Liquidity and Management’s Plans (continued)

While ourOur current liquid cash resources as of August 31,November 30, 2011, are expected to provide the funds necessary to support our operations through at least the next twelve months assuming we do not continue to fund the obligations of PDS.  The cash flows from our interest in PDS representsrepresent our primary significant source of cash generation.  In the event of a continued decrease or interruption in MMP Portfolio licensing we will incur a significant reduction to our cash position as the revenues from our PDSG subsidiary are insufficient to cover the costs of their operations and the costs of Patriot Scientific Corporation as a whole.  It is highly unlikely that we would be able to obtain any additional sources of financing to supplement our cash and short-term investment position of $9,814,564$8,975,788 at November 30, 2011.  In December 2011, TPL engaged new counsel on behalf of PDS, and committed PDS to paying an initial retainer in the amount of $2,400,000, payable in monthly installments from December 2011 through August 31, 2011.2012.  The $200,000 that we contributed to PDS referred to above, was used to pay the first installment of such retainer.  The remaining balance of the retainer is anticipated to be funded by PDS from licensing revenues. In the event that PDS does not have the funds to pay one or more installments of the retainer, we and TPL must decide whether to contribute additional capital to PDS to fund such installments. The newly retained counsel will continue the Northern California cases to trial after the claims construction hearing.

Investments in Marketable Securities

We determine the appropriate classification of our investments at the time of purchase and reevaluate such designation at each balance sheet date.  Our investments in marketable securities have been classified and accounted for as available-for-sale based on management’s investment intentions relating to these securities.  Available-for-sale marketable securities are stated at fair market value.  Unrealized gains and losses, net of deferred taxes, are recorded as a component of other comprehensive income (loss).  We follow the authoritative guidance to assess whether our investments with unrealized loss positions are other than temporarily impaired.  Realized gains and losses and declines in fair value judged to be other than temporary are determined based on the specific identification method and are reported in other income (expense), net in the condensed consolidated statements of operations.

Investment in Affiliated Company

We review our investment in an affiliated companyPDS to determine whether events or changes in circumstances indicate that the carrying amount may not be recoverable. The primary factors we consider in our determination are the financial condition, operating performance and near term prospects of the investee.PDS. If the decline in value is deemed to be other than temporary, we would recognize an impairment loss.

We have a 50% interest in PDS (see Note 6).  As of the date of this filing, PDS is a variable interest entity (“VIE”) of which we are not the primary beneficiary and therefore will not consolidate PDS’ financial statements with our own as we cannot direct the licensing activity of TPL on behalf of PDS.

This investment is accounted for using the equity method of accounting since the investment provides us the ability to exercise significant influence, but not control, over the investee. Significant influence is generally deemed to exist if we have an ownership interest in the voting stock of the investee of between 20% and 50%, although other factors, such as representation on the investee’s board of directors, are considered in determining whether the equity method of accounting is appropriate. Under the equity method of accounting, the investment, originally recorded at cost, is adjusted to recognize our share of net earnings or losses of the investee which is presented in the condensed consolidated statements of operations in the caption “Equity in loss of affiliated company” and also is adjusted by contributions to and distributions from PDS.

During the threesix months ended August 31,November 30, 2011, our share of loss in PDS exceeds our investment in PDS by $732,286.$1,563,261. We presently do not have a contractual obligation to fund any cash requirements of PDS (see Note 6) and accordingly we have not recorded the excess loss on our consolidated financial statements, as we do not intend to fund any cash requirements of PDS, which is a change in our policy of accounting for PDS.  Under the equity method of accounting, we are to continue to report losses up to our carrying amount of the investment.investment and advances. Once the investment balance is reduced to $0, we are to discontinue applying the equity method until such time that our share of future net income reported by PDS equals our share of net losses not recognized during the period the equity method was suspended.

Comprehensive Income (Loss)

Comprehensive income (loss) includes unrealized gains and losses which are excluded from the condensed consolidated statements of operations.

Revenue Recognition

Revenue from technology license agreements is recognized at the time a contract is entered into, the license method is determined (paid-in-advance or on-going royalty), and the customer is provided with the licensed technology, if applicable.

PDSG sells software and services to end users primarily through relationships with systems integrators and prime contractors.  PDSG recognizes revenue in accordance with authoritative guidance for the software industry.  PDSG’s revenue is derived primarily from the following sources: (i) software licensing, (ii) related professional services, and (iii) post contract customer support (“PCS”) agreements.  PCS agreements typically include software updates, on a when and if available basis, telephone and Internet access to technical support personnel. Software updates provide customers with rights to unspecified software product upgrades and to maintenance releases and patches released during the term of the support period.

PDSG’s contracts with customers, including systems integrators and prime contractors, are multiple element arrangements which contain professional services that are considered essential to the functionality of the other elements of the arrangement.  PDSG accounts for revenue on these arrangements according to authoritative guidance for contract accounting. Under this guidance, PDSG recognizes revenue based on progress towards contract completion measured by actual hours incurred in relation to the estimate of total expected hours. PDSG measures these revenues by applying the contract-specific estimated percentage of completion to the total contract amount for software and professional services.  PDSG routinely updates the estimates of future hours for agreements in process and reports any cumulative effects of such adjustments in current operations. PDSG immediately recognizes any loss expected on these contracts when it is projected that loss is probable.

On June 1, 2010, we adopted new authoritative guidance on a prospective basis for revenue arrangements containing multiple deliverables.  This guidance requires us toWe allocate PDSG’s revenues to all deliverables based on their relative selling price using a specific hierarchy.  The hierarchy is as follows:  vendor-specific objective evidence (“VSOE”), third-party evidence of selling price (“TPE”) or best estimate of selling price (“BESP”).

PDSG has not yet demonstrated VSOE for the professional services that are rendered in conjunction with its software license sales.  In accordance with the hierarchy we would attempt to establish the selling price of professional services using TPE.  PDSG’s product contains significant differentiation such that the comparable pricing of products with similar functionality cannot be obtained.  PDSG is typically not able to obtain TPE for professional services.

When we are unable to establish selling prices using VSOE or TPE, we use BESP.  The objective of BESP is to determine the price at which PDSG would transact a sale if professional services were sold on a stand-alone basis.  BESP is generally used for offerings that are not typically sold on a stand-alone basis or for highly customized offerings which is the case with PDSG’s professional services deliverable.

Research and development costs are expensed as incurred and primarily include payroll and related benefit costs and contractor fees.

Net Loss Per Share

Basic net loss per share includes no dilution and is computed by dividing net loss available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution of securities that could share in the earnings of an entity.

At August 31,For the three and six months ended November 30, 2011 potential common shares of 3,010,0002,895,000 related to our outstanding options were not included in the calculation of diluted income per share as we had no income.  At August 31,For the three and six months ended November 30, 2010 potential common shares of 5,687,8035,637,292 related to our outstanding warrants and options were not included in the calculation of diluted income per share as we had no income.  Had we reported net income for the three and six months ended August 31,November 30, 2011 and 2010, an additional 0 and 779,994, respectively,755,000 shares of common stock, respectively, would have been included in the calculationnumber of shares used to calculate diluted incomeearnings per share and an additional 0 and 755,000 shares of common stock, respectively, would have been included in the number of shares used to calculate diluted earnings per share.

In connection with our acquisition of Crossflo, which is now a part of PDSG, we issued escrow shares that are contingent upon certain representations and warranties made by Crossflo at the time of the merger agreement (see Note 9).  We exclude these escrow shares from the basic loss per share calculations and include the escrowed shares in the diluted earnings per share calculations.

Share-Based Compensation

Share-based compensation expense recognized during the three and six months ended August 31,November 30, 2011 and 2010 is based on the grant date fair value of the portion of share-based payment awards ultimately expected to vest during the year.  As share-based compensation expense recognized in the condensed consolidated statements of operations is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures.  Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.  Forfeiture rates are based on historical forfeiture experience and estimated future employee forfeitures.

Goodwill originating from acquisitions was not amortized and was tested for impairment on an annual basis and between annual tests based on certain circumstances.

Changes in the net carrying amount of goodwill were as follows:

Purchased identifiable intangible assets were being amortized on a straight linestraight-line basis over their estimated lives.  Management’s plan of restructuring and the continuing inability of PDSG to meet its business plan were indicators of potential impairment on our intangible assets. Accordingly, during the fiscal year ended May 31, 2011 it was determined that intangibles were fully impaired by approximately $1,470,000.  We have recorded this as an impairment of purchased intangibles on our consolidated statement of operations for the fiscal year ended May 31, 2011.

The amortization expense related to intangible assets was as follows:

 

Cash, Cash Equivalents, Restricted Cash and Marketable Securities (continued)

All realized gains or losses related to financial instruments whose fair value is determined based on Level 3 inputs are included in other income. All unrealized gains or losses related to financial instruments whose fair value is determined based on Level 3 inputs are included in other comprehensive income (loss).

At August 31,During September 2010, the Level 3 fair value of our ARS consistswe reached a confidential settlement agreement with Deutsche Bank.  Under terms of the par value ofagreement, we transferred approximately $5.2 million adjustedin illiquid auction rate securities instruments to Deutsche Bank for realized lossa substantial portion of $648,740, recorded as “Realized loss on salethe face value of marketable securities” in the accompanying condensed consolidated statementsecurities, and if the instruments are redeemed by a certain date then we will receive the full face amount of operations at August 31, 2010.the instruments.  On October 4, 2010, we received settlement proceeds from Deutsche Bank of $4,551,260 plus $6,330 of interest income.

Beginning in fiscal 2011, we purchased certificates of deposit with varying maturity dates greater than three months.  The following table summarizes the maturities, gross unrealized gains or losses and fair value of the certificates of deposit as of August 31,November 30, 2011:

 

 

Trade accounts receivable at August 31,November 30, 2011 and May 31, 2011 is $27,456$113,786 and $187,465, respectively, which relates entirely to PDSG. No allowance for doubtful accounts has been recorded at August 31,November 30, 2011 or May 31, 2011.

At August 31,November 30, 2011, work-in-process consisting of recognized revenue on PDSG’s current contracts was $574,616$442,773 and invoices to customers were $452,256.was $405,875.  At May 31, 2011, work-in-process consisting of recognized revenue on PDSG’s current contracts was $455,381 and invoices to customers were $424,800.  These amounts are shown on our August 31,November 30, 2011 and May 31, 2011 balance sheets at net of $122,360$36,898 and $30,581, respectively, due to their immateriality.

On June 7, 2005, we entered into a Master Agreement (the “Master Agreement”) with TPL, and Charles H. Moore (“Moore”), the co-inventor of the technology which is the subject of the MMP Portfolio of microprocessor patents, pursuant to which the parties resolved all legal disputes between them. Pursuant to the Master Agreement, we and TPL entered into the Limited Liability Company Operating Agreement of PDS (the “LLC Agreement”) into which we and Moore contributed our rights to certain of our technologies.

We and TPL each own 50% of the membership interests of PDS, and each of us has the right to appoint one member of the three member management committee. The two appointees are required to select a mutually acceptable third member of the management committee. There has not been a third management committee member since May 2010, nor are there any current attempts to seek a replacement member. Pursuant to the LLC Agreement, we and TPL agreed to establish a working capital fund for PDS of $4,000,000, of which our contribution was $2,000,000. The working capital fund increases to a maximum of $8,000,000 as license revenues are achieved. We and TPL are obligated to fund future working capital requirements at the discretion of the management committee of PDS in order to maintain working capital of not more than $8,000,000. NeitherIf the management committee determines that additional capital is required, neither we nor TPL are required to contribute more than $2,000,000 in any fiscal year. Since there is currently not a third member of the management committee, working capital contributions made to PDS require the approval of both management committee members. On December 14, 2011 we contributed $200,000 and TPL forfeited rights to $200,000 of special litigation support payments due it pursuant to the October 6, 2011 settlement agreement for an in-kind capital contribution of $200,000 in order to fund a portion of a retainer due to new counsel engaged (see Note 1, Liquidity and Management’s Plans).  Distributable cash and allocation of profits and losses will be allocated to the members in the priority defined in the LLC Agreement. PDS has committed to pay a quarterly amount ranging between $500,000 and $1,000,000 (based upon a percentage of the working capital fund balance of PDS) for supporting efforts to secure licensing agreements by TPL on behalf of PDS. During the threesix months ended August 31,November 30, 2011 and 2010, PDS expensed $500,000$1,000,000 and $0,$500,000, respectively, pursuant to this commitment.  This expense is recorded in the accompanying statements of operations presented below.

PDS reimburses TPL for payment of all legal and third-party expert fees and other related third-party costs and other expenses.  During the threesix months ended August 31,November 30, 2011 and 2010, PDS expensed $1,635,516$3,296,798 and $615,585,$2,017,463, respectively, pursuant to the agreement.  These expenses are recorded in the accompanying PDS statements of operations presented below.

On April 12, 2010, we filed an action against TPL in the San Diego Superior Court.  On January 19, 2011, pursuant to our settlement agreement with TPL, PDS agreed to pay TPL $67,000 per month from September 1, 2010 to April 30, 2011 relating to TPL’s special work and effort regarding internal costs related to litigation support and patent re-examinations.

On April 22, 2010, we filed an action against TPL in the Superior Court of Santa Clara County.  We and TPL had been in negotiations to restructure our relationship.  On October 6, 2011, we announced that we had settled this action (see Note 11).action.  Pursuant to this executed settlement agreement with TPL, PDS agreed to pay TPL $172,000 for June 2011, and $86,000 per month thereafter until 60 days after the Markman hearing relating to TPL’s special work and effort regarding internal costs related to litigation support.  Accordingly, we havePDS has accrued $344,000$602,000 at August 31,November 30, 2011 pursuant to the executed settlement agreement and this expense is recorded in the accompanying PDS statements of operations presented below.

During the three months ended August 31,November 30, 2011 and 2010, TPL entered into licensing agreements with third parties, pursuant to which PDS received aggregate proceeds of $512,300$45,000 and $0,$1,409,000, respectively.

During the six months ended November 30, 2011 and 2010, TPL entered into licensing agreements with third parties, pursuant to which PDS received aggregate proceeds of $557,300 and $1,409,000, respectively.

At August 31,November 30, 2011, PDS had accounts payable balances of approximately $2,026,000$2,965,704 and $227,000 to TPL and PTSC, respectively.  At May 31, 2011, PDS had accounts payable balances of approximately $1,754,000 and $129,000 to TPL and PTSC, respectively.

At October 7, 2011,On January 9, 2012, PDS’ cash and cash equivalents balance was $79,130.$314,388.  Management has concluded that PDS’our equity investment at risk in PDS is insufficient to finance its activities as the volume of license revenue has not supported litigation costs independent of additional working capital funding.

We have not provided financial support to PDS other than required capital contributions and the $200,000 contribution we agreed to make in December 2011 as described above, and we are not contractually obligated to provide financial support to PDS other than to fund the working capital account at the discretion of PDS’ management committee.  In the event we, and not TPL, provide working capital funding to PDS we would consolidate PDS’ financial statements with our own as our ownership in PDS would be greater than 50%.

Our variable interest in PDS consists of 50% of PDS’ Members Equity (Deficit) or $(732,286)in addition to the accounts payable balance due us for a total of $(2,017,797) at August 31,November 30, 2011.  We are unable to quantify our maximum exposure to loss associated with this VIE, however, we do not have any contractual commitments and do not intend to fund any cash requirements of PDS.

PDS’ balance sheets at August 31,November 30, 2011 and May 31, 2011 and statements of operations for the three and six months ended August 31,November 30, 2011 and 2010 are as follows:

Investment in Affiliated Company (continued)