================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 ---------- FORM 10-QSB/A [X] AMENDMENT NO. 1 TO QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2005 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT For the transition period from __________ to __________ Commission file number 333-87224 ELECTRONIC SENSOR TECHNOLOGY, INC. (Exact Name of Small Business Issuer as Specified in Its Charter) NEVADA 98-0372780 (State or Other Jurisdiction of (I.R.S. Employer Identification No.) Incorporation or Organization) 1077 Business Center Drive Newbury Park, California 91320 (Address of Principal Executive Offices) (805) 480-1994 (Issuer's Telephone Number, Including Area Code) Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [ ] No [X](*) ---------- * We were not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act during the past 12 months because (i) our registered common stock was registered under the Securities Act during such period and was not registered under the Exchange Act, (ii) we did not have any registration statement that became effective during such period and (iii) we had less than 300 shareholders of record throughout such period. Although we were not required to do so, we voluntarily filed such reports with the Securities and Exchange Commission during such period. On March 24, 2006 we filed a registration statement on Form 10-SB to register our common stock pursuant to the Exchange Act, which we subsequently withdrew pursuant to the request of the Securities and Exchange Commission until our registration statement on Form SB-2, for which an amendment was last filed on May 1, 2006, is declared effective. Once our registration statement on Form SB-2 is declared effective, we plan to file another registration statement on Form 10-SB to register our common stock pursuant to the Exchange Act. Once our registration statement on Form 10-SB is effective, we will be subject to the filing requirements of the Securities Exchange Act. Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date. 54,173,745 shares of common stock as of September 7, 2006 Transitional Small Business Disclosure Format Yes [ ] No [X] ================================================================================ EXPLANATORY NOTE We are filing this amended quarterly report on Form 10-QSB/A for the three months ended March 31, 2005 to restate our unaudited consolidated financial statements at March 31, 2005 and for the period ended March 31, 2005 in order to: (i) properly account for the fair value of derivative liabilities resulting from the issuance of freestanding warrants and registration rights granted in connection with the issuance of such warrants (the effect of this restatement is described further in Note 3 to the Consolidated Financial Statements included herein), (ii) correct the classification of a certificate of deposit maintained by us with East West Bank as unrestricted and properly classify such certificate of deposit as a restricted asset, and (iii) properly account for the receipt of a one-time licensing fee for which the amount received is classified as deferred revenue and amortized to earned revenue over the five (5) year life of the agreement (the effect of this restatement is described further in Note 7 to the Consolidated Financial Statements included herein). We have also amended the cover page in order to correct and clarify certain disclosures contained therein. The following Items of this amended quarterly report on Form 10-QSB/A for the three months ended March 31, 2005 are amended and restated herein: Cover Page: o Disclosure relating to the registration of our common stock under the Securities Exchange Act has been removed and corrected to reflect that we did not have any equity securities registered under the Exchange Act as of March 31, 2005, nor were we subject to the filing requirements of Section 13 or 15(d) of the Securities Exchange Act as of such date. Part I Financial Information: o Item 1. Financial Statements--Consolidated Balance Sheet as of March 31, 2005 (unaudited), Consolidated Statements of Operations for the Three Months Ended March 31, 2005 and March 31, 2004 (unaudited), Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2005 and March 31, 2004 (unaudited) and Notes to Consolidated Financial Statements as of March 31, 2005 (unaudited); o Item 2. Management Discussion and Analysis of Operations or Plan of Operations (excluding Risk Factors); and o Item 3. Controls and Procedures. Part II Other Information: o Item 6. Exhibits--Exhibits 31.1, 31.2, 32.1 and 32.2--currently-dated certifications from our President and Chief Executive Officer and Treasurer and Vice President of Finance and Administration, as required by Section 302 and 906 of the Sarbanes-Oxley Act of 2002. The remaining Items are unaffected by the correction in classification, have not been updated from the disclosure originally contained in our quarterly report on Form 10-QSB for the three months ended March 31, 2005 filed with the Securities and Exchange Commission on May 23, 2005 and are not reproduced in this Form 10-QSB/A. This amended quarterly report on Form 10-QSB/A for the three months ended March 31, 2005 does not reflect events occurring after the filing of the quarterly report on Form 10-QSB filed with the Commission on May 23, 2005, nor does it modify or update the disclosures contained in the quarterly report on Form 10-QSB filed with the Commission on May 23, 2005, other than as described above and to correct typographical errors contained therein. 1 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS ELECTRONIC SENSOR TECHNOLOGY, INC. CONSOLIDATED BALANCE SHEET MARCH 31, 2005 (Restated) (Unaudited) ASSETS CURRENT ASSETS: Cash and cash equivalents $ 1,879,647 Certificate of deposit-restricted 900,651 Accounts receivable, net of allowance for doubtful accounts 137,036 Prepaid expenses 21,582 Inventories 473,436 --------------- TOTAL CURRENT ASSETS 3,412,352 PROPERTY AND EQUIPMENT, net of accumulated depreciation of $897,555 88,334 SECURITY DEPOSITS 12,817 --------------- $ 3,513,503 =============== LIABILITIES AND STOCKHOLDERS' DEFICIT CURRENT LIABILITIES: Line of credit borrowings $ 1,769,137 Accounts payable and accrued expenses 335,101 Interest payable 21,417 Derivative liabilities 5,897,800 Deferred revenues 179,167 Other current liabilities 34,650 --------------- TOTAL CURRENT LIABILITIES 8,237,272 STOCKHOLDERS' DEFICIT: Preferred stock, $.001 par value 50,000,000 shares authorized none issued and outstanding - Common stock, $.001 par value, 200,000,000 shares authorized, 53,968,643 issued and outstanding 53,969 Additional paid-in capital 8,420,609 Accumulated deficit (13,198,347) --------------- TOTAL STOCKHOLDERS' DEFICIT (4,723,769) --------------- $ 3,513,503 =============== See unaudited notes consolidated to financial statements 2 ELECTRONIC SENSOR TECHNOLOGY, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) Three Months Ended March 31, ---------------------------------- 2005 2004 --------------- --------------- (Restated) (Restated) REVENUES $ 219,511 $ 326,083 COST OF SALES 290,134 244,341 --------------- --------------- GROSS PROFIT (70,623) 81,742 OPERATING EXPENSES: Compensation 59,093 66,599 Selling 39,210 8,314 General and administrative 469,647 83,346 --------------- --------------- TOTAL OPERATING EXPENSES 567,950 158,259 --------------- --------------- LOSS FROM OPERATIONS (638,573) (76,517) OTHER INCOME AND EXPENSE: Other expense (239) (24,834) Other income - Derivatives 119,550 - Other expense - Derivatives (2,205,642) - Gain (loss) on sale of property and equipment 13,257 (7,711) Interest expense (20,566) (16,370) --------------- --------------- TOTAL OTHER INCOME AND EXPENSE (2,093,640) (48,915) --------------- --------------- NET INCOME (LOSS) $ (2,732,214) $ (125,432) =============== =============== Earnings (loss) per share, basic and diluted $ (0.05) $ (0.00) =============== =============== Weighted average number of shares, basic and diluted 52,640,310 49,983,643 =============== =============== See unaudited notes to consolidated financial statements 3 ELECTRONIC SENSOR TECHNOLOGY, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) Three Months Ended March 31, -------------------------------- 2005 2004 -------------- -------------- (Restated) (Restated) CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) $ (2,732,214) $ (125,432) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization 1,845 863 Fair value of derivatives at date of issuance 2,205,642 - Decrease in fair value of derivative liability (119,550) - Donated services - 6,000 Changes in assets and liabilities: Accounts receivable (106,349) 221,811 Inventories 7,212 (44,528) Prepaid expenses (7,324) (3,644) Security deposits 140 - Accounts payable and accrued expenses 120,797 (36,080) Deferred revenues (12,500) 229,167 Due to related party (60,000) 45,500 Interest payable (5,544) (5,534) Other current liabilities (1,016) (1,515) -------------- -------------- Net cash provided by (used in) operating activities (708,861) 286,608 CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from sale of property and equipment 16,064 9,716 Investment in restricted security deposit (900,651) - Purchase of property and equipment (55,044) - -------------- -------------- Net cash provided by (used in) investing activities (939,631) 9,716 -------------- -------------- CASH FLOWS FROM FINANCING ACTIVITIES: Decrease in line of credit (200,000) (205,000) Repayment of partners' loans payable (110,000) (230,000) Proceeds from issuance of common stock 3,811,708 62,500 -------------- -------------- Net cash provided by financing activities 3,501,708 (372,500) -------------- -------------- NET INCREASE (DECREASE) IN CASH 1,853,217 (76,176) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 26,430 121,069 -------------- -------------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 1,879,647 $ 44,893 ============== ============== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Cash paid during the period for: Interest $ 21,217 $ 16,412 ============== ============== NON-CASH FINANCING ACTIVITIES Fair value of derivative liabilities issued in connection with issuance of Shares of common stock $ 5,897,800 $ - ============== ============== See unaudited notes to consolidated financial statements. 4 ELECTRONIC SENSOR TECHNOLOGY, INC. Notes to Financial Statements (Unaudited) MARCH 31, 2005 (1) BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial statements and with the instructions to Form 10-QSB and Article 10 of Regulation S-B. Accordingly, they do not include all the information and disclosures required for annual financial statements. These financial statements should be read in conjunction with the consolidated financial statements and related footnotes thereto for the year ended December 31, 2004, included in the current report filed on Form 8-K with the Securities and Exchange Commission on April 19, 2005. In the opinion of the management of Electronic Sensor Technology, Inc. (formerly Bluestone Ventures Inc.) (the "Company"), all adjustments (consisting of normal recurring accruals) necessary to present fairly the Company's financial position as of March 31, 2005, and the results of operations and cash flows for the three month period ending March 31, 2005 have been included. The results of operations for the three- month period ended March 31, 2005 are not necessarily indicative of the results to be expected for the full year. For further information, refer to the consolidated financial statements and related footnotes thereto for the year ended December 31, 2004, included in the current report filed on Form 8-K with the Securities and Exchange Commission on April 19, 2005. (2) BASIS OF CONSOLIDATION The accompanying financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. (3) NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) NATURE OF BUSINESS The Company develops and manufactures electronic devices used for vapor analysis. (b) CASH AND CASH EQUIVALENTS The Company considers highly liquid financial instruments with maturities of three months or less at the time of purchase to be cash equivalents. The Company did not have any cash equivalents at March 31, 2005. (c) REVENUE RECOGNITION The Company records revenue from direct sales of products to end-users when the products are shipped, collection of the purchase price is probable and the Company has no significant further obligations to the customer. Costs of remaining insignificant Company obligations, if any, are accrued as costs of revenue at the time of revenue recognition. Cash payments received in advance of product or service revenue are recorded as deferred revenue. (d) SHIPPING AND HANDLING The Company accounts for shipping and handling costs as a component of "Cost of Sales". 5 (e) PROPERTY AND EQUIPMENT Property and equipment are stated at cost, net of accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of five years. (f) INVENTORIES Inventories are comprised of raw materials, work in process, and finished goods. Inventories are stated at the lower of cost or market and are determined using the first-in, first-out method. (g) USE OF ESTIMATES The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the recorded amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. (h) FAIR VALUE OF FINANCIAL INSTRUMENTS The fair value of certain financial instruments, including accounts receivable, accounts payable and accrued liabilities, approximates their carrying value due to the short maturity of these instruments. (i) LONG-LIVED ASSETS The Company reviews long-lived assets, such as property and equipment, to be held and used or disposed of, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If the sum of the expected cash flows, undiscounted and without interest, is less than the carrying amount of the asset, an impairment loss is recognized as the amount by which the carrying amount of the asset exceeds its fair value. At March 31, 2005 no assets were impaired. (j) DERIVATIVE LIABILITIES The Company accounts for liquidated damages granted pursuant to registration rights which are not included in a separate registration right agreement as a combined unit with the warrants which are contemporaneously issued with the registration rights pursuant to SFAS 133 "Accounting for Derivative and Hedging Activities" and EITF 00-19. The Company accounts for its embedded conversion features and freestanding warrants pursuant to SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", which requires a periodic valuation of their fair value and a corresponding recognition of liabilities associated with such derivatives. The recognition of derivative liabilities related to the issuance of shares of common stock is applied first to the proceeds of such issuance, at the date of issuance, and the excess of derivative liabilities over the proceeds is recognized as other expense in the accompanying consolidated financial 6 statements. Any subsequent increase or decrease in the fair value of the derivative liabilities, which are measured at the balance sheet date, are recognized as other expense or other income, respectively. (k) Basic and Diluted Earnings Per Share Basic earnings per share are calculated by dividing income available to stockholders by the weighted-average number of common shares outstanding during each period. Diluted earnings per share are computed using the weighted average number of common and dilutive common share equivalents outstanding during the period. Dilutive common share equivalents consist of shares issuable upon the exercise of stock options and warrants embedded conversion features (calculated using the reverse treasury stock method). The outstanding options, warrants and shares equivalent issuable pursuant to embedded conversion features amounted to 5,576,871 and 0 at March 31, 2005 and 2004, respectively. The outstanding options, warrants and shares equivalent issuable pursuant to embedded conversion features and warrants at March 31, 2005 are excluded from the loss per share computation for that period due to their anti-dilutive effect. The Company adjusted the numerator for any changes in income or loss that would result if the contract had been recorded as an equity instrument for accounting purposes during the period. However, the Company did not adjust the numerator for interest charges during the period on the convertible debentures because it would have been anti-dilutive. The following sets forth the computation of basic and diluted earnings per share at March 31: 2005 2004 -------------- -------------- (Restated) (Restated) Numerator: Net income (loss) $ (2,732,214) $ (125,432) Net other income/expense associated with derivative contracts 2,086,092 - -------------- -------------- Net income (loss) for diluted earnings per share purposes $ (646,122) $ (125,432) ============== ============== Denominator: Denominator for basic earnings per share- Weighted average shares outstanding 52,640,310 49,983,643 Effect of dilutive warrants, embedded conversion features and liquidated damages - - -------------- -------------- Denominator for diluted earnings per share- Weighted average shares outstanding 52,640,310 49,983,643 ============== ============== Basic earnings (loss) per share $ (0.05) $ (0.00) ============== ============== Diluted earnings (loss) per share $ (0.05) $ (0.00) ============== ============== (4) MERGERS AND ACQUISITIONS Bluestone Ventures, Inc. ("Bluestone") executed an Agreement and Plan of Merger ("Merger Agreement") by and among Bluestone, Amerasia Technology, Inc., ("Amerasia"), holder of approximately 55% of the partnership interests of Electronic Sensor Technology, L.P., ("EST"), L & G Sensor Technology, L.P., ("L&G"), holder of approximately 45% of the partnership interests of EST, Amerasia Acquisition Corp., ("AAC") a wholly-owned subsidiary of Bluestone, and L & G Acquisition Corp., ("LAC") a wholly owned subsidiary of Bluestone on January 31, 2005. Under the Merger Agreement (i) AAC merged with and into Amerasia such that Amerasia became a wholly-owned subsidiary of Bluestone, (ii) LAC merged with and into L&G such that L&G became a wholly-owned subsidiary of Bluestone, (iii) as a result of the merger of (i) and (ii), Bluestone indirectly acquired all of the partnership interests of EST and (iv) Bluestone issued 20,000,000 shares of its common stock to the shareholders of Amerasia and L&G. This merger has been treated as a purchase only of the partnership interests of Electronic Sensor Technology L.P. For accounting purposes, the transaction will be treated as a recapitalization of EST and accounted for as a reverse acquisition. Bluestone also entered into various Subscription Agreements with certain investors on January 31, 2005. Under these Subscription Agreements, Bluestone issued 3,985,000 shares of its common stock ("shares") and warrants to purchase 3,985,000 shares at $1.00 per share to certain investors for gross proceeds of $3,985,000. Bluestone received the gross proceeds of the sale of these shares on February 1, 2005. Bluestone received net proceeds of approximately $3,822,000. This amount was net of legal fees, including counsel fees for the investors and EST of approximately $163,000. By virtue of the Mergers, all shares of common stock of Amerasia were converted into the right to receive shares of common stock of Bluestone at an exchange ratio of 4.6223537 shares of Bluestone common stock for each share of Amerasia common stock and all shares of common stock L&G were converted into the right to receive shares of common stock of Bluestone at an exchange ratio of 90 shares of Bluestone common stock for each share of L&G common stock. In addition, all 200,000 Class C limited partnership units of Electronic Sensor Technology L.P. were automatically converted into 200,000 shares of Bluestone common stock. The purchase price for the Mergers was 20,000,000 shares of Bluestone common stock. The closing of the mergers occurred on February 1, 2005 (the "Closing Date"). In January 2005 the loans payable to three partners of Electronic Sensor Technology L.P., totaling $1,198,630 were converted into 1,198,630 shares of common stock of Bluestone. In January 2005 the notes payable to related parties of $1,272,000 plus accrued interest were converted into 1,585,111 shares of common stock of Bluestone. Bluestone has changed its name to Electronic Sensor Technology, Inc. as of February 2005. The Company adopted a Stock Incentive Option Plan in April 2005. There were 969,500 initial options granted to former EST limited partnership employees. (5) DERIVATIVE LIABILITIES During February 2005, we recognized derivative liabilities of approximately $6.0 million pursuant to the issuance of 3,985,000 freestanding warrants and granting certain registration rights which provided for liquidated damages in the event of failure to timely register the shares in connection with the issuance of shares of common stock and the related warrants. 7 There are no liquidated damages provided for untimely effectiveness of the registration of shares pursuant to piggy-back registration rights. The Company intends to register all shares and warrants pursuant to the subscriber piggy-back registration rights. The agreement pursuant to which the warrants were issued and the registration rights were granted provided for liquidated damages pursuant to demand registration rights in the event of a failure to timely register the shares after demand is made by the holders of a majority of the warrants and shares of common stock issued pursuant to such agreement. The demand registration rights of these investors are such that if the Company fails to register the investors shares, including the shares underlying the warrants, the Company will pay a cash penalty amounting to 1% of the amount invested per month, $39,850, if the registration statement is not filed within 60 days of demand or is not declared effective within 150 days from the date of initial filing. The maximum liability associated with the liquidated damages amounts to 49% of the gross proceeds associated with the issuance of shares of common stock, which amounts to $1,952,650. The percentage of liquidated damages amounts to the difference between 60 months, which is the inherent time limitation under which the underlying shares would be free-trading (three year term and two year holding period) and 11 months, which is the grace period for registering the shares (no demand permitted for four months, two-month period to file and five-month period to become effective), times the penalty percentage, which is 1%. The Company believes that the likelihood that it will incur any liabilities resulting from the liquidated damages pursuant to the demand registration rights is remote considering that it will register the shares and the shares underlying the warrants pursuant to piggy-back registration rights, which do not contain liquidated damages. Because the registration rights were not granted under a separate registration rights agreement, we considered those features in evaluating whether the associated warrants should be classified as derivative liabilities. Considering that the amount of the maximum penalty is 49%, the Company cannot conclude that that this discount represents a reasonable approximation of the difference between registered and unregistered shares under paragraph 16 of EITF 00-19. Accordingly, the warrants issued in connection with the February 2005 transaction are considered derivative liabilities. The fair value of the warrants issued in connection with the February 2005 transaction at the date of issuance of the warrants and the granting of registration rights and at March 31, 2005 is as follows: At issuance At March 31, 2005 ------------- ------------------- Freestanding warrants $6,017,350 $5,897,800 The Company used the following assumptions, using the Black Scholes Model to measure the identified derivatives as follows: Freestanding warrants At issuance At March 31, 2005 --------------- --------------------- Market price: $2.40 $2.32 Exercise price: $1.00 $1.00 Term: 3 years 2.91 years Volatility: 39% 39% Risk-free interest rate: 2.78% 2.78% Number of warrants: 3,985,000 3,985,000 (6) LINE OF CREDIT In September 2004, the Company's subsidiary renewed its revolving line of credit agreement for borrowings up to $1,800,000. The line of credit was assumed and renewed by the Company. Borrowings under this 8 agreement bear interest at prime, are guaranteed by certain related parties and are collateralized with the assets of the Company and by the certificate of deposit. (7) RESTATEMENT OF INTERIM FINANCIAL STATEMENTS In connection with the filing of an amendment to our registration statement on Form SB-2/A with the Securities and Exchange Commission, and after reviewing certain accounting principles we had applied in our financial statements for the periods ended March 31, 2005, June 30, 2005, September 30, 2005, and March 31, 2006 previously filed with the Commission, management has determined that those financial statements should no longer be relied upon as they did not properly account for certain liquidated damages associated with a $3.985 million private placement of warrants and shares of our common stock that occurred in February 2005. Previously, the Company had not reflected the liquidated damages at their fair value nor their effect on other outstanding convertible instruments. Pursuant to the terms of the warrants that the Company issued and the registration rights granted in such private placement, the warrant holders are entitled to liquidated damages pursuant to demand registration rights in the event of a failure to timely register the shares after demand is made by the holders of a majority of the warrants and shares of common stock issued pursuant to such agreement. The demand registration rights of these investors are such that if the Company fails to register the investors shares, including the shares underlying the warrants, the Company will pay a cash penalty amounting to 1% of the amount invested per month, $39,850, if the registration statement is not filed within 60 days of demand or is not declared effective within 150 days from the date of initial filing. The maximum liability associated with the liquidated damages amounts to 49% of the gross proceeds associated with the issuance of shares of common stock, which amounts to $1,952,650. The percentage of liquidated damages amounts to the difference between 60 months, which is the inherent time limitation under which the underlying shares would be free-trading (three year term and two year holding period) and 11 months, which is the grace period for registering the shares (no demand permitted for four months, two-month period to file and five-month period to become effective), times the penalty percentage, which is 1%. The Company believes that the likelihood that it will incur any liabilities resulting from the liquidated damages pursuant to the demand registration rights is remote considering that it will register the shares and the shares underlying the warrants pursuant to piggy-back registration rights, which do not contain liquidated damages. Because the registration rights were not granted under a separate registration rights agreement, we considered those features in evaluating whether the associated warrants should be classified as derivative liabilities. Considering that the amount of the maximum penalty is 49%, the Company cannot conclude that that this discount represents a reasonable approximation of the difference between registered and unregistered shares under paragraph 16 of EITF 00-19. Accordingly, the warrants issued in connection with the February 2005 transaction are considered derivative liabilities. Furthermore, the Company failed to indicate that its certificate of deposit was restricted as it is used as collateral to secure its line of credit. The Company had accounted for its restricted certificate of deposit as part of cash and cash equivalents in its statement of cash flows while it should have accounted for its purchase of the certificate of deposit as an investing activity. Additionally, the Company did not properly account for a prior year one-time advance from a customer related to a five (5) year licensing agreement with this customer. The Company had accounted for the entire amount as revenue at the time the funds were received. The funds, at the time of its receipt, should have, instead, been accounted for as deferred revenue and then amortized to earned revenue over the five (5) year life of the agreement. The proper accounting for such liquidated damages provision, the restricted certificate of deposit, and the advancement of funds from a customer for licensing rights affects the following figures in our quarterly financial statements: Increase in certificate of deposit-restricted ($900,651), derivative liabilities ($5,897,800), deferred revenues ($179,167), accumulated deficit ($2,265,261), revenues ($12,500), other income-derivatives ($119,500), other expense-derivatives ($2,205,642), net loss ($2,073,593), loss per share ($.04), and cash used in investing activities ($900,651)on the statement of cash flows. 9 Decrease in additional paid-in capital ($3,811,707). 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. You should read the following discussion and analysis of our financial condition and results of operations together with our interim financial statements and the related notes appearing at the beginning of this report. The interim financial statements and this Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2004 and the related Management's Discussion and Analysis of Financial Condition and Results of Operations, both of which are contained in our annual report on Form 10-KSB filed with the Securities and Exchange Commission on April 15, 2005 and the consolidated financial statements and related footnotes thereto for the year ended December 31, 2004, included in the current report filed on Form 8-K with the Securities and Exchange Commission on April 19, 2005. The following discussion and other parts of this Form 10-QSB contain forward-looking statements that involve risks and uncertainties. Forward-looking statements can be identified by words such as "anticipates," "expects," "believes," "plans," and similar terms. Our actual results could differ materially from any future performance suggested in this report as a result of factors, including those discussed in "Factors That May Affect Future Operating Results" and elsewhere in this report and in our Annual Report on Form 10-KSB for the fiscal year ended December 31, 2004. All forward-looking statements are based on information currently available to the Company and we assume no obligation to update such forward-looking statements, except as required by law. Service marks, trademarks and trade names referred to in this Form 10-QSB are the property of their respective owners. -------------------------------------------------------------------------------- OVERVIEW We are engaged in the development, manufacturing, and sales of a patented product we call zNose(R): a device designed to detect and analyze chemical odors and vapors, or, in other words, an electronic "nose". We believe the zNose(R) is superior to other electronic "noses" because of its speed, specificity and sensitivity. The zNose(R) is capable of measuring and quantifying the chemistry of any compound, fragrance, vapor or odor with parts per trillion sensitivity in 10 seconds. We also believe the zNose(R) has the unique ability to quantify and speciate the subject chemical vapor by creating visual olfactory images. This enables the measured odor or vapor to be easily identified by the user. We believe that our products will have broad applications in the homeland security and laboratory instrumentation markets. We are involved in ongoing product research and development efforts in that regard. We have also concentrated our efforts on further product development, testing and proving and assembling our sales and support organization. The Company was originally incorporated under the name "Bluestone Ventures, Inc.", on July 12, 2000. From inception until February 1, 2005, we engaged in the business of acquiring, exploring and developing certain mining properties in Canada. Upon the acquisition of Electronic Sensor Technology, LP (the "ELP"), we abandoned our mining business and adopted ELP's business of developing, manufacturing and selling the vapor analysis device. Prior to the closing of the Mergers, on January 26, 2005, we changed our name to "Electronic Sensor Technology, Inc." Our executive offices are located at 1077 Business Center Circle, Newbury Park, California 91320 and our telephone number is (805) 480-1994. RESULTS OF OPERATIONS The following table sets forth, as a percentage of revenues, certain items included in the Company's Income Statements (see Financial Statements and Notes) for the periods indicated: 11 Three months ended March 31, ---------------------------- 2005 2004 (Restated) (Restated) ----------- ------------- STATEMENTS OF OPERATIONS DATA: Revenues.................................... 100% 100% Cost of sales............................... 132% 75% Gross profit (loss) ........................ (32%) 25% Operating expenses.......................... 259% 49% (Loss) from operations...................... (291%) (24%) Other (expense)............................. (954%) (15%) Net loss.................................... (1,245%) (39%) QUARTER ENDED MARCH 31, 2005 COMPARED TO QUARTER ENDED MARCH 31, 2004 Revenues for the quarter ended March 31, 2005 were $219,500 compared to $326,100 in 2004. Our revenues experienced a decline of 33% due to the slip of deliveries of some newly re-designed parts. Gross loss was ($70,600) for the first quarter ended March 31, 2005 compared to a gross profit of $81,700 for the quarter ended March 31, 2004. This decrease of $152,300 resulted from increased manufacturing overheads from additional personnel. Compensation expenses in the first quarter of 2005 were $59,100 as compared to $66,600 in 2004. As a percentage of sales, total compensation expenses increased from 20% of sales to 27% of sales. The decrease of $7,500 was due to decrease of sales commissions. Selling expenses in the first quarter of 2005 were $39,200 as compared to $8,300 in 2004. As a percentage of sales, total selling expenses increased from 3% of sales to 18% of sales. This increase of $30,900 was due to increase of personnel costs. General and administrative expenses for the first quarter of 2005 were $469,600 as compared to $83,300 in 2004. As a percentage of sales, general and administration expenses increased from 26% of sales to 214% of sales. This increase of $386,300 was primarily due to consulting and professional fees in connection with the reverse merger. Interest expense for the first quarter of 2005 was $20,566 as compared to $16,370 for the same period in 2004. This increase in interest expense, is due to expanded line of credit and higher interest rate. Net loss was $2,732,214 for the period ended March 31, 2005 as compared to a loss of $125,432 for the period ended March 31, 2004. The increase was primarily due to a combination of higher operating expenses in the first quarter of 2005, including expenses related to our merger in February 2005, increased sales activities, increased personnel costs and an expanded new product development effort, and the recognition of derivative liabilities, as described further below. Other income-derivatives primarily consist of the decrease in the fair value of derivative liabilities between the date of issuance of such derivatives and the end of the first quarter of 2005. The increase in other income-derivative during the first quarter of 2005 when compared to the same period in 2004 is primarily attributable to a decrease in the quoted price of our common stock. We are unable to determine whether we will record further decreases in the fair value of derivative liabilities in the foreseeable future, which would be recorded as other income-derivatives. Such decreases would be generally triggered by a decrease in the fair value of our stock price, upon satisfaction of liquidated damages pursuant to registration rights, or, possibly, upon satisfaction of our convertible debentures. No such derivatives were issued during the first quarter of 2004. Other expense-derivatives primarily consist of the recognition of derivative liabilities we issued during the first quarter of 2005. No such derivatives were issued during the first quarter of 2004. LIQUIDITY AND CAPITAL RESOURCES In the first quarter of 2005 net cash used by the Company for operating activities was $708,900. In the first quarter of 2004, the cash provided by Company's operations was $286,600. Cash used in the first quarter of 2005 was 12 comprised of the net loss incurred for the quarter of $2,732,200, plus net non-cash expenses (including depreciation and amortization of $1,800, the fair value of issued derivatives of $2,205,600, less decrease in fair value of derivative liability of $119,600) of $2,087,800, less the net change in operating assets and liabilities of $64,600. Cash provided from operations in the first quarter of 2004 consisted of the net loss of $125,400 plus net non-cash expenses of $6,900, plus the net change in operating assets and liabilities of cash of $405,100 for a total of $286,600. Investing activities used cash of $939,600 in the first quarter of 2005, primarily from the purchase of a certificate of deposit used as collateral for our line credit, and purchase of property and equipment. Investing activities provided $9,700 during the first quarter ended March 31, 2004 from the sale of property and equipment. Financing activities for the first quarter of 2005 provided cash of $3.5 million, primarily from the issuance of common stock ($3,811,700) less partial repayment of the line of credit ($200,000) and repayment of partners' loan ($110,000). $373,000 of cash was used in financing activities during the first quarter of 2004 for repayment of the line of credit ($205,000) and partners' loan ($230,000). At March 31, 2005 the Company had cash of $1.9 million compared to $45,000 at March 31, 2004. At March 31, 2005, the Company had a working deficit of $4.8 million, as compared to a working deficit of $5.5 million at March 31, 2004. The Company, at present, has a credit facility in place with East West Bank for $1.8 million. Although we have a bank operating line of credit, there can be no assurance that these proceeds will be adequate for our capital needs. There can no assurance that any required or desired financing will be available through any other bank borrowings, debt, or equity offerings, or otherwise, on acceptable terms. If future financing requirements are satisfied through the issuance of equity securities, investors may experience significant dilution in the net book value per share of common stock and there is no guarantee that a market will exist for the sale of the Company's shares. The Company's primary capital needs are to fund its growth strategy, which includes creating a sales and marketing staff for the marketing, advertising and selling of the zNose(R) family of chemical detection products, increasing distribution channels, introducing new products, improving existing product lines and development of a strong corporate infrastructure. SEASONALITY AND QUARTERLY RESULTS We do not foresee any seasonality to our revenues or our results of operations. INFLATION Our raw materials and finished products are sourced from cost-competitive industries. As such, we do not foresee any material inflationary trends for our product sources. 13 ITEM 3. CONTROLS AND PROCEDURES Within 90 days prior to the date of this Form 10-QSB, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's President and Chief Executive Officer along with the Company's Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b). Based upon that evaluation, the Company's President and Chief Executive Officer along with the Company's Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective in timely alerting them to material information relating to the Company required to be included in this Form 10-QSB. There have been no changes in the Company's internal controls or in other factors, which could significantly affect the internal controls subsequent to the date the Company carried out its evaluation. 19 PART II - OTHER INFORMATION ITEM 6. EXHIBITS A. EXHIBITS Exhibit No. Description ------- ---------------------------------------------------------------------- 31.1 Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/ 15d-14(a) of the Exchange Act. 31.2 Certification of Principal Financial and Accounting Officer Pursuant to Rule 13a-14(a)/15d-14(a) of the Exchange Act. 32.1 Certification of Chief Executive Officer Pursuant to Rule 13a-14(b) or 15d-14(b) of the Exchange Act and 18 U.S.C. 1350. 32.2 Certification of Principal Financial and Accounting Officer Pursuant to Rule 13a-14(b) or 15d-14(b) of the Exchange Act and 18 U.S.C. 1350. -------------------------------------------------------------------------------- 20 SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused this amended report to be signed on its behalf by the undersigned, thereunto duly authorized. ELECTRONIC SENSOR TECHNOLOGY, INC. Dated September 25, 2006 By: /s/ Teong C. Lim ----------------------------- Name: Teong C. Lim Title: President and Chief Executive Officer (Principal Executive Officer) Dated September 25, 2006 By: /s/ Francis Chang ----------------------------- Name: Francis Chang Title: Secretary, Treasurer and Vice President of Finance and Administration (Principal Accounting Officer) 21