                                          Revenues                                Gross Profit                                     ------------------------------------------ --------------------------------------- (in thousands)                          2005          2004           2003          2005        2004          2003                                     -------------  ------------  -------------  ------------  ----------  ------------        Institutional Security Systems     $      60,652  $     53,952  $      98,653  $      9,896  $    6,437  $     14,203 Attack Protection                         27,017        25,161         28,375         6,105       1,551         5,694 Integrated Electronic Systems             10,110        14,293         16,441         1,625       2,019         2,606 Public Safety and Justice                 43,871        49,376         49,794        24,913      27,671        23,893 CompuDyne Corporate                            -             -              -             -           -             -                                     -------------  ------------  -------------  ------------  ----------  ------------                                    $     141,650  $    142,782  $     193,263  $     42,539  $   37,678  $     46,396                                     =============  ============  =============  ============  ==========  ============                                              Total Assets, at Year End                   Pre-tax Income (Loss)                                    ------------------------------------------- ---------------------------------------                                             2005          2004           2003          2005        2004          2003                                     -------------  ------------  -------------  ------------  ----------  ------------ Institutional Security Systems     $      23,755  $     26,895  $      34,343  $        629  $   (5,174) $      3,613 Attack Protection                         20,621        15,760         21,202        (2,333)     (5,444)          551 Integrated Electronic Systems              4,354         3,807          6,076           431         563           953 Public Safety and Justice                 57,780        56,538         49,439        (2,928)      2,364           407 CompuDyne Corporate                       20,182        29,891          4,672        (4,705)     (2,739)          232                                     -------------  ------------  -------------  ------------  ----------  ------------                                    $     126,692  $    132,891  $     115,732  $     (8,906) $  (10,430) $      5,756                                     =============  ============  =============  ============  ==========  ============                                                Capital Expenditures                  Depreciation and Amortization                                    ------------------------------------------- ---------------------------------------                                             2005          2004           2003          2005        2004          2003                                     -------------  ------------  -------------  ------------  ----------  ------------ Institutional Security Systems     $         132  $        411  $         312  $        388  $      531  $        330 Attack Protection                            264            64            215           767         644           885 Integrated Electronic Systems                  8            16             72            35          41            68 Public Safety and Justice                    815         1,140            451         2,145       1,664         1,679 CompuDyne Corporate                           33           153             18            58          41            26                                     -------------  ------------  -------------  ------------  ----------  ------------                                    $       1,252  $      1,784  $       1,068  $      3,393  $    2,921  $      2,988                                     =============  ============  =============  ============  ==========  ============    Included in the 2005 results are certain contract closeout activities in the ISS segment which  resulted in the  recognition  of $2.0 million of gross margin and $2.0  million  in losses  recorded  in the ISS  segment  related  to  continuing problems in its West Coast office. In addition,  PS&J increased its focus on its Next  Generation  products,  expending $884 thousand.  Also included in the 2005 results are costs related to SOX 404 compliance in the amount of $2.4 million.  Included in the 2004  results is a $739  thousand  pre-tax  charge to record the impairment of the Institutional  Security Systems segment's  goodwill and a $1.1 million charge to record the impairment of certain of the Institutional Security Systems segment's other intangible assets. In addition,  the continuing problems in the West Coast  office of ISS  resulted in the Company  recording  additional losses of $6.1 million from the work  performed in this office and an additional $2.0 million was added to a project's estimated cost to complete.  Also included in 2004's results are charges of $411 thousand for terminated deal costs related to unconsummated acquisitions,  and $2.6 million of interest expense incurred in connection  with the 2011 Notes  issued in January  2004;  these  expenses  were recorded in CompuDyne Corporate's accounts.  Included in the 2003 results is a $1.6 million  pre-tax charge for a contract in litigation,  which occurred in the Public Safety and Justice segment. During the second  quarter of 2004 this matter was settled  resulting in a reversal of $0.3 million of the accrued charge, which was reflected as a reduction of its cost of sales.  During 2003,  the Company  increased  its  allowance  for  doubtful  accounts by approximately  $725 thousand in its  Institutional  Security Systems segment for past due receivables.  Pre-tax income in the Attack Protection segment benefited by approximately $900 thousand from a successful arbitration decision related to a disputed customer receivable.  During 2002, the West Coast  operations of the  Institutional  Security  Systems segment  experienced  significant  cost overruns on many of its projects.  These cost  overruns  were  incurred and  recorded  during the latter half of 2002 and amounted to  approximately  $2.4 million.  As a result,  as these  projects were brought to completion in 2003, the revenues generated by them resulted in little margin or in some cases losses.  The Company recorded $1.9 million of additional write-downs  on its West Coast  projects  that were either  completed  or neared completion  in 2003.  In 2004 and  2005,  the West  Coast  operations  generated pre-tax losses of $6.1 million and $2.0 million, respectively.                                          54     20.  SELECTED QUARTERLY FINANCIAL DATA (Unaudited)                                                     First         Second         Third          Fourth (In thousands, except per share data)          Quarter        Quarter        Quarter        Quarter         Total - -------------------------------------------------------------------------------------------------------------------       Year Ended December 31, 2005 Revenues - -------- Institutional Security Systems             $      15,732  $     11,728  $      15,548  $      17,644  $     60,652 Attack Protection                                  6,898         6,065          5,892          8,162        27,017 Integrated Electronic Systems                      2,019         1,888          2,898          3,305        10,110 Public Safety and Justice                         11,657        11,423          9,161         11,630        43,871                                             -------------  ------------  -------------  -------------  ------------ Total revenues                             $      36,306  $     31,104  $      33,499  $      40,741  $    141,650  Gross Profit - ------------ Institutional Security Systems             $       3,567  $      1,581  $       2,343  $       2,405  $      9,896 Attack Protection                                  2,368         1,380            341          2,016         6,105 Integrated Electronic Systems                        282           340            473            530         1,625 Public Safety and Justice                          6,166         7,126          5,360          6,261        24,913                                             -------------  ------------  -------------  -------------  ------------ Total gross profit                         $      12,383  $     10,427  $       8,517  $      11,212  $     42,539  Pre-tax Income (loss) - --------------------- Institutional Security Systems             $       1,230  $       (532) $        (170) $         101  $        629 Attack Protection                                    499          (840)        (1,800)          (192)       (2,333) Integrated Electronic Systems                         (8)           16            172            251           431 Public Safety and Justice                           (482)          400         (3,188)           342        (2,928) Unallocated corporate expense                     (1,558)       (1,683)          (791)          (673)       (4,705)                                             -------------  ------------  -------------  -------------  ------------ Pre-tax loss from operations               $        (319) $     (2,639) $      (5,777) $        (171) $     (8,906)                                             -------------  ------------  -------------  -------------  ------------ Net loss                                   $        (319) $     (2,639) $      (5,277) $        (456) $     (8,691)                                             -------------  ------------  -------------  -------------  ------------ Basic loss per share                       $        (.04) $       (.33) $        (.65) $        (.06) $      (1.07)                                             -------------  ------------  -------------  -------------  ------------ Diluted loss per share                     $        (.04) $       (.33) $        (.65) $        (.06) $      (1.07)                                             -------------  ------------  -------------  -------------  ------------                                                  First         Second         Third          Fourth (In thousands, except per share data)         Quarter        Quarter        Quarter        Quarter         Total - ------------------------------------------------------------------------------------------------------------------- Year Ended December 31, 2004 Revenues - -------- Institutional Security Systems             $      16,057  $     13,954  $      11,783  $      12,158  $     53,952 Attack Protection                                  6,953         6,741          6,510          4,957        25,161 Integrated Electronic Systems                      3,575         4,371          3,296          3,051        14,293 Public Safety and Justice                         12,442        12,717         11,771         12,446        49,376                                             -------------  ------------  -------------  -------------  ------------ Total revenues                             $      39,027  $     37,783  $      33,360  $      32,612  $    142,782  Gross Profit - ------------ Institutional Security Systems             $       2,505  $      2,244  $       1,773  $         (85) $      6,437 Attack Protection                                    919         1,082           (477)            27         1,551 Integrated Electronic Systems                        490           611            501            417         2,019 Public Safety and Justice                          6,284         7,210          7,011          7,166        27,671                                             -------------  ------------  -------------  -------------  ------------ Total gross profit                         $      10,198  $     11,147  $       8,808  $       7,525  $     37,678  Pre-tax Income (loss) - --------------------- Institutional Security Systems             $         207  $        (84) $        (806) $      (4,491) $     (5,174) Attack Protection                                   (679)         (456)        (2,101)        (2,208)       (5,444) Integrated Electronic Systems                        200           214            137             12           563 Public Safety and Justice                            435           960            370            599         2,364 Unallocated corporate expense                       (674)         (481)          (671)          (913)       (2,739)                                             -------------  ------------  -------------  -------------  ------------ Pre-tax (loss) income from operations      $        (511) $        153  $      (3,071) $      (7,001) $    (10,430)                                             -------------  ------------  -------------  -------------  ------------ Net (loss) income                          $        (307) $         90  $      (1,850) $      (6,131) $     (8,198)                                             -------------  ------------  -------------  -------------  ------------ Basic (loss) earnings per share            $        (.04) $        .01  $        (.23) $        (.74) $      (1.01)                                             -------------  ------------  -------------  -------------  ------------ Diluted (loss) earnings per share          $        (.04) $        .01  $        (.23) $        (.74) $      (1.01)                                             -------------  ------------  -------------  -------------  ------------                                            55     Included  in  the  first,  second,  third  and  fourth  quarters  of  2005  were approximately  $0.6  million,  $0.9  million,  $0.5  million  and $0.4  million, respectively, in costs related to SOX 404 compliance.  Included in the results of the fourth quarter of 2004 is a $739 thousand pre-tax charge to record the impairment of the Institutional  Security Systems segment's goodwill and a $1.1 million  charge to record the  impairment  of certain of the Institutional  Security Systems segment's other intangible  assets. In addition, the continuing  problems in the West Coast office of ISS resulted in the Company recording  additional  losses of $2.2  million  from the work  performed in this office.  Included in the results of the fourth quarter of 2003 is a $1.6 million  pre-tax charge for a contract in  litigation,  which  occurred in the Public  Safety and Justice  segment.  During the second  quarter  of 2004 this  matter was  settled resulting  in a  reversal  of $0.3  million  of the  accrued  charge,  which was reflected as a reduction of its cost of sales.                                          56     ITEM  9.  CHANGES  IN AND  DISAGREEMENTS  WITH  ACCOUNTANTS  ON  ACCOUNTING  AND FINANCIAL DISCLOSURE  None.
Changes in Accelerated Filer Status  On December 21, 2005 the Securities and Exchange  Commission  issued Release No. 33-8644 "Revisions to Accelerated Filer Definition and Accelerated Deadlines For Filing  Periodic  Reports"  (the  "Release").  Included  in the  Release  was an amendment to revise the definition of the term "accelerated  filer" to permit an accelerated  filer that has an  aggregate  worldwide  market value of voting and non-voting  common equity held by  non-affiliates of less than $50 million as of the last business day of its second  fiscal  quarter to exit  accelerated  filer status at the end of the fiscal year in which the  company's  equity falls below $50 million as of the last business day of its second fiscal quarter and to file its  annual  report  for  that  year  and  subsequent   periodic  reports  on  a non-accelerated basis.  The aggregate worldwide market value of CompuDyne  Corporation's  equity held by non-affiliates as of June 30, 2005, the last business day of CompuDyne's  second fiscal quarter, was less than $50 million. As a result, as of December 31, 2005, CompuDyne exited accelerated filer status.  Prior to the Release, CompuDyne was classified as an "accelerated filer" and was required to comply with the  requirements  of Section 404 of the  Sarbanes-Oxley Act of 2002. In light of the Release,  CompuDyne,  as a non-accelerated filer as of December  31,  2005,  is not required to comply with Section 404 for the year ended December 31, 2005.  Disclosure Controls and Procedures  The Company  maintains  disclosure  controls and procedures that are designed to ensure that  information  required to be  disclosed  in the  Company's  periodic Securities Exchange Act of 1934 ("Exchange Act") reports is recorded, processed, summarized,  and reported  within the time periods  specified in the SEC's rules and forms,  and that such  information is accumulated  and  communicated  to the Company's management,  including its Chief Executive Officer and Chief Financial Officer, as appropriate,  to allow timely decisions regarding required financial disclosure.  As of December  31,  2005,  the Company  carried  out an  evaluation,  under the supervision and with the  participation of the Company's  management,  including the  Chief  Executive   Officer  and  the  Chief  Financial   Officer,   of  the effectiveness  of the  design  and  operation  of its  disclosure  controls  and procedures  pursuant to Exchange Act Rules 13a-15(e) and 15d-15(e).  Based upon, and as of the date of,  this  evaluation,  the Chief  Executive  Officer and the Chief Financial  Officer  concluded that the Company's  disclosure  controls and procedures were effective.  Remediation of Material Weaknesses  In the  Company's  2004  Annual  Report on Form 10-K for the  fiscal  year ended December 31, 2004 (the "Annual Report"),  we disclosed three material weaknesses in our internal control over financial reporting.  The following is a discussion of specific  changes  that we have made to our internal  control over  financial reporting during 2005 relating to the material weaknesses  previously  disclosed in the 2004 Annual Report.  After consideration of the remediation efforts below and  testing of the design and  operating  effectiveness  of  controls,  we have concluded that as of December 31, 2005, the material weaknesses disclosed in the 2004 Annual Report have been remediated.       1.   The Company did not maintain a sufficient complement of personnel with           an appropriate level of accounting knowledge,  experience and training           in the application of accounting  principles generally accepted in the           United  States  of  America  (GAAP)  commensurate  with the  Company's           financial  reporting  requirements  to support  the size,  complexity,           operating  activities,  and  locations of the Company.  This  material           weakness  contributed  to the  other  individual  material  weaknesses           described  below. To address this material  weakness,  the Company has           upgraded  and   supplemented   the  talent  of  its  accounting  staff           throughout  the   organization  by  hiring  and  promoting   qualified           candidates,   including  a  number  of  external  candidates.  Through           management's  review of the accounting  personnel and additions to the           accounting staff,  management has achieved a general control objective           related to the material weakness.                                          57          2.   The Company did not maintain  effective  controls over the  accounting           for income taxes, including income taxes payable,  deferred income tax           assets  and   liabilities   and  the  related  income  tax  provision.           Specifically,  the Company did not have  effective  controls  over the           reconciliation  between the tax and financial  reporting  bases of the           Company's  assets and liabilities  with its deferred income tax assets           and  liabilities.  Additionally,  there  was a lack of  oversight  and           review over the income taxes payable,  deferred  income tax assets and           liabilities   and  the  related  income  tax  provision   accounts  by           accounting   personnel  with  appropriate   expertise  in  income  tax           accounting. This control deficiency resulted in an audit adjustment to           the   fourth   quarter   2004   consolidated   financial   statements.           Additionally,  this control  deficiency could result in a misstatement           of  the  income  taxes  payable,   deferred   income  tax  assets  and           liabilities  and the related income tax provision  accounts that would           result in a  material  misstatement  to annual  or  interim  financial           statements  that  would not be  prevented  or  detected.  Accordingly,           management  determined  that this  control  deficiency  constituted  a           material weakness. To address this material weakness,  the Company has           engaged  an outside  tax  consultant,  other  than from the  Company's           independent  registered public accounting firm, and has implemented an           ongoing  training  program to enhance the capabilities of its internal           tax personnel.       3.   The Company did not maintain  effective controls over certain contract           revenues,   contract   costs  in  excess  of  billings   and  accounts           receivable.  Specifically, the Company did not have effective controls           over  the  accounting  for  non-routine   change  orders  to  customer           contracts  to  ensure  that  change  orders  were   accounted  for  in           accordance  with GAAP.  This control  deficiency  resulted in an audit           adjustment  to  the  fourth   quarter  2004   consolidated   financial           statements.  Additionally,  this control  deficiency could result in a           misstatement  of the contract  revenues,  contract  costs in excess of           billings  and  accounts  receivable  accounts  that would  result in a           material  misstatement to annual or interim financial  statements that           would not be prevented or detected. Accordingly, management determined           that this  control  deficiency  constituted  a material  weakness.  To           address this material weakness,  the Company has instituted formal new           procedures  requiring the accounting for all significant,  non-routine           transactions   to  be  documented   and  submitted  to  the  Corporate           Accounting  Group for approval.  CompuDyne  management has implemented           controls  to achieve  the control  objective  related to the  material           weakness;  therefore,  we have  concluded  that the material  weakness           related to Ineffective  Controls over the  Accounting for  Non-Routine           Change Orders has been fully remediated and no longer is considered to           represent an internal control deficiency.
None.                                          58                                         PART III  Information  required  by  Items  10,  11,  12,  13 and 14  about  CompuDyne  is incorporated  herein  by  reference  from  the  definitive  proxy  statement  of CompuDyne  to be filed  with the SEC within  120 days  following  the end of the fiscal year ended December 31, 2005.                                       PART IV
(a)  Financial Statements      (1)  Index to Financial Statements           Report of Independent  Registered  Public  Accounting Firm - Aronson &           Company           Report   of   Independent   Registered   Public   Accounting   Firm  -           PricewaterhouseCoopers LLP           Report of Independent  Registered  Public Accounting Firm - Deloitte &           Touche LLP           Consolidated Balance Sheets at December 31, 2005 and 2004           Consolidated Statements of Operations for the years ended December 31,           2005, 2004 and 2003           Consolidated  Statement  of  Changes in  Shareholders'  Equity for the           years ended December 31, 2005, 2004 and 2003           Consolidated Statements of Cash Flows for the years ended December 31,           2005, 2004 and 2003           Notes to Consolidated Financial Statements       (2)  Schedule II - Schedule of valuation and qualifying accounts  (b)  Exhibits      The  Exhibits  listed on the index below are filed as a part of this Annual      Report.                                          59                                        SCHEDULE II                       COMPUDYNE CORPORATION AND SUBSIDIARIES                   SCHEDULE OF VALUATION AND QUALIFYING ACCOUNTS                   YEARS ENDED DECEMBER 31, 2005, 2004, and 2003                                 ($ in thousands)                                                              Balance at      Charged to                   Balance                                                           Beginning      Costs and                    At End Description                                               Of Period       Expenses      Deduction    Of Period - -----------                                               ---------       --------      ---------    ---------      Year Ended December 31, 2005 Reserve and allowances deducted from asset accounts: Reserve for excess and slow moving inventory              $  1,362           315          (306)      $   1,371 Reserve for accounts receivable                           $  1,919           699          (297)      $   2,321 Deferred tax asset valuation allowance                    $  1,858         4,268            -        $   6,126  Year Ended December 31, 2004 Reserve and allowances deducted from asset accounts: Reserve for excess and slow moving inventory              $    840           649          (127)      $   1,362 Reserve for accounts receivable                           $  1,252         1,153          (486)      $   1,919 Deferred tax asset valuation allowance                    $      -         1,858             -       $   1,858   Year Ended December 31, 2003 Reserve and allowances deducted from asset accounts: Reserve for excess and slow moving inventory              $    642           367          (169)      $     840 Reserve for accounts receivable                           $  1,173           996          (917)      $   1,252                                            60                                   COMPUDYNE CORPORATION                                 INDEX TO EXHIBITS                                   (Item 15(b))  2(A). Agreement  and Plan of Merger dated May 8, 1996,  herein  incorporated  by      reference to Exhibit 3(B) to Registrant's 10-K filed March 31, 1997.  3(A). Articles  of  Incorporation  of  CompuDyne   Corporation  filed  with  the      Secretary  of  State  of  the  State  of  Nevada  on May  8,  1996,  herein      incorporated  by reference to  Registrant's  Proxy  Statement dated May 13,      1996 for its 1996 Annual Meeting of Shareholders.  3(B). Amendment  to the  Articles  of  Incorporation  of  CompuDyne  Corporation      increasing the number of authorized  common shares filed with the Secretary      of the  State of  Nevada on  February  16,  2001,  herein  incorporated  by      reference to Exhibit 3(B) to the Registrant's 10-K filed March 27, 2001.  3(C). By-Laws,  as amended  through January 28, 1997 and as presently in effect,      herein incorporated by reference to Exhibit 3(C) to Registrant's 10-K filed      March 31, 1997.  10(A). CompuDyne   Corporation  1996  Stock  Incentive   Compensation  Plan  for      Employees, herein incorporated by reference to Registrant's Proxy Statement      dated July 17, 2001 for its 2001 Annual Meeting of Shareholders.  10(B). Credit  Agreement   dated   November  16,  2001  by  and among  CompuDyne      Corporation, its subsidiaries,  certain participating lenders and PNC Bank,      National  Association  in its  capacity  as agent for the  lenders,  herein      incorporated  by  reference  to  Exhibit 10 (b) to  Registrant's  8-K filed      November 21, 2001.  10(C)(1).  Amended  and  Restated Credit  Agreement dated  March 31, 2004 by and      among CompuDyne  Corporation and its  subsidiaries,  certain  participating      lenders and PNC Bank,  National  Association,  in its capacity as agent for      the  lenders,   herein   incorporated   by  reference  to  Exhibit  3.1  to      Registrant's 10-Q filed May 7, 2004.  10(C)(2).  Amendment to Amended and Restated Credit  Agreement dated October 29,      2004  by  and  among  CompuDyne  Corporation,  its  subsidiaries,   certain      participating lenders and PNC Bank, National Association in its capacity as      agent for the lenders,  herein incorporated by reference to Exhibit 10.1 to      Registrant's 8-K filed on November 1, 2004.  10(C)(3).  Second  Amendment  to  Amended  and  Restated  Credit  Agreement  and      Amendment to Securities  Pledge  Agreement dated March 4, 2005 by and among      CompuDyne Corporation, its subsidiaries,  certain participating lenders and      PNC Bank,  National  Association  in its capacity as agent for the lenders,      herein  incorporated by reference to Exhibit 10.1 to registrant's 8-K filed      on March 7, 2005.  10(C)(4).  Third  Amendment  to Amended  and  Restated  Credit  Agreement  dated      November 17, 2005 by and among CompuDyne Corporation and PNC Bank, National      Association,  and Sixth Amended and Restated  Revolving Note dated November      17, 2005,  herein  incorporated  by reference to Exhibits  10.1 and 10.2 to      Registrant's 8-K filed on November 17, 2005.  10(C)(5). Second Amended and Restated  Revolving  Credit and Security  Agreement      dated  December  19,  2005  by  and  among   CompuDyne   Corporation,   its      subsidiaries and PNC Bank,  National  Association,  herein  incorporated by      reference to Exhibit 10.1 to Registrant's 8-K filed on December 19, 2005.  10(D). 2005 Employment  Agreement between  CompuDyne  Corporation and Mr. Daniel      Crawford, herein incorporated by reference,  filed on Form 8-K, October 27,      2004.  10(E). Transition Agreement by and among CompuDyne Corporation, Norment Security      Group, Inc., and Mr. Jon Lucynski, herein incorporated by reference,  filed      on Form 8-K, January 26, 2005.  10(F). 1996 Stock Non-Employee  Director Plan, herein  incorporated by reference      to  Registrant's  Proxy  Statement dated April 18, 1997 for its 1997 Annual      Meeting of Shareholders.                                          61     10(G). Stock Option  Agreement  dated  August 21, 1995 by and between  Martin A.      Roenigk and  CompuDyne  Corporation,  herein  incorporated  by reference to      Exhibit (4.5) to Registrant's Form 8-K filed September 5, 1995.  10(H).* Compensatory Arrangements.  10(I). 2005 Stock Option Plan for Non-Employee  Directors,  2005 Stock Incentive      Compensation  Plan for  Employees,  Amendment to the 1996 Stock Option Plan      for  Non-Employee  Directors,  and  Amendment  to the 1996 Stock  Incentive      Compensation  Plan for  Employees,  herein  incorporated  by  reference  to      Registrant's  Proxy  Statement  dated  April 29,  2005 for its 2005  Annual      Meeting of Shareholders.  10(J).  CompuDyne  Corporation  Retention  Plan for Selected  Employees,  herein      incorporated by reference to Exhibit 10.1 to Registrant's 8-K filed July 1,      2005.  21.*  Subsidiaries of the Registrant.  23.1* Consent  of  Independent  Registered  Public  Accounting  Firm - Aronson &       Company.  23.2* Consent   of   Independent    Registered    Public   Accounting   Firm   -       PricewaterhouseCoopers LLP.  23.3* Consent of  Independent  Registered  Public  Accounting  Firm - Deloitte &       Touche LLP.  31.1* Certification  of Chief Executive  Officer pursuant to Rule 13(a)-14(a) or       15(d)-14(a).  31.2* Certification  of Chief Financial  Officer pursuant to Rule 13(a)-14(a) or       15(d)-14(a).  32.1* Certification  Pursuant To 18 U.S.C.  Section 1350 As Adopted  Pursuant To       Section 906 of The Sarbanes-Oxley Act Of 2002, for Mr. Martin Roenigk.  32.2* Certification  Pursuant To 18 U.S.C.  Section 1350 As Adopted  Pursuant To       Section  906 of The  Sarbanes-Oxley  Act  Of  2002,  for  Mr.  Geoffrey F.       Feidelberg.  *      Filed herewith.                                          62                                        SIGNATURES        Pursuant to the requirements of Section 13 or 15(d) 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.                                        COMPUDYNE CORPORATION                                       ---------------------                                       (Registrant)                                        By:                                          ---------------------------------------                                       Martin Roenigk                                       Chief Executive Officer                                        By:                                          ---------------------------------------                                       Geoffrey F. Feidelberg Dated: March 27, 2006                 Chief Financial Officer        Pursuant to the  requirements of the Securities  Exchange Act of 1934, this report  has  been  signed  below  by the  following  persons  on  behalf  of the Registrant and in the capacities indicated on March 27, 2006.         - ----------------------   Director, Chairman, President        -------------------------       Director Martin A. Roenigk        and Chief Executive Officer          David W. Clark, Jr.   - ----------------------   Director                             -------------------------       Director John H. Gutfreund                                             Ronald J. Angelone   - ----------------------   Director                             -------------------------       Director Albert R. Dowden                                              Wade B. Houk   - ----------------------   Director, Chief Financial Officer    -------------------------       Director Geoffrey F. Feidelberg   and Treasurer                        John Michael McConnell                                           63    EX-10 2 a5110929ex10_h.txt EXHIBIT 10 (H)                                     EXHIBIT 10(H)                              COMPENSATORY ARRANGEMENTS  Compensatory Arrangement with the Board of Directors - -----------------------------------------------------  Effective May 27, 2004, non-employee board members receive an annual retainer of $16,000  paid in  quarterly  increments.  Audit  committee  members  receive  an additional  $6,500 and the Chairman of the Audit  Committee  receives  $9,000 in addition to his audit committee compensation. Each independent director receives a grant of 10,000 CompuDyne (CDCY)  non-qualified  stock options upon his or her initial  election  as a  director,  5,000 of which  vest after two years and the remaining  5,000 vest after three  years.  An annual  grant of 10,000  CompuDyne (CDCY) non-qualified stock options is granted to each Director thereafter; 5,000 of the  options  vest after two years and the  remaining  5,000 vest after three years.  The grant price of the options is equal to the fair market  value of the common stock on the date of grant.  Compensatory Arrangements with Certain Named Executive Officers - ----------------------------------------------------------------  The following named executive officers of the Registrant (as of the Registrant's 2005 Proxy  Statement) do not have  employment  agreements  with the  Registrant unless noted below and, accordingly, their employment with the Registrant is "at will." For the Registrant's 2006 fiscal year, the current annual base salary for each named executive below is the following:         Name and Title                                                            Fiscal 2006 Salary     --------------                                                            ------------------        Martin A. Roenigk, Chairman, President and Chief Executive Officer           $   275,000      Geoffrey F. Feidelberg, Chief Financial Officer and Treasurer                $   288,750      Robert Brown, Senior V.P. of Operations, CompuDyne-Public Safety and         $   181,000     Justice, Inc.      Jon Lucynski(a), Director of Special Projects, Norment Security Group,       $   159,321     Inc.      Daniel Crawford(b), CEO and President, CompuDyne-Public Safety and           $   315,000     Justice, Inc.      Bradley Wiggins, President of Attack Protection                              $   220,000    The annual base salaries are subject to adjustment  pursuant to the Registrant's employee  compensation  policies  in effect  from time to time.  Each  executive officer is eligible to receive a bonus and other employee  benefits  pursuant to the Registrant's employee benefit plans.    - -------------------------- (a)  Company  filed a Form 8-K dated  January  26,  2005  disclosing  employment      agreement. (b)  Company  filed a Form 8-K dated  October  27,  2004  disclosing  employment      agreement.                                          64    EX-21 3 a5110929ex21.txt EXHIBIT 21                                     EXHIBIT 21                           SUBSIDIARIES OF THE REGISTRANT       Each of the below-listed subsidiaries is 100 percent directly or indirectly owned by CompuDyne Corporation.                                                                                                                   Percentage                                                                                                                of voting                                                                                                                securities                                                     Incorporated                                               owned by                                                       under the                                                immediate Name                                                  laws of                 Parent                             parent - ----                                                ------------         ------------------                   -----------     CompuDyne Corp. of Maryland *                          Maryland          CompuDyne Corporation                     100% CompuDyne-Integrated Electronics Division, LLC *       Delaware          CompuDyne Corporation                     100% CompuDyne, Inc.**                                      Delaware          CompuDyne Corporation                     100% CorrLogic, LLC *                                       Delaware          CompuDyne-Public Safety and Justice       100% Norment Security Group, Inc. *                         Delaware          CompuDyne Corporation                     100% Norshield Corporation  *                               Alabama           CompuDyne Corporation                     100% Norment Industries S.A. (Pty) Ltd.                     South Africa      Norment Security Group, Inc.              100% Fiber SenSys, LLC *                                    Delaware          CompuDyne Corporation                     100% CompuDyne-Public Safety and Justice, Inc. *            Virginia          CompuDyne Corporation                     100% Xanalys Corporation *                                  Delaware          CompuDyne-Public Safety and Justice       100% Xanalys Limited *                                      United Kingdom    Xanalys Corporation                       100% Xanalys Pty. Ltd. *                                    Australia         Xanalys Corporation                       100% Xanalys Corp.  *                                       Canada            Xanalys Corporation                       100%    Note:     *    All  subsidiaries  of the Registrant as of December 31, 2005, are                included  in  the  consolidated   financial   statements  of  the                Registrant.           **   CompuDyne,  Inc. filed for petition in bankruptcy on December 31,                1991.                                          65    EX-23.1 4 a5110929ex23_1.txt EXHIBIT 23.1                                                                       EXHIBIT 23.1  CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM  We  hereby  consent  to the  incorporation  by  reference  in  the  Registration Statements on Form S-8 (Nos.  333-87445 and 333-09435) of CompuDyne  Corporation of our report  dated March 10, 2006  relating to the  financial  statements  and financial statement schedule, which appears in this Form 10-K.  ARONSON & COMPANY  Rockville, Maryland March 27, 2006                                         66      EX-23.2 5 a5110929ex23_2.txt EXHIBIT 23.2                                                                      EXHIBIT 23.2  CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM  We  hereby  consent  to the  incorporation  by  reference  in  the  Registration Statement on Form S-8 (Nos. 333-87445 and 333-09435) of CompuDyne Corporation of our report  dated  March 31,  2005  relating  to the  financial  statements  and financial statement schedule, which appears in this Form 10-K.  PRICEWATERHOUSECOOPERS LLP  Baltimore, Maryland March 27, 2006                                         67    EX-23.3 6 a5110929ex23_3.txt EXHIBIT 23.3                                                                      EXHIBIT 23.3   CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM  We consent to the  incorporation  by reference in  Registration  Statement  Nos. 333-87445 and 333-09435 of CompuDyne Corporation on Form S-8 of our report dated March 8,  2004,  appearing  in this  Annual  Report  on Form  10-K of  CompuDyne Corporation for the year ended December 31, 2005.  DELOITTE & TOUCHE LLP  Baltimore, Maryland March 27, 2006                                          68    EX-31.1 7 a5110929ex31_1.txt EXHIBIT 31.1    CERTIFICATION                                                       Exhibit 31.1  I, Martin A. Roenigk, certify that:  1. I have reviewed this annual report on Form 10-K of CompuDyne Corporation;  2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact  necessary to make the statements made, in light of the  circumstances  under which such statements were made, not misleading with respect to the period covered by this report;  3.  Based  on my  knowledge,  the  financial  statements,  and  other  financial information included in this report, fairly present in all material respects the financial  condition,  results of operations and cash flows of the registrant as of, and for, the period presented in this report;  4.  The  registrant's  other  certifying  officer  and I,  are  responsible  for establishing and maintaining  disclosure  controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:           (a) Designed such disclosure  controls and  procedures,  or caused such disclosure  controls and  procedures to be designed  under our  supervision,  to ensure that  material  information  relating to the  registrant,  including  its consolidated subsidiaries,  is made known to us by others within those entities, particularly during the period in which this report is being prepared;           (b) Evaluated the effectiveness of the registrant's disclosure controls and  procedures  and  presented  in  this  report  our  conclusions   about  the effectiveness  of the disclosure  controls and procedures,  as of the end of the period covered by this report based on such evaluation; and           (c)  Disclosed in this report any change in the  registrant's  internal control over financial  reporting  that occurred  during the  registrant's  most recent fiscal quarter that has materially  affected,  or is reasonably likely to materially affect, the registrant's  internal control over financial  reporting; and  5. The registrant's other certifying officer and I have disclosed,  based on our most recent  evaluation of internal  control over  financial  reporting,  to the registrant's   auditors  and  the  audit  committee  of  registrant's  board  of directors:           (a) All significant  deficiencies and material weaknesses in the design or operation of internal controls over financial  reporting which are reasonably likely  to  adversely  affect  the  registrant's  ability  to  record,  process, summarize and report financial information; and           (b) Any fraud,  whether or not material,  that  involves  management or other employees who have a significant role in the registrant's internal control over financial reporting.           Date:  March 27, 2006                                              /s/ Martin Roenigk                                              ------------------                                              Martin Roenigk                                              Chief Executive Officer                                           69    EX-31.2 8 a5110929ex31_2.txt EXHIBIT 31.2    CERTIFICATION                                                       Exhibit 31.2  I, Geoffrey F. Feidelberg, certify that:  1. I have reviewed this annual report on Form 10-K of CompuDyne Corporation;  2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact  necessary to make the statements made, in light of the  circumstances  under which such statements were made, not misleading with respect to the period covered by this report;  3.  Based  on my  knowledge,  the  financial  statements,  and  other  financial information included in this report, fairly present in all material respects the financial  condition,  results of operations and cash flows of the registrant as of, and for, the period presented in this report;  4.  The  registrant's  other  certifying  officer  and I,  are  responsible  for establishing and maintaining  disclosure  controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:           (a) Designed such disclosure  controls and  procedures,  or caused such disclosure  controls and  procedures to be designed  under our  supervision,  to ensure that  material  information  relating to the  registrant,  including  its consolidated subsidiaries,  is made known to us by others within those entities, particularly during the period in which this report is being prepared;           (b) Evaluated the effectiveness of the registrant's disclosure controls and  procedures  and  presented  in  this  report  our  conclusions   about  the effectiveness  of the disclosure  controls and procedures,  as of the end of the period covered by this report based on such evaluation; and           (c)  Disclosed in this report any change in the  registrant's  internal control over financial  reporting  that occurred  during the  registrant's  most recent fiscal quarter that has materially  affected,  or is reasonably likely to materially affect, the registrant's  internal control over financial  reporting; and  5. The registrant's other certifying officer and I have disclosed,  based on our most recent  evaluation of internal  control over  financial  reporting,  to the registrant's   auditors  and  the  audit  committee  of  registrant's  board  of directors:           (a) All significant  deficiencies and material weaknesses in the design or operation of internal controls over financial  reporting which are reasonably likely  to  adversely  affect  the  registrant's  ability  to  record,  process, summarize and report financial information; and           (b) Any fraud,  whether or not material,  that  involves  management or other employees who have a significant role in the registrant's internal control over financial reporting.           Date:  March 27, 2006                                            /s/ Geoffrey F. Feidelberg                                            --------------------------                                            Geoffrey F. Feidelberg                                            Chief Financial Officer                                          70    EX-32.1 9 a5110929ex32_1.txt EXHIBIT 32.1                                                                       Exhibit 32.1                              CERTIFICATION PURSUANT TO                              18 U.S.C. SECTION 1350                              AS ADOPTED PURSUANT TO                   SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002  In connection with the Annual Report of CompuDyne Corporation (the "Company") on Form 10-K for the period ended December 31, 2005 accompanying this certification and filed with the  Securities  and Exchange  Commission on the date hereof (the "Report"),  I, Martin Roenigk, Chief Executive Officer of the Company,  certify, to the best of my knowledge,  pursuant to ss. 906 of the  Sarbanes-Oxley  Act of 2002, 18 U.S.C. ss. 1350, that:           1. The Report fully complies with the  requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and           2. The  information  contained in the Report  fairly  presents,  in all material  respects,  the  financial  condition  and results of operations of the Company.   Date:  March 27, 2006                                       /s/ Martin Roenigk                                      ------------------                                      Martin Roenigk                                      Chief Executive Officer                                          71    EX-32.2 10 a5110929ex32_2.txt EXHIBIT 32.2                                                                       Exhibit 32.2                              CERTIFICATION PURSUANT TO                              18 U.S.C. SECTION 1350                              AS ADOPTED PURSUANT TO                   SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002  In connection with the Annual Report of CompuDyne Corporation (the "Company") on Form 10-K for the period ended December 31, 2005 accompanying this certification and filed with the  Securities  and Exchange  Commission on the date hereof (the "Report"),  I, Geoffrey F. Feidelberg,  Chief Financial  Officer of the Company, certify, to the best of my knowledge,  pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. ss. 1350, that:           1. The Report fully complies with the  requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and           2. The  information  contained in the Report  fairly  presents,  in all material  respects,  the  financial  condition  and results of operations of the Company.   Date:  March 27, 2006                                        /s/ Geoffrey F. Feidelberg                                       --------------------------                                       Geoffrey F. Feidelberg                                       Chief Financial Officer                                          72     -----END PRIVACY-ENHANCED MESSAGE-----