XNNHQ Xenonics Holdings Inc (CE)

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Rounded in thousands)

1. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. These financial statements and notes thereto should be read in conjunction with the financial statements and notes thereto for the year ended September 30, 2012 included in the Xenonics Holdings, Inc. (“Holdings”) Form 10-K filing. The results for the interim period are not necessarily indicative of the results for the full fiscal year.

The condensed consolidated financial statements include the accounts of Holdings and its wholly-owned subsidiary, Xenonics, Inc. (“Xenonics”), collectively, the “Company”.

2. GOING CONCERN

The Company’s financial statements are prepared using generally accepted accounting principles in the United States of America applicable to a going concern which contemplates the realization of assets and liquidation of liabilities in the normal course of business. At this time the Company has not yet received pending substantial purchase orders for its products to cover their operating costs and liquidate outstanding notes payable which raises doubt about its ability to continue as a going concern.

The future of the Company as an operating business will depend on its ability to (1) obtain purchase orders and ship its products, (2) collect for shipments in a timely manner, (3) continue to exercise tight cost controls to conserve cash and attain profitable operations, and (4) obtain sufficient financing as may be required to sustain its operations.

The accompanying financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern. If the Company is unable to obtain adequate revenues and financing, it could be forced to cease operations.

3. RECENT ACCOUNTING PRONOUNCEMENTS

In September 2011, the FASB issued authoritative accounting guidance included in ASC Topic 350, “ Intangibles—Goodwill and Other ”. This guidance amends the requirements for goodwill impairment testing. The Company has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, the Company determines it is more likely than not that the fair value of a reporting unit is greater than its carrying amount, then performing the two-step impairment test is unnecessary. This guidance is effective for the Company for its annual goodwill impairment testing for the year ending September 30, 2013. The Company does not expect this guidance to have a significant impact on the Company’s consolidated results of operations, financial position or cash flows.

In July 2012, the FASB issued authoritative guidance included in ASC Topic 350, “ Intangibles—Goodwill and Other .” This guidance permits an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of an indefinite-lived intangible asset is impaired, as a basis for determining whether it is necessary to perform the quantitative impairment test described in FASB ASC Topic 350, “ Intangibles—Goodwill and Other.” This guidance is effective for the Company for its annual impairment testing for the year ending September 30, 2013. The Company does not expect this guidance to have a significant impact on the Company’s consolidated results of operations, financial position or cash flows.

4

Table of Contents

4. EARNINGS (LOSS) PER SHARE

Earnings (loss) per share is computed by dividing the income available to common shareholders by the weighted average number of common shares outstanding. Diluted earnings per share is computed similarly to basic earnings per share, except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential additional common shares that were dilutive had been issued. Common share equivalents are excluded from the computation if their effect is anti-dilutive. The Company’s common share equivalents consist of stock options and warrants.

The diluted earnings per share did not include the dilutive effect, if any, from the potential exercise of stock options and warrants outstanding using the treasury stock method, because the exercise prices for all of the stock options and warrants outstanding was greater than the average stock price for the period. For the three and six months ended March 31, 2013, the number of stock options (not including performance options) and warrants excluded was 6,199,000. For the three and six months ended March 31, 2012, the number of stock options and warrants excluded was 6,243,000.

6. 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. Actual results could differ from those estimates.

7. NOTES PAYABLE

On July 15, 2009 the Company borrowed $525,000 under the terms of promissory notes due July 15, 2012 with interest only payments due quarterly at an annual rate of 13%. The notes could have been prepaid without penalty on or after January 15, 2010.

In connection with the notes payable transaction, the Company granted and issued 525,000 warrants with an exercise price of $0.75 and valued the warrants at $250,000 using the Black-Scholes option-pricing model and the following assumptions: the market price was $0.68, the volatility was estimated at 104%, the life of the warrants was 5 years, the risk free rate was 2.06% and the dividend yield of 0%. The value assigned for the warrants issued in conjunction with the notes payable was recorded as debt discount and is being amortized over the three year life of the notes. Pursuant to the terms of the promissory notes, the exercise price for the warrants was adjusted to $0.65 in April 2010 when the Company issued warrants at that lower price in connection with a stock offering. The Company recorded a valuation adjustment in 2010 of $6,000 for this change in the exercise price. Because the debt discount had already been fully amortized, for the three and six months ended March 31, 2013 the Company did not record any amortization for this transaction. For the three and six months ended March 31, 2012 the Company recorded amortization of $21,000 and $42,000, respectively.

5

Table of Contents

On December 7, 2011 the Company and the holders of the promissory notes agreed to amend the due date to October 15, 2012. In conjunction with the amendment, the Company amended the warrants issued with the original notes to lower the exercise price from $0.65 per share to $0.40 per share. The Company evaluated these amendments under ASC 470-50, Debt-Modification and Extinguishment, and concluded that the amendments were not significant and were therefore treated as debt modification. As a result, the Company recognized additional compensation expense of $5,000 for the year ended September 30, 2012.

On March 19, 2012 the Company borrowed $500,000 under the terms of a promissory note. Repayment of the promissory note is secured by a first lien security interest in all of the Company’s assets and was due no later than December 31, 2012, subject to earlier repayment upon the Company’s receipt of purchase orders. A total of $50,000 of interest was required to be paid on the loan.

On May 22, 2012 the Company borrowed an additional $500,000 under the terms of a promissory note. Repayment of the promissory note was due no later than December 31, 2012, subject to earlier repayment upon the Company’s receipt of purchase orders. A total of $50,000 of interest was prepaid on the loan and was to be amortized over the term of the loan.

On October 15, 2012 the Company and the holders of the promissory notes totaling $525,000, agreed to amend the maturity dates to October 15, 2013. In conjunction with the amendment, the Company granted and issued 525,000 warrants with an exercise price of $0.285 and valued the warrants at $94,000 using the Black-Scholes option-pricing model and the following assumptions: the market price was $0.23, the volatility was estimated at 114%, the life of the warrants was 5 years, the risk free rate was 0.67% and the dividend yield of 0%. The value assigned to the warrants issued in conjunction with the amendment of the notes payable will be recorded as a debt discount and amortized over the one year extended life of the notes. The Company evaluated amendment under ASC 470, “ Deb t—Modification and Extinguishment,” and concluded that the extension and additional warrants resulted in significant and consequential changes to the economic substance of the debt and thus resulted in an extinguishment of the debt. The extinguishment of the debt had an insignificant impact on the condensed statement of operations for the period ended March 31, 2013.

On December 20, 2012 the Company and the holders of the two promissory notes totaling $1,000,000 agreed to amend the due dates to January 15, 2013. The Company evaluated the amendment under ASC 470-50, Debt-Modification and Extinguishment, and concluded that the amendment was not significant and was therefore treated as debt modification.

On December 20, 2012 the Company borrowed $75,000 under the terms of promissory notes with interest at an annual rate of 13%. Repayment of the promissory notes is secured by a first lien security interest in all of the Company’s assets and were due no later than January 15, 2013.

6

Table of Contents

On January 23, 2013, the Company entered into an Agreement dated as of January 22, 2013 and closed the transactions contemplated by the Agreement. Pursuant to the Agreement:

7

Table of Contents

8. STOCK BASED COMPENSATION

Stock Options - US GAAP requires that compensation cost relating to share-based payment arrangements be recognized in the financial statements. US GAAP requires measurement of compensation cost for all employee share-based awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The fair value of stock options is determined using the Black-Scholes valuation model. Such fair value is recognized as expense over the service period, net of estimated forfeitures.

US GAAP requires that equity instruments issued to non-employees in exchange for services be valued at the more accurate of the fair value of the services provided or the fair value of the equity instruments issued. For equity instruments issued that are subject to a required service period the expense associated with the equity instruments is recorded as the instruments vest or the services are provided. The Company has granted options and warrants to non-employees and recorded the fair value of these equity instruments on the date of issuance using the Black-Scholes valuation model. The Company has granted stock to non-employees for services and values the stock at the more reliable of the market value on the date of issuance or the value of the services provided. For grants subject to vesting or service requirements, expenses are deferred and recognized over the more appropriate of the vesting period, or as services are provided.

In July 2003, the Company’s board of directors adopted a stock option plan. Under the 2003 option plan, options to purchase up to 1,500,000 shares of common stock are available for employees, directors, and outside consultants.

In December 2004, the Company’s board of directors adopted a 2004 stock incentive plan. The Company may issue up to 1,500,000 shares of common stock under the 2004 plan and no person may be granted awards during any twelve-month period that cover more than 300,000 shares of common stock.

The fair value of each option award is estimated on the date of grant using the Black-Scholes valuation model. There were 2,305,000 performance options granted during the six months ended March 31, 2013, all of which were subject to a requirement that the Company reports Income from Operations for the fiscal year ended September 30, 2013, not including the non-cash charge for these options. There were no options granted during the six months ended March 31, 2012.

Expected volatility is determined based on historical volatility. Expected life is determined based on historical experience of similar awards, giving consideration to the contractual terms of the stock-based awards and vesting schedules. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. Share-based compensation expense recognized is based on the options ultimately expected to vest. US GAAP requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimated. Forfeitures were estimated based on the Company’s historical experiences.

8

Table of Contents

A summary of the Company’s stock option activity as of March 31, 2013, and changes during the six months then ended is presented below:

There were 2,305,000 non-vested stock options as of March 31, 2013.

There was no compensation expense related to outstanding options for the three and six months ended March 31, 2013 and 2012.

Stock warrants – The Company recognizes the value of stock warrants issued based upon an option-pricing model at their fair value as an expense over the period in which the grants vest from the measurement date, which is the date when the number of warrants, their exercise price and other terms became certain.

At March 31, 2013 and 2012, 6,199,000 and 5,438,000 warrants were outstanding and 6,199,000 and 5,131,000 warrants were vested, respectively.

There was no compensation expense related to outstanding warrants for the three and six months ended March 31, 2013. Compensation expense related to outstanding warrants for the three and six months ended March 31, 2012 was $26,000.

Common stock – On October 10, 2009 the Company issued 300,000 shares of unregistered common stock to an independent firm for investor relations, financial public relations and marketing services for a period of three years. The total value of the common stock issued was $240,000, of which $80,000 was recorded in Other current assets and $142,000 was recorded in Other assets. On April 28, 2010 the Company issued 300,000 shares to the same independent firm for an additional year for investor relations, financial public relations and marketing services. The total value of the common stock issued was $147,000, of which $43,000 was recorded in Other current assets and $104,000 was recorded in Other assets. Because the value of the common stock had been fully amortized, for the three and six months ended March 31, 2013 the Company did not record any expense. For the three and six months ended March 31, 2012 $25,000 and $50,000, respectively, was recorded as selling, general and administrative expense.

9. INCOME TAXES

The Company made a comprehensive review of its portfolio of uncertain tax positions in accordance with recognition standards established for certain tax positions. In this regard, an uncertain tax position represents the Company’s expected treatment of a tax position taken in a filed tax return, or planned to be taken in a future tax return, that has not been reflected in measuring income tax expense for financial reporting purposes. As of March 31, 2013 and September 30, 2012, the Company does not have a liability for unrecognized tax benefits. The Company concluded that at this time there are no uncertain tax positions. As of March 31, 2013, the Company does not expect any material changes to unrecognized tax positions within the next twelve months.

9

Table of Contents

The Company recognizes the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences could materially impact our financial position or our results of operations. For the three months ended March 31, 2013, deferred income tax assets and the corresponding valuation allowance increased by $108,000.

The Company’s 2013 provision for income taxes primarily relates to state taxes. The difference between the Company’s 2013 effective rate and statutory rate is primarily due to the use of federal net operating losses to offset taxable income. The difference between the Company’s 2012 effective rate and statutory rate is primarily due to the utilization of net operating losses.

10. FAIR VALUE OF FINANCIAL INSTRUMENTS

The Company’s cash and cash equivalents are measured at fair value in the Company’s condensed consolidated financial statements and are valued using unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 inputs under ASC 820). The carrying amount of our accounts receivable, accounts payable and accrued expenses reported in the consolidated balance sheets approximates fair value because of the short maturity of those instruments. The fair value of the notes payable is estimated based on current rates offered to the Company for similar debt of the same remaining maturities.

11. COMMITMENTS AND CONTINGENCIES

The Company is occasionally subject to legal proceedings and claims that arise in the ordinary course of business. It is impossible to predict with any certainty the outcome of pending disputes, and management cannot predict whether any liability arising from pending claims and litigation will be material in relation to the Company’s consolidated financial position or results of operations.

12. GOODWILL

The $375,000 recorded as goodwill represents the excess of the purchase price over the recorded minority interest of the Xenonics common stock repurchased as of December 10, 2009. The Company does not amortize goodwill. Instead, the Company evaluates goodwill annually in the fourth quarter and whenever events or changes in circumstances indicate that it is more likely than not that an impairment loss has been incurred. As of March 31, 2013, the Company determined that no such impairment indicators exist.

13. SUBSEQUENT EVENTS

On May 15, 2013, the Company announced that it has received purchase orders valued at a total of approximately $1.2 million from Aardvark Tactical, Inc. (ATI) for the Company’s NightHunter high-intensity illumination devices to be included in ATI’s non-lethal force protection kits for the U.S. Marine Corp. Shipments are scheduled to begin in June and to be completed by September 2013.

Management evaluated all other activity through the date that the consolidated financial statements were issued, and concluded that no subsequent events have occurred that would require recognition in the condensed consolidated financial statements or disclosure in the notes to the condensed consolidated financial statements.

10

Table of Contents