UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended June 30, 2012

or

For the transition period from __________ to __________

Commission File Number 0-29185

SAVE THE WORLD AIR, INC.

(Exact name of registrant as specified in its charter)

735 State Street, Suite 500

Santa Barbara, California 93101

(Address, including zip code, of principal executive offices

(805)-845-3561

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Exchange Act: None.

Securities registered pursuant to Section 12(g) of the Exchange Act: Common Stock, $0.001 par value.

Check whether the Registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No x

The number of shares of the Registrant’s Common Stock outstanding as of August 6, 2012 was 128,461,034.

SAVE THE WORLD AIR, INC.

FORM 10-Q

 INDEX

PART I

Item 1. Financial Statements

SAVE THE WORLD AIR, INC. AND SUBSIDIARY

(A DEVELOPMENT STAGE ENTERPRISE)

CONDENSED CONSOLIDATED BALANCE SHEETS

See notes to condensed consolidated financial statements.

SAVE THE WORLD AIR, INC.

(A DEVELOPMENT STAGE ENTERPRISE)

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)       

See notes to condensed consolidated financial statements.

SAVE THE WORLD AIR, INC.

(A DEVELOPMENT STAGE ENTERPRISE)

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ DEFICIENCY

SIX MONTHS ENDED JUNE 30, 2012 (UNAUDITED)

See notes to condensed consolidated financial statements.

SAVE THE WORLD AIR, INC. AND SUBSIDIARY

 (A DEVELOPMENT STAGE ENTERPRISE)

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(continued)

SAVE THE WORLD AIR, INC. AND SUBSIDIARY

 (A DEVELOPMENT STAGE ENTERPRISE)

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(continued)

See notes to condensed consolidated financial statements.

SAVE THE WORLD AIR, INC. AND SUBSIDIARY

(A DEVELOPMENT STAGE ENTERPRISE)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SIX MONTHS ENDED JUNE 30, 2012 AND 2011 (UNAUDITED)

1. Organization and basis of presentation

Description of business

Save the World Air, Inc. (“STWA” or “Company”) designs, licenses and develops products to reduce operational costs for oil pipelines, and improve fuel economy and reduce emissions from diesel-powered internal combustion engines.  The Company is a green technology company that leverages a suite of patented, patent-pending and licensed intellectual properties related to the treatment of fuels. Technologies patented by or licensed to us utilize either magnetic or uniform electrical fields to alter physical characteristics of fuels and are designed to create cleaner combustion or improve efficiency of crude oil pipeline transportation. Cleaner combustion has been shown to improve performance, enhance fuel economy and/or reduce harmful emissions in laboratory testing.

The Company was incorporated on February 18, 1998, as a Nevada corporation, under the name Mandalay Capital Corporation. The Company changed its name to Save the World Air, Inc. on February 11, 1999, following the acquisition of marketing and manufacturing rights of the ZEFS technologies. Our executive offices are at 735 State Street, Suite 500, Santa Barbara, California 93101.  The telephone number is (877) USA-STWA. Our research and development facility is at 235 Tennant Avenue, Morgan Hill, California 95037. The corporate website is www.stwa.com.  The Company’s common stock is quoted under the symbol “ZERO” on the Over-the-Counter Bulletin Board 

The Company’s technology has two commercial applications; AOT™ (Applied Oil Technology) and ELEKTRA™ and legacy technologies of ZEFS and MK IV.  AOT™ and ELEKTRA™ are nearing the end of the product development cycle, which we believe will culminate at the U.S. Department of Energy’s Rocky Mountain Oilfield Testing Center (RMOTC). We believe the testing of AOT™ at the RMOTC will determine the value of savings the product presents at full scale operation on an active pipeline.

The AOT™ and ELEKTRA™ are technologies, which use electric fields to alter some physical properties of petrochemical fluids to reduce viscosity of the fluids. The Company differentiates AOT™ and ELEKTRA™ products based on their differing attributes and marketing focus. AOT™ products are primarily designed to reduce operation costs for oil pipelines, and ELEKTRA™ products are primarily designed to improve fuel economy and reduce emissions from diesel-powered internal combustion engines. Our AOT™ products are intended to reduce the viscosity of crude oil, thereby making it less restrictive to pipeline transport. Our AOT™ products will be marketed primarily to pipeline operators as well as to pilot and government mandated delivery programs. Our ELEKTRA™ products are intended to increase fuel efficiency and reduce emissions.  ELEKTRA™ will be marketed primarily to specialty consumer accessories market for many types of diesel-fueled vehicles, including but not limited to trucks, trains, maritime, military and aviation.

Basis of presentation

The accompanying unaudited condensed consolidated financial statements of Save the World Air, Inc. (the "Company") have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Regulation S-K for scaled disclosures for smaller reporting companies. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in United States of America for complete financial statements. However, such information reflects all adjustments (consisting solely of normal recurring adjustments), which are, in the opinion of management, necessary for the fair presentation of the consolidated financial position and the consolidated results of operations. Results shown for interim periods are not necessarily indicative of the results to be obtained for a full fiscal year.

The condensed consolidated balance sheet information as of December 31, 2011 was derived from the audited consolidated financial statements included in the Company's Annual Report on Form 10-K filed with the SEC. These interim financial statements should be read in conjunction with that report. 

Going concern

Since its inception, the Company has been primarily engaged in organizational and pre-operating activities. The Company has generated insignificant revenues and has incurred accumulated losses of $76,157,415 from February 18, 1998 (Inception) through June 30, 2012. As reflected in the accompanying condensed consolidated financial statements, the Company had a net loss of $6,867,948 and a negative cash flow from operations of $2,335,322 for the six months ended June 30, 2012, and had a working capital deficiency (excluding derivative liabilities) of $1,798,382 and a stockholders' deficiency of $3,443,137 at June 30, 2012. As a result, the Company’s independent registered public accounting firm, in their report on the Company’s 2011 consolidated financial statements, raised substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.

The ability of the Company to continue as a going concern is dependent upon the Company’s ability to raise additional funds and implement its business plan. The Company’s operations from inception, February 18, 1998 to June 30, 2012 have been funded through issuances of its common stock and convertible notes. As of June 30, 2012, the Company raised an aggregate of $29,171,312 of which $17,891,788 was from the sale of convertible notes. As of June 30, 2012, the outstanding balance of convertible notes was $483,813. The Company expects substantially all of the outstanding notes will be converted into shares of common stock of the Company. See Note 11 for subsequent conversions.

On June 30, 2012, the Company had cash on hand in the amount of $59,892. In addition to the funds on hand, the Company will require additional funds to continue to operate our business. This includes expenses we will incur in connection with license agreements; product development and commercialization of the AOT and ELEKTRA technologies; costs to manufacture and ship our products; costs to design and implement an effective system of internal controls and disclosure controls and procedures; costs of maintaining our status as a public company by filing periodic reports with the SEC and costs required to protect our intellectual property. In addition, the Company has contractual commitments for salaries to its executive officers pursuant to employment agreements, consulting fees and Licensing Fees commitment to Temple University, during 2012 and beyond. In light of the Company’s financial commitments over the next several months and its liquidity constraints, we have implemented cost reduction measures in all areas of operations. The Company intends to review these measures on an ongoing basis and make additional decisions as may be required. See Note 11 for subsequent offering.

2. Summary of significant accounting policies

Development stage enterprise

The Company is a development stage enterprise.  All losses accumulated since the inception of the Company have been considered as part of the Company’s development stage activities.

The Company’s focus is on product development and marketing of proprietary devices that are designed to reduce operation costs of petrochemical pipeline transport and fuel efficiency of diesel engines and has not yet generated meaningful revenues.  The technologies are called “AOT” and “ELEKTRA”.  The Company is currently in the mid-late stages of developing its AOT™ and ELEKTRA™ technologies for commercial applications.  Expenses have been funded through the sale of company stock, convertible notes and the exercise of warrants.  The Company has taken actions to secure the intellectual property rights to the AOT™ and ELEKTRA™ technologies and is the worldwide exclusive licensee for patent pending technologies associated with the development of ELEKTRA™.

Estimates

The preparation of 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 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. Certain significant estimates were made in connection with preparing the Company’s financial statements. Actual results could differ from those estimates.

Loss per share

Basic loss per share is computed by dividing net loss available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted loss per share reflects the potential dilution, using the treasury stock method that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the loss of the Company. In computing diluted loss per share, the treasury stock method assumes that outstanding options and warrants are exercised and the proceeds are used to purchase common stock at the average market price during the period. Options and warrants may have a dilutive effect under the treasury stock method only when the average market price of the common stock during the period exceeds the exercise price of the options and warrants. For the six month period ended June 30, 2012 and 2011, the dilutive impact of outstanding stock options of 28,899,558 and 22,177,892 respectively, and outstanding warrants of 51,690,896 and 37,701,079 have been excluded because their impact on the loss per share is anti-dilutive.

Stock-Based Compensation

The Company periodically issues stock options and warrants to employees and non-employees in non-capital raising transactions for services and for financing costs. The Company accounts for stock option and warrant grants issued and vesting to employees based on the authoritative guidance provided by the Financial Accounting Standards Board whereas the value of the award is measured on the date of grant and recognized over the vesting period. The Company accounts for stock option and warrant grants issued and vesting to non-employees in accordance with the authoritative guidance of the Financial Accounting Standards Board whereas the value of the stock compensation is based upon the measurement date as determined at either a) the date at which a performance commitment is reached, or b) at the date at which the necessary performance to earn the equity instruments is complete. Non-employee stock-based compensation charges generally are amortized over the vesting period on a straight-line basis. In certain circumstances where there are no future performance requirements by the non-employee, option grants are immediately vested and the total stock-based compensation charge is recorded in the period of the measurement date.

The fair value of the Company's common stock option grant is estimated using the Black-Scholes option pricing model, which uses certain assumptions related to risk-free interest rates, expected volatility, expected life of the common stock options, and future dividends. Compensation expense is recorded based upon the value derived from the Black-Scholes option pricing model, and based on actual experience. The assumptions used in the Black-Scholes option pricing model could materially affect compensation expense recorded in future periods.

Accounting for Warrants and Derivatives

The Company evaluates all of its financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded derivatives. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported in the consolidated statements of operations.  For stock-based derivative financial instruments, the Company uses a probability weighted average series Black-Scholes-Merton option pricing models to value the derivative instruments at inception and on subsequent valuation dates.

The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is evaluated at the end of each reporting period.  Derivative instrument liabilities are classified in the balance sheet as current or non-current based on whether or not net-cash settlement of the derivative instrument could be required within 12 months of the balance sheet date.

Fair value of financial instruments

Effective January 1, 2008, fair value measurements are determined by the Company's adoption of authoritative guidance issued by the FASB, with the exception of the application of the statement to non-recurring, non-financial assets and liabilities as permitted. The adoption of the authoritative guidance did not have a material impact on the Company's fair value measurements.  Fair value is defined in the authoritative guidance as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. A fair value hierarchy was established, which prioritizes the inputs used in measuring fair value into three broad levels as follows:

Level 1—Quoted prices in active markets for identical assets or liabilities.

Level 2—Inputs, other than the quoted prices in active markets, are observable either directly or indirectly.

Level 3—Unobservable inputs based on the Company's assumptions.

The Company is required to use observable market data if such data is available without undue cost and effort

The following table presents certain investments and liabilities of the Company’s financial assets measured and recorded at fair value on the Company’s condensed consolidated balance sheets on a recurring basis and their level within the fair value hierarchy as of June 30, 2012 and 2011.

Recent Accounting Pronouncements

In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”. ASU No. 2011-4 does not require additional fair value measurements and is not intended to establish valuation standards or affect valuation practices outside of financial reporting. The ASU is effective for interim and annual periods beginning after December 15, 2011. The Company adopted ASU No. 2011-04 effective January 1, 2012 and it did not affect the Company’s results of operations, financial condition or liquidity.

In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income”. The ASU eliminates the option to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity, and instead requires consecutive presentation of the statement of net income and other comprehensive income either in a continuous statement of comprehensive income or in two separate but consecutive statements. ASU No. 2011-5 is effective for interim and annual periods beginning after December 15, 2011. The Company adopted ASU 2011-05 effective January 1, 2012 and it did not affect the Company’s results of operations, financial condition or liquidity.

In September 2011, the FASB issued ASU 2011-08, “Testing Goodwill for Impairment”, an update to existing guidance on the assessment of goodwill impairment. This update simplifies the assessment of goodwill for impairment by allowing companies to consider qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount before performing the two step impairment review process. It also amends the examples of events or circumstances that would be considered in a goodwill impairment evaluation. The amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The Company adopted ASU 2011-08 effective January 1, 2012. We do not believe that the adoption of this new accounting guidance will have a significant effect on our goodwill impairment assessments in the future.

In December 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-11, “Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities.” This ASU requires an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. ASU No. 2011-11 will be applied retrospectively and is effective for annual and interim reporting periods beginning on or after January 1, 2013. The Company does not expect adoption of this standard to have a material impact on its consolidated results of operations, financial condition, or liquidity.

Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the Securities Exchange Commission (the “SEC”) did not or are not believed by management to have a material impact on the Company's present or future consolidated financial statements.

3. Certain relationships and related transactions

Accounts Payable to related parties

As of June 30, 2012 and December 31, 2011, the Company had accounts payable to related parties in the amount of $49,328 and $63,003, respectively. These amounts are unpaid Directors Fees and expenses incurred by officers and directors.

Accrued expense due to related parties

As of June 30, 2012 and December 31, 2011, the Company accrued the unpaid salaries, unused vacation and the corresponding payroll taxes of its employees in the amount of $795,450 and $812,993, respectively. Included in these accruals are the salaries due to the President and to a former officer of the Company.

The President of the Company has agreed to defer payment of salary for an indefinite period of time. No payment was made during the period ended June 30, 2012 and balance as of June 30, 2012 was $459,143 including payroll taxes of $32,628.

A former officer of the Company has agreed to a monthly payment schedule $10,000 to $15,000 which will end in October 2013 pursuant to a December 2011 Settlement Agreement upon his resignation. During the period ended June 30, 2012, the Company paid $75,000 leaving a balance of $245,000.  

Cash Bonus Paid to Chief Executive Officer

General and administrative expenses for the three and six months ending June 30, 2012, include a cash bonus of $100,000 paid to the Company’s Chief Executive Officer.

4.   Convertible Debentures

Convertible debentures consist of the following:

From December 13, 2010 through February 3, 2012, the Company conducted private offerings of up to $10,000,000 aggregate face amount of its convertible notes. A total of $7,722,783 aggregate face amount of the notes were sold for an aggregate purchase price of $7,020,711. Through December 31, 2011, $6,239,029 of these notes were sold, of which $4,518,425 were converted during 2011, leaving a balance of convertible notes outstanding as of December 31, 2011 of $1,720,460. During 2012, the Company sold an additional $1,495,854 of these convertible notes, and an additional $2,732,501 of these notes were converted, leaving a balance of convertible notes outstanding of June 30, 2012 of $483,813. While the stated interest rate on the notes is 0%, the actual interest rate on the notes is 10% per annum. The notes mature on the first anniversary of their respective date of issuance. The notes outstanding at June 30, 2012 are convertible, at the option of the note holder, into 1,935,252 shares of common stock of the Company (the “Conversion Shares”) a conversion price of $0.25 per share.

Each of the investors in the offerings received, for no additional consideration, a warrant entitling the holder to purchase a number of shares of the Company’s common stock equal to 100% of the number of shares of common stock into which the notes are convertible (the “Warrant Shares”).  Each warrant is exercisable on a cash basis only at an initial price of $0.30 per share, and is exercisable immediately upon issuance and for a period of two (2) years from the date of issuance. Warrants to acquire 5,983,416 shares of common stock were granted during the six months ended June 30, 2012.

During 2012, the Company sold $1,495,854 of convertible notes for aggregate consideration of $1,326,740, resulting in a discount of $135,374 and conversion of previously recorded liabilities of $33,740. The aggregate relative value of the warrants issued in the 2012 offerings were valued at $593,208 using the Black-Scholes-Merton option valuation model with the following assumptions; risk-free interest rate of .27%; dividend yield of 0%; volatility factors of the expected market price of common stock of 121%; and an expected life of two years (statutory term). The Company also determined that the notes contained a beneficial conversion feature of $766,603.  The aggregate value of $1,495,854 of the 2012 Offering Warrants, the beneficial conversion feature and the note discount are considered as debt discount and will be amortized over the life of the notes.  The value of this debt discount was added to the outstanding debt discount of $1,550,918 as of December 31, 2011.  During the period ended June 30, 2012, the Company amortized $2,813,959 of debt discount, resulting in an unamortized debt discount balance of 232,813 as of June 30, 2012.

As of June 30, 2012, the outstanding balance of the notes was $483,813.

5. Capital stock  

During the six months ended June 30, 2012, the Company issued 10,930,004 shares of common stock in exchange for conversion of $2,732,501 of Convertible Notes.

During the six months ended June 30, 2012, the Company issued 1,294,726 shares of common stock upon exercise of warrants at an average price of $0.35 per share and valued at $458,500.

During the six months ended June 30, 2012, the Company issued 1,500,000 shares of common stock for consulting services at an average price of $0.35 per share and valued at $520,000.

During the six months ended June 30, 2012, the Company issued 18,334 shares of common stock upon exercise of options at $0.27 per share and valued at $4,950.

6. Stock Options and warrants

The Company periodically issues stock options and warrants to employees and non-employees in capital raising transactions, for services and for financing costs.  Stock-based compensation is measured at the grant date, based on the fair value of the award, and is recognized as expense over the requisite service period.  Options vest and expire according to terms established at the grant date.

Options

The Company currently issues stock options to employees, directors and consultants under the 2004 Stock Option Plan (the Plan). The Company could issue options under the Plan to acquire up to 5,000,000 shares of common stock. In February 2006, the board approved an amendment to the Plan (approved by the Shareholders in May 2006), increasing the authorized shares by 2,000,000 shares to 7,000,000 shares. At June 30, 2012, 2,750,442 were available to be granted under the Plan. Prior to 2004, the Company granted 3,250,000 options outside the Plan to officers of the Company.

On February 1, 2012, the Company issued 4,000,000 options to its Chief Financial Officer, valued at $1,207,193 using Black-Scholes-Merton calculation. The options have an exercise price of $0.25 per share, vest over a four year period, and expire ten years from date of grant. Twelve and a half percent vested immediately, twelve and a half percent will vest on the first anniversary date, and twenty-five percent will vest on the following three anniversary dates. During the period ended June 30, 2012, the Company recognized $213,774 in compensation costs based upon the vesting of these options.

On May 18, 2012, the Company issued 850,000 options to its employees valued at $242,963 using Black-Scholes-Merton calculation. The options have an exercise price $0.30 per share, vesting immediately, and expire ten- years from date of grant.

Employee options vest according to the terms of the specific grant and expire from 5 to 10 years from date of grant. Non-employee option grants to date are vested upon issuance. The weighted-average, remaining contractual life of employee options outstanding at June 30, 2012 was 8.3 years. Stock option activity for the period January 1, 2012 to June 30, 2012, was as follows:

The weighted average exercise prices, remaining contractual lives for options granted, exercisable, and expected to vest under the Plan as of June 30, 2012 were as follows:

During the six months ended June 30, 2012, the Company amortized $683,423 of compensation cost based on the vesting of the options granted in prior periods. Future unamortized compensation expense on the outstanding options at June 30, 2012 is $5,987,964.

Black-Scholes-Merton value of options

During the six months ended June 30, 2012 and 2011, the Company valued options at the grant date using the Black-Scholes-Merton pricing model with the following average assumptions:

Warrants

During the period ended June 30, 2012, the Company granted warrants to consultants to purchase 600,000 shares of its common stock.  The warrants have an average exercise price of $0.26/share, vesting immediately and will expire in two to three years from grant date. Total fair value of the warrant amounted to $123,734 using the Black-Scholes Merton valuation model with the following average assumptions: risk-free interest rate of 0.23% to 0.37%; dividend yield of 0%; volatility of 112%; and an expected life of two to three years. During the period ended June 30, 2012, the Company recognized compensation expense of $123,734 based upon vesting of warrants..

During the period ended June 30, 2012, the Company granted issued 5,983,416 warrants to acquire shares of its common stock in connection of its issuance of convertible notes.  The warrant is exercisable at $0.30/share, fully vested, and will expire in two years for date of grant (See note 4).

The following table summarizes certain information about the Company’s stock purchase warrants from January 1, 2012 to June 30, 2012:

During the six months ended June 30, 2012, the Company amortized $189,768 of the compensation based on the vesting of these warrants granted in prior periods. Future unamortized compensation expense on the outstanding warrants at June 30, 2012 is $311,168.

7.  Research and development 

The Company has research and development facilities in Morgan Hill, California. The Company has tested ELEKTRA technologies and legacy products incorporating its “legacy” ZEFS, MK IV, ELEKTRA for multiple makes and models diesel engines, motorbikes, boats, generators, lawn mowers and other small engines. The Company has purchased test vehicles, test engines and testing equipment. 

The Company incurred costs of $183,424 and $81,213 and $350,890 and $552,568 for the three and six months ended June 30, 2012 and 2011, respectively, on its research and development activities and $7,795,887 from February 18, 1998 (inception) to June 30, 2012.

Temple University Research & Development Agreement

On February 2, 2007, the Company entered into a research and development agreement (R&D Agreement) with Temple University to conduct further research on the ELEKTRA technology. Under the R&D Agreement Temple University will conduct a 24-month research project towards expanding the scope of, and developing products utilizing, the technologies covered under the License Agreements, including design and manufacture of prototypes utilizing electric fields to improve diesel, gasoline and kerosene fuel injection in engines using such fuels and a device utilizing a magnetic field to reduce crude oil viscosity for crude oil (paraffin and mixed base) and edible oil flow in pipelines. If the research project yields results within the scope of the technologies licensed pursuant to the License Agreements, those results will be deemed included as rights licensed to the Company pursuant to the License Agreements. If the research project yields results outside of the scope of the technologies covered by the License Agreements, the Company has a six-month right of first negotiation to enter into a new worldwide, exclusive license agreement with Temple University for the intellectual property covered by those results. Pursuant to the R & D Agreement, the Company will make payments to Temple University in the aggregate amount of $500,000. At June 30, 2012 the Company has completed payment in full of $500,000 under the R & D Agreement.

On August 1, 2011, the Company and Temple University (“Temple”) entered into two (2) Exclusive License Agreements (collectively, the “License Agreements”) relating to Temple’s patent applications, patents and technical information pertaining to technology associated with an electric and/or magnetic field assisted fuel injector system (the “First Temple License”), and to technology to reduce crude oil viscosity (the “Second Temple License”).  The License Agreements are exclusive and the territory licensed to the Company is worldwide and replace previously issued License Agreements.

Pursuant to the two licensing agreements, the Company agreed to pay Temple the following: (i) non-refundable license maintenance fee of $300,000; (ii) annual maintenance fees of $187,500; (iii) royalty fee ranging from 4% up to 7% from revenues generated from the licensing agreements; and (iv) 25% of all revenues generated from sub-licensees to secure or maintain the sub-license or option thereon. Temple also agreed to defer payment of the $37,500 of the amount due if the Company agrees to fund at least $250,000 in research or development of Temple’s patent rights licensed to the Company. The term of the licenses commences in August 2011 through the expiration of the patents contemplated thereunder, or unless sooner terminated under terms of the licensing agreements. The Company recorded the entire $300,000 non-refundable license maintenance fee as part of its research and development costs at the date of the agreement, of which, $200,000 was paid in November 2011 and $100,000 was paid in February 2012.

Research and development costs on the accompanying statement of operations for the six month period ending June 30, 2012, include $93,750 relating to these agreements.

As of June 30, 2012, there were no revenues generated from these two licenses.

Sponsored Research Agreement 

Effective April 1, 2012 the Company entered into an agreement with Temple University in the amount of $500,000 to be paid over a two year period to engage the University as well as Physics Department Chairman Dr. Rongia Tao. This agreement specifies that the Company and Temple University will work collaboratively regarding further research and development of the AOT device. This agreement allows the Company to have access to Temple University proprietary research and intellectual property.

Research and development costs on the accompanying statement of operations for the six month period ending June 30, 2012, include $62,500 relating to this agreement.

AOT Testing

On July 16, 2010, the Company entered into a Letter of Intent with the U.S. Department of Energy-Naval Petroleum Reserve/Rocky Mountain Oilfield Testing Center (RMOTC) in Wyoming. On December 22, 2010, a formal Agreement was entered into with RMOTC for testing of our Applied Oil Technology (AOT). Third-party vendors were used to build the AOT 1.X prototype(s) to be used at for full scale testing purposes. Third-party vendors were also used to furnish hardware, electrical supplies, oil tanks and engineering testing devices, and other testing-related equipment. Costs incurred for the testing during the six months ended June 30, 2012 was $182,692. Testing began in July 2011 and the Company has the exclusive right to use the facility for testing until December 31, 2016.

8. Derivative liability

In June 2008, the FASB issued authoritative guidance on determining whether an instrument (or embedded feature) is indexed to an entity’s own stock.  Under the authoritative guidance, effective January 1, 2009, instruments which do not have fixed settlement provisions are deemed to be derivative instruments.  The strike price of the warrants issued by the Company in connection with certain convertible note offerings made during 2009 and 2010 in the aggregate of 8,322,500 warrants, exercisable at $.25 per share, contain exercise prices that may fluctuate based on the occurrence of future offerings or events.  As a result, these warrants are not considered indexed to the Company’s own stock.  The Company characterized the fair value of these warrants as derivative liabilities upon issuance.  The FASB’s guidance requires the fair value of these liabilities be re-measured at the end of every reporting period with the change in value reported in the statement of operations.

The derivative liabilities were valued using a probability weighted average series of Black-Scholes-Merton models as a valuation technique with the following assumptions:

The risk-free interest rate is based on the yield available on U.S. Treasury securities.  The Company estimates volatility based on the historical volatility of its common stock.  The expected life warrants are based on the expiration date of the related warrants.  The expected dividend yield was based on the fact that the Company has not paid dividends to common shareholders in the past and does not expect to pay dividends to common shareholders in the future. 

As of June 30, 2012, the Company re-measured the derivative liabilities and determined the fair value to be $1,725,138. For the six months ended June 30, 2012, the Company recorded a loss on the change in fair value of derivatives of $167,575 and a gain on extinguishment of derivative liability of $85,576 due to exercise of warrants to shares of common stock.

9. Commitments and contingencies

Legal matters

There is no other litigation of any significance with the exception of the matters that have arisen under, and are being handled in, the normal course of business.

Lease agreement

The Company entered into a lease agreement with Balboa building on February 1, 2012. This agreement calls for the company to lease suites 215, 216, 217, 218, 219, 220, 221, 229, 230 on the second floor of the Balboa building located at 735 State St. Santa Barbara, CA. This lease was executed in anticipation of the Company's growth and the need to increase square footage while space is available. The lease agreement calls for a monthly rental of $5,845 and will expire on December 31, 2013.  

10. Other income

One of the Company’s legal counsel agreed to cancel $223,774 of unpaid legal fees for services rendered as of June 30, 2012.  As a result, the Company recognized a gain of $223,774 during the period ended due to the cancellation of debt. 

11.  Subsequent events

2012 Summer Offering

From June 29, 2012 through July 23, 2012, the Company conducted a private offering (the "Summer 2012 Offering") of up to $2,000,000 aggregate face amount of its convertible notes (the "Summer 2012 Notes"). A total of $568,920 aggregate face amount of the Summer 2012 Notes were sold for an aggregate purchase price of $517,200. While the stated interest rate on the Summer 2012 Notes is 0%. the actual interest rate on the Summer 2012 Notes is 10% per annum. The Summer 2012 Notes mature on the first anniversary of their date of issuance. The Summer 2012 Notes are convertible, at the option of the noteholders into 1,422,300 shares of common stock of the Company (the "Conversion Shares") at an initial conversion price of $0.40 per share (the "Conversion Price").

Each of the investors in the Summer 2012 Offering received, for no additional consideration, a warrant (the "Summer 2012 Warrants"), entitling the holder to purchase a number of shares of the Company's common stock equal to 100% of the number of shares of common stock into which the Summer 2012 Notes are convertible (the "Warrant Shares"). Each Summer 2012 Warrant is exercisable on a cash basis only at an initial price of $0.40 per share, and is exercisable immediately upon issuance and for a period of three (3) years from the date of issuance. Up to 1,422,300 Warrant Shares are initially issuable to date on exercise of the Summer 2012 Warrants.

Increase in Outstanding Shares

During the period from July 1, 2012 through August 6, 2012, the Company issued 444,500 shares of its common stock.  This was comprised of the following:

The Company issued 198,000 shares of its common stock upon conversion of $49,500 of debt to its existing convertible note holders.

The Company issued 246,500 shares of its common stock upon exercise of warrants for aggregate proceeds of $73,950.

Investor Relations Agreements

The Company entered into two separate Independent Contractor Agreements whereby, contractor will provide investor relations and communication services for the Company. The term of the agreement shall be for one year commencing on July 1, 2012 and shall continue from month-to-month thereafter. The Company issued warrants to purchase 1,000,000 shares of restricted common stock at an exercise price of $0.30 per share, vested immediately and shall expire in three years. The warrants were valued at $301,600 based on Black-Scholes-Merton valuation method.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements. These forward-looking statements include predictions regarding our future:

You can identify these and other forward-looking statements by the use of words such as “may,” “will,” “expects”, “anticipates,” “believes,” “estimates,” “continues,” or the negative of such terms, or other comparable terminology.

Forward-looking statements also include the assumptions underlying or relating to any of the foregoing statements.

Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under the heading “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011. All forward-looking statements included in this document are based on information available to us on the date hereof. We assume no obligation to update any forward-looking statements.

Overview

Save the World Air, Inc. (“STWA” or “Company” or “we”) designs, licenses and develops products to improve energy efficiency of large-scale energy production and improve diesel engine performance reducing emissions and improving fuel economy. We are a green technology company that leverages a suite of patented, patent-pending and licensed intellectual properties related to the treatment of fuels. Technologies patented by or licensed to us utilize either magnetic or uniform electrical fields to alter physical characteristics of fuels and are designed to create cleaner combustion. Cleaner combustion has been shown to improve performance, enhance fuel economy and/or reduce harmful emissions in laboratory testing.

On August 1, 2011, Save The World Air, Inc. and Temple University entered into two Exclusive License Agreements. One Agreement relates to Temple’s international patent applications, patents and technical information pertaining to technology associated with an electric and/or magnetic field assisted fuel injection system. The second agreement relates Temple’s international patent applications and patents and technical information pertaining to technology to reduce crude oil viscosity. The License Agreements are exclusive to the Company and the territory licensed to the Company is worldwide.

We have two product lines;  Applied Oil Technology (“AOT”) and ELEKTRA™.

AOT

On July 16, 2010, the Company entered into a Letter of Intent with the U.S. Department of Energy-Naval Petroleum Reserve/Rocky Mountain Oilfield Testing Center (RMOTC) in Wyoming. On December 22, 2010, a formal Agreement was entered into with RMOTC for testing of our Applied Oil Technology (AOT). Third-party vendors and suppliers were used by the Company to provide the facility construction materials and the prototype’s design and fabrication To conduct the testing, the Company was responsible for upgrading the testing facility’s existing infrastructure, located on the Naval Petroleum Reserve #3. Design and engineering began in January 2011 and construction was completed in June 2011.

The AOT Phase II testing program began in July 2011. It is the Company’s belief that the Phase II testing of the prototype will yield important information and data to the Company’s product development team. Costs incurred for the testing during the six months ended June 30, 2012 was $182,692. (See “Item 5 Other information”)

Elektra

The Company’s ELEKTRA technology improves diesel fuel economy in both land and marine diesel engines. The Company’s preliminary experimental prototypes have shown repeatable improvements in fuel economy. Research is being conducted under controlled conditions at the Company’s research facility in Morgan Hill California.

We operate in a highly competitive industry.  Many of our activities are subject to governmental regulation.  We have taken aggressive steps to protect our intellectual property.  

There are significant risks associated with our business, our Company and our stock.  

We are a development stage Company that generated minimal revenues in 2006 and 2007. We did not generate any sales or revenues from 2008 up to June 30, 2012. Our expenses to date have been funded primarily through the sale of stock and convertible debt, as well as proceeds from the exercise of stock purchase warrants. We raised capital in 2011 and will need to raise substantial additional capital in 2012, and beyond, to fund our sales and marketing efforts, continuing research and development, and certain other expenses, until our revenue base grows sufficiently to cover such expenditures.  See “Management’s Discussion and Analysis” below.

Our company was incorporated on February 18, 1998, as a Nevada corporation, under the name Mandalay Capital Corporation. We changed our name to Save the World Air, Inc. on February 11, 1999, following the acquisition of marketing and manufacturing rights of the ZEFS (legacy) technologies. Our mailing address is 735 State Street, Suite 500, Santa Barbara, California 93101. Our telephone number is (805) 845-3581. Our corporate website is www.stwa.com.  

Our common stock is quoted under the symbol “ZERO” on the Over-the-Counter Bulletin Board

Results of Operations

We did not generate any revenue for the three-month and six-month periods ended June 30, 2012 and 2011.

Operating expenses were $1,921,814 for the three-month period ended June 30, 2012, compared to $1,428,251 for the three-month period ended June 30, 2011, an increase of $493,563. This increase is attributable to an increase in non-cash expenses of $515,081, offset by a decrease in cash expenses of $21,518. Specifically, the increase in non-cash expense is attributable to increases in stocks, options and warrants given to consultants and employees of $463,081 and bad debt expense of $52,000. Specifically, the decrease in cash expense is attributable to decreases consulting and professional fees of $211,984, corporate expenses of $52,853, office and other expenses of $10,320, offset by an increase in salaries and benefits of $253,639.

Operating expenses were $3,859,719 for the six-month period ended June 30, 2012, compared to $2,511,235 for the six-month period ended June 30, 2011, an increase of $1,348,484. This increase is attributable to increases in non-cash expenses of $1,215,028 and cash expenses of $133,456. Specifically, the increase in non-cash expense is attributable to increases in stocks, options and warrants given to consultants and employees of $1,163,028 and bad debt expense of $52,000. Specifically, the increase in cash expense is attributable to increases in salaries and benefits of $349,561, office and other expenses of $34,361, offset by decreases in consulting and professional fees of $186,070 and corporate expenses of $64,396.

Research and development expenses were $183,424 for the three-month period ended June 30, 2012, compared to $81,213 for the three-month period ended June 30, 2011, an increase of $102,211. This increase is attributable to an increase in contract fees of $109,375, offset by a decrease in product testing, research and supplies of $7,164.

Research and development expenses were $350,890 for the six-month period ended June 30, 2012, compared to $552,568 for the six-month period ended June 30, 2011, a decrease of $201,678. This decrease is attributable to a decrease in product testing, research and supplies of $357,928, offset by an increase in contract fees of $156,250.

Other income and expense were $708,440 income for the three-month period ended June 30, 2012, compared to $2,886,206 expense for the three-month period ended March 31, 2011, a decrease in expense of $3,594,646. This decrease is attributable to decreases in interest and financing expense of $2,853,858, fair value of derivative liabilities of $711,491 and other expense of $29,297.

Other income and expense were $2,656,539 expense for the six-month period ended June 30, 2012, compared to $2,194,658 expense for the six-month period ended June 30, 2011, an increase in expense of $461,881. This increase is attributable to increases in the fair value of derivative liabilities of $1,645,583, other expense of $22,475, offset by a decrease in interest and financing expense of $982,403 and an increase in other income of $223,774 due to settlement of debt.

We had a net loss of $1,397,598, or $0.01 per share, for the three-month period ended June 30, 2012, compared to a net loss of $4,396,470, or $0.04 per share, for the three-month period ended June 30, 2011. 

We had a net loss of $6,867,948, or $0.06 per share, for the six-month period ended June 30, 2012, compared to a net loss of $5,259,261, or $0.06 per share, for the six-month period ended June 30, 2011.

We expect to incur additional net loss in the fiscal year ending December 31, 2012 primarily attributable to continued operating and marketing-related expenditures without the benefit of any significant revenue for the remainder of the year.

Liquidity and Capital Resources

Since its inception, we have been primarily engaged in organizational and pre-operating activities. We have generated insignificant revenues and have incurred accumulated losses of $76,157,415 from February 18, 1998 (Inception) through June 30, 2012. As reflected in the accompanying condensed consolidated financial statements, we had a net loss of $6,867,948 and a negative cash flow from operations of $2,335,322 for the six months ended June 30, 2012, and had a working capital deficiency (excluding derivative liabilities) of $1,798,382 and a stockholders' deficiency of $3,443,137 at June 30, 2012. As a result, our independent registered public accounting firm, in their report on our 2011 consolidated financial statements, raised substantial doubt about our ability to continue as a going concern.  The financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern.

Our ability to continue as a going concern is dependent upon our ability to raise additional funds and implement our business plan. Our operations from inception, February 18, 1998 to June 30, 2012 have been funded through issuances of our common stock and convertible notes. As of June 30, 2012, we raised an aggregate of $29,171,312 of which $17,891,788 was from the sale of convertible notes. As of June 30, 2012, the outstanding balance of convertible notes was $483,813, of which $148,753 represented convertible note offering, which closed on February 3, 2012. We expect substantially all of the outstanding notes will be converted into shares of common stock of the Company (see “Item 5 Other Information”).

On June 30, 2012, we had cash on hand in the amount of $59,892. In addition to the funds on hand, we will require additional funds to continue to operate our business. This includes expenses we will incur in connection with license agreements; product development and commercialization of the AOT and ELEKTRA technologies; costs to manufacture and ship our products; costs to design and implement an effective system of internal controls and disclosure controls and procedures; costs of maintaining our status as a public company by filing periodic reports with the SEC and costs required to protect our intellectual property. In addition, we have contractual commitments for salaries to one of our executive officers pursuant to an employment agreement, severance payments to a former officer and consulting fees, during 2011 and beyond. In light of our financial commitments over the next several months and its liquidity constraints, we have implemented cost reduction measures in all areas of operations. We intend to review these measures on an ongoing basis and make additional decisions as may be required.

Details of Recent Financing Transactions

From December 13, 2010 through February 3, 2012, we conducted private offerings of up to $10,000,000 aggregate face amount of its convertible notes. A total of $7,722,783 aggregate face amount of the notes were sold for an aggregate purchase price of $7,020,711. Through December 31, 2011, $6,239,029 of these notes were sold, of which $4,518,425 were converted during 2011, leaving a balance of convertible notes outstanding as of December 31, 2011 of $1,720,460. During 2012, we sold an additional $1,495,854 of these convertible notes, and an additional $2,732,501 of these notes were converted, leaving a balance of convertible notes outstanding of June 30, 2012 of $483,813. While the stated interest rate on the notes is 0%, the actual interest rate on the notes is 10% per annum. The notes mature on the first anniversary of their respective date of issuance. The notes outstanding at June 30, 2012 are convertible, at the option of the note holder, into 1,935,252 shares of our common stock (the “Conversion Shares”) a conversion price of $0.25 per share.

Each of the investors in the offerings received, for no additional consideration, a warrant entitling the holder to purchase a number of shares of our common stock equal to 100% of the number of shares of common stock into which the notes are convertible (the “Warrant Shares”).  Each warrant is exercisable on a cash basis only at an initial price of $0.30 per share, and is exercisable immediately upon issuance and for a period of two (2) years from the date of issuance. Warrants to acquire 5,983,416 shares of common stock were granted during the six months ended June 30, 2012.  

During 2012, we sold $1,495,854 of convertible notes for aggregate consideration of $1,326,740, resulting in a discount of $135,374 and conversion of previously recorded liabilities of $33,740. The aggregate relative value of the warrants issued in the 2012 offerings were valued at $593,208 using the Black-Scholes-Merton option valuation model with the following assumptions; risk-free interest rate of .27%; dividend yield of 0%; volatility factors of the expected market price of common stock of 121%; and an expected life of two years (statutory term). We determined that the notes contained a beneficial conversion feature of $766,603.  The aggregate value of $1,495,854 of the 2012 Offering Warrants, the beneficial conversion feature and the note discount are considered as debt discount and will be amortized over the life of the notes.  The value of this debt discount was added to the outstanding debt discount of $1,550,918 as of December 31, 2011.  During the period ended June 30, 2012, we amortized $2,813,959 of debt discount, resulting in an unamortized debt discount balance of 232,813 as of June 30, 2012.

As of June 30, 2012, the outstanding balance of the notes was $483,813.

Critical Accounting Policies and Estimates

Our discussion and analysis of our condensed consolidated financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these condensed consolidated financial statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, expenses, and related disclosure of contingent assets and liabilities. We evaluate, on an on-going basis, our estimates and judgments, including those related to the useful life of the assets. We base our estimates on historical experience and assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

The methods, estimates and judgments we use in applying our most critical accounting policies have a significant impact on the condensed consolidated results that we report in our financial statements. The SEC considers an entity’s most critical accounting policies to be those policies that are both most important to the portrayal of a company’s financial condition and results of operations and those that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about matters that are inherently uncertain at the time of estimation.. For a more detailed discussion of the accounting policies of the Company, see Note 2 of Notes to the condensed consolidated financial statements.

We believe the following critical accounting policies, among others, require significant judgments and estimates used in the preparation of our condensed consolidated financial statements:

The preparation of 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 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. Certain significant estimates were made in connection with preparing our condensed consolidated financial statements as described in Note 1 to Notes to condensed consolidated financial statements. Actual results could differ from those estimates.

Stock-Based Compensation

The Company periodically issues stock options and warrants to employees and non-employees in non-capital raising transactions for services and for financing costs. The Company accounts for stock option and warrant grants issued and vesting to employees based on the authoritative guidance provided by the Financial Accounting Standards Board whereas the value of the award is measured on the date of grant and recognized over the vesting period. The Company accounts for stock option and warrant grants issued and vesting to non-employees in accordance with the authoritative guidance of the Financial Accounting Standards Board whereas the value of the stock compensation is based upon the measurement date as determined at either a) the date at which a performance commitment is reached, or b) at the date at which the necessary performance to earn the equity instruments is complete. Non-employee stock-based compensation charges generally are amortized over the vesting period on a straight-line basis. In certain circumstances where there are no future performance requirements by the non-employee, option grants are immediately vested and the total stock-based compensation charge is recorded in the period of the measurement date.

The fair value of the Company's common stock option grant is estimated using the Black-Scholes option pricing model, which uses certain assumptions related to risk-free interest rates, expected volatility, expected life of the common stock options, and future dividends. Compensation expense is recorded based upon the value derived from the Black-Scholes option pricing model, and based on actual experience. The assumptions used in the Black-Scholes option pricing model could materially affect compensation expense recorded in future periods.

Accounting for Warrants and Derivatives

The Company evaluates all of its financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded derivatives. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported in the consolidated statements of operations. For stock-based derivative financial instruments, the Company uses a probability weighted average series Black-Scholes-Merton option pricing models to value the derivative instruments at inception and on subsequent valuation dates.

The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is evaluated at the end of each reporting period. Derivative instrument liabilities are classified in the balance sheet as current or non-current based on whether or not net-cash settlement of the derivative instrument could be required within 12 months of the balance sheet date.

Recent Accounting Pronouncements

In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”. ASU No. 2011-4 does not require additional fair value measurements and is not intended to establish valuation standards or affect valuation practices outside of financial reporting. The ASU is effective for interim and annual periods beginning after December 15, 2011. The Company adopted ASU No. 2011-04 effective January 1, 2012 and it did not affect the Company’s results of operations, financial condition or liquidity.

In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income”. The ASU eliminates the option to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity, and instead requires consecutive presentation of the statement of net income and other comprehensive income either in a continuous statement of comprehensive income or in two separate but consecutive statements. ASU No. 2011-5 is effective for interim and annual periods beginning after December 15, 2011. The Company adopted ASU 2011-05 effective January 1, 2012 and it did not affect the Company’s results of operations, financial condition or liquidity.

In September 2011, the FASB issued ASU 2011-08, “Testing Goodwill for Impairment”, an update to existing guidance on the assessment of goodwill impairment. This update simplifies the assessment of goodwill for impairment by allowing companies to consider qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount before performing the two step impairment review process. It also amends the examples of events or circumstances that would be considered in a goodwill impairment evaluation. The amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The Company adopted ASU 2011-08 effective January 1, 2012. We do not believe that the adoption of this new accounting guidance will have a significant effect on our goodwill impairment assessments in the future.

In December 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-11, “Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities.” This ASU requires an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. ASU No. 2011-11 will be applied retrospectively and is effective for annual and interim reporting periods beginning on or after January 1, 2013. The Company does not expect adoption of this standard to have a material impact on its consolidated results of operations, financial condition, or liquidity.

Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the Securities Exchange Commission (the "SEC") did not or are not believed by management to have a material impact on the Company's present or future consolidated financial statements.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Not applicable.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)  is not effective as of June 30, 2012.

Disclosure controls are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.  Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.  Internal control consists of procedures which are designed with the objective of providing reasonable assurance that our transactions are properly authorized, recorded and reported and our assets are safeguarded against unauthorized or improper use, to permit the preparation of our financial statements in conformity with generally accepted accounting principles.

We identified certain matters that constitute material weakness (as defined under the Public Company Accounting Oversight Board Auditing Standard No. 2) in our internal control over financial reporting as discussed on Management’s Annual Report on Internal Control Over Financial Reporting below.

In light of the material weaknesses in internal control over financial reporting described below, we performed additional analysis and other post-closing procedures to ensure that our financial statements were prepared in accordance with generally accepted accounting principles. Despite material weaknesses in our internal control over financial reporting, we believe that the financial statements included in our Form 10-Q for the period ended June 30, 2012 fairly present, in all material respects, our financial condition, results of operations, changes in shareholder’s equity and cash flows for the periods presented.

We have created policies and procedures to allow for segregation of duties, check of disbursements, level of authorities and operating budget. These are currently being implemented. The reviewing, recording, and depositing of money received are completed by separate employees. Bank reconciliations will be performed by two accounting personnel on a monthly basis. We require all disbursements to be reviewed by the appropriate personnel and be signed by two other personnel. We have set a limit to each signer’s authority to sign and have required all disbursements be supported with appropriate documents, invoices, receipts, etc. We have also required Board approval for contracts and agreements exceeding $200,000USD. The Company also implemented a monthly operating budget which must be analyzed with explanation of variances. We expect these procedures to be fully implemented by December 31, 2012.  

Management’s Annual Report on Internal Control over Financial Reporting.

Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transaction and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.

Because of its inherent limitation, internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives.

Our Chief Executive Officer, Chief Financial Officer and Controller conducted an assessment of the effectiveness of our internal control over financial reporting as of June 30, 2012 based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). A material weakness is a deficiency or a combination of deficiencies in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis.

Based on that assessment, we have identified the following material weaknesses and have implemented the following remediation of material weaknesses in internal control over financial reporting:

Lack of segregation of duties

We have limited staff in our corporate offices and, as such, there is a lack of segregation of duties. We recently developed an internal control procedure manual that allows for segregation of duties from within the accounting department. This will be submitted for approval with a Board Resolution and will be implemented soon.

Lack of documented and reviewed system of internal control

We have an internal control weakness due to the lack of a documented and reviewed system of internal control. We are currently reviewing an implementation process so as to be more in line with Sarbanes-Oxley 302. We have started to enhance some of our key internal control systems surrounding inventory purchasing and control, and to document those changes; however, this process is on-going and the implementation of policies and procedures may take several quarters.

As a result of the material weaknesses described above, we are currently implementing a process to ensure all invoices and statements of account are reviewed and approved by at least two individuals within the financial department.

We are conducting an evaluation to design and implement adequate systems of accounting and financial statement disclosure controls. We expect to complete a review during 2012 to comply with the requirements of the SEC, which as required by SEC rules, may include an opinion from our auditors regarding management’s report on internal control over financial reporting for our fiscal year ending 2012. We believe that the ultimate success of our plan to improve our internal control over financial reporting will require a combination of additional financial resources, outside consulting services, legal advice, additional personnel, further reallocation of responsibility among various persons, and substantial additional training of those of our officers, personnel and others, including certain of our directors such as our Chairman of the Board and committee chairs, who are charged with implementing and/or carrying out our plan. It should also be noted that the design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

In addition, our management with the participation of our Chief Executive Officer and Chief Financial Officer have determined that no change in our internal control over financial reporting (as that term is defined in Rules 13(a)-15(f) and 15(d)-15(f) of the Securities Exchange Act of 1934) occurred during or subsequent to the quarter ended June 30, 2012 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II

Item 1. Legal Proceedings

There is no other litigation of any significance with the exception of the matters that have arisen under, and are being handled in, the normal course of business.  

Item 1A. Risk Factors

There have been no material changes in the risk factors previously disclosed in Form 10-K for the period ended December 31, 2011, which we filed with the SEC on March 30, 2012. 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

2011 and 2012 Offering. From December 13, 2010, through February 3, 2012, we conducted a private offering consisting of an aggregate of $7,722,783 of Convertible Promissory Notes. The Notes were sold for an aggregate purchase price of $7,020,711 net proceeds. The Notes are convertible into 30,891,132 shares of our common stock and in addition investors received warrants to purchase up to 30,891,130 shares of our common stock.  (See “Details of Recent Financing Transactions”).

The sales of the securities described above were made in reliance on the exemptions from registration set forth in Section 4(2) of the Securities Act of 1933, as amended (the “Act”), or Regulation S promulgated thereunder, and other applicable exemptions. 

Other Issuances.

During the six months ended June 30, 2012, we issued 10,930,004 shares of common stock in exchange for conversion of $2,732,501 of Convertible Notes.

During the six months ended June 30, 2012, we issued 1,294,726 shares of common stock upon exercise of warrants at an average price of $0.35 per share and valued at $458,500.

During the six months ended June 30, 2012, we issued 1,500,000 shares of common stock for consulting services at and average price of $0.35 per share and valued at $520,000.

During the six months ended June 30, 2012, we issued 18,334 shares of common stock upon exercise of options at $0.27 per share and valued at $4,950.

Item 3. Defaults Upon Senior Securities

None

Item 4. Mine Safety Disclosures

None

Item 5. Other Information

Increase in Outstanding Shares

During the period from July 1, 2012 through August 6, 2012, we issued 444,500 shares of our common stock.  This was comprised of the following:

We issued 198,000 shares of our common stock upon conversion of $49,500 of debt to its existing convertible note holders.

We issued 246,500 shares of our common stock upon exercise of warrants for aggregate proceeds of $73,950.

Investor Relations Agreements

We entered into two separate Independent Contractor Agreements whereby, contractor will provide investor relations and communication services for the Company. The term of the agreement shall be for one year commencing on July 1, 2012 and shall continue from month-to-month thereafter. We issued warrants to purchase 1,000,000 shares of restricted common stock at an exercise price of $0.30 per share, vested immediately and shall expire in three years. The warrants were valued at $301,600 based on Black-Scholes-Merton valuation method. 

Cash Bonus to Cecil B. Kyte

On July 19, 2012, the Company’s Board of Directors elected to ratify and approve a cash bonus for Cecil B. Kyte, the Company’s CEO and Chairman of the Board, in the amount of $100,000 for his efforts and services during the period December 1, 2011, through July 19, 2012. On Mr. Kyte’s request, the Company initially paid him the sum of $100,000 under the mistaken belief that such sum represented payment in lieu of accrued vacation time. The Board determined otherwise; but nonetheless acknowledged Mr. Kyte’s exceptional services to the Company. The Board also acknowledged that a cash bonus to Mr. Kyte was already under consideration. The Board thus determined to treat the payments to Mr. Kyte as a cash bonus.

Item 6. Exhibits

SIGNATURES

In accordance with Section 13 or 15(d) of the Exchange Act, the Registrant has caused this Report to be signed on its behalf by the undersigned, hereunto duly authorized.

EXHIBIT INDEX

* Pursuant to Rule 405(a)(2) of Regulation S-T, the Company will furnish the XBRL Interactive Data Files with detailed footnote tagging as Exhibit 101 in an amendment to this Form 10-Q within the permitted 30-day grace period for the first quarterly period in which detailed footnote tagging is required after the filing date of this Form 10-Q.

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