INHC Innolog Holdings Corporation (CE)

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011

Note 1: Organization and Nature of Business and Basis of Presentation

Organization and Nature of Business

Innolog Holdings Corporation (“Holdings” or “Innolog”) was formed as a holding company on March 23, 2009 for the purpose of acquiring companies that provide services primarily to federal government entities. Its wholly owned subsidiaries are Innolog Group Corporation and Innovative Logistics Techniques, Inc. (“Innovative”). Holdings was previously a wholly owned subsidiary of Galen Capital Corporation (“Galen”). In June 2010, Holdings was spun out and the stockholders of Galen became the stockholders of Holdings.

Innovative Logistics Techniques, Inc., a Virginia corporation, formed in March 1989, is a solutions oriented organization providing supply chain logistics and information technology solutions to clients in the public and private sector. Innovative's services and solutions are provided to a wide variety of clients, including the Department of Defense, Department of Homeland Security and civilian agencies in the federal government and state and local municipalities, as well as selected commercial organizations.

Innolog Holdings Corporation and its wholly owned subsidiary are referred to herein as the “Company.”

Basis of Presentation

In the opinion of management, all adjustments consisting of normal recurring accruals considered necessary for a fair presentation have been included. Accordingly, the results from operations for the nine months period ended September 30, 2012, are not necessarily indicative of the results that may be expected for the year ending December 31, 2012. The unaudited condensed consolidated financial statements should be read in conjunction with the December 31, 2011 consolidated financial statements and footnotes thereto included in the Company's SEC Form 10-K.

The unaudited condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant inter-company transactions and balances have been eliminated in consolidation

Note 2: Going Concern

The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with generally accepted accounting principles, which contemplate continuation of the Company as a going concern. However, the Company has sustained substantial operating losses since inception, the Company has reported a net loss of $3,170,835 for the nine months ended September 30, 2012 and $2,179,852 for the nine months ended September 30, 2011. As of September 30, 2012 the Company has reported an accumulated deficit of $15,439,209, had a stockholders’ deficiency (defined as total assets minus total liabilities) of $12,111,911 and a working capital deficit (current liabilities minus current assets) of $10,248,082. There are delinquent claims and obligations, such as payroll taxes, employee income tax withholdings, employee benefit plan contributions, delinquent loans payable and accounts payable that could ultimately cause the Company to cease operations.

The Company anticipates it may not have sufficient cash flows to fund its operations over the next twelve months without the completion of additional financing. The unaudited condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of asset carrying amounts or the amounts and classification of liabilities that might result should the Company be unable to continue as a going concern.

The report of the Company’s independent registered public accounting firm relating to the December 31, 2011 consolidated financial statements states that there is substantial doubt about the Company’s ability to continue as a going concern.

Management believes that actions presently being taken such as continued expense reduction, the implementation of a renewed sales effort and the capital financing efforts of the Company will help to enhance the Company’s operating and financial weaknesses.

Note 3: Summary of Significant Accounting Policies

Principles of Consolidation:

The unaudited condensed consolidated financial statements include the assets, liabilities and operating results of Holdings and it’s wholly owned subsidiary since the date of the acquisition. All significant intercompany accounts and transactions have been eliminated in consolidation.

Use of Estimates:

Management uses estimates and assumptions in preparing these financial statements in accordance with accounting principles generally accepted in the United States of America. Those estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses. Actual results could vary from the estimates.

Cash and cash equivalents:

For the purpose of the statements of cash flows, Company has considered all highly liquid investments purchased with original maturities of three months or less to be cash equivalents.

Reclassifications:

Certain items in prior unaudited condensed consolidated financial statements are reclassified to conform to the current presentation. These reclassifications had no effect on reported net loss.

Contract Revenue Recognition:

Revenue on cost-plus-fee contracts is recognized to the extent of costs incurred plus provisional rates for fringe, overhead and applied G&A, plus a percentage of fees earned. On fixed price service contracts, revenue is recognized using straight line over the life of the project. Revenue on time-and-materials contracts is recognized at contractual rates as hours and out of pocket expenses are incurred. Anticipated losses on contracts are recognized in the period they are first determined.

Concentration of Credit Risk:

The Company maintains its cash, which, at times may exceed federally insured limits, in bank deposit accounts with a high credit quality financial institution. The Company believes it is not exposed to any significant credit risk with regards to those accounts. Accounts receivable principally consist of amounts due from the federal government and large prime federal government contractors. Management believes associated credit risk is not significant.

Allowance for Doubtful Accounts:

The Company provides an allowance for doubtful accounts equal to the estimated collection losses that will be incurred in collection of all receivables. Estimated losses are based on historical collection experience coupled with review of the current status of existing receivables. The allowance for doubtful accounts amounted to $35,590 at September 30, 2012 and December 31, 2011.

Property and Equipment:

Property and equipment are stated at cost and depreciated by the straight-line method over estimated useful lives which are as follows:

Leasehold improvements and lease acquisition costs are amortized over the shorter of the life of the applicable lease or the life of the asset. Maintenance and repairs are charged to operations when incurred. Betterments and renewals are capitalized. When property and equipment are sold or otherwise disposed of, the asset account and related accumulated depreciation account are relieved, and any gain or loss is included in operations.

Long-Lived Assets:

The Company follows Accounting Standards Codification subtopic 360-10, Property, Plant and Equipment (“ASC 360-10”). ASC 360-10 requires those long-lived assets and certain identifiable intangibles held and used by the Company be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of any asset may not be recoverable. Events relating to recoverability may include significant unfavorable changes in business conditions, recurring losses, or a forecasted inability to achieve break-even operating results over an extended period. An impairment loss would be recognized when the estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition is less than the carrying amount. If impairment is indicated, the amount of the loss to be recorded is based on an estimate of the difference between the carrying amount and the fair value of the asset. Fair value is based upon discounted estimated cash flows expected to result from the use of the asset and its eventual disposition and other valuation methods.

Goodwill:

In accordance with FASB ASC 350, “Intangibles – Goodwill and Other”, goodwill is tested for impairment at least annually. There was no impairment loss recorded for the period ended September 30, 2012.

Income Taxes:

Effective January 1, 2009, the Company has adopted the provisions of FASB ASC 740, “Income Tax” which clarifies the accounting for uncertainty in tax positions. FASB ASC 740 requires the recognition of the impact of a tax position in the financial statements if that position is more likely than not to be sustained on a tax return upon examination by the relevant taxing authority, based on the technical merits of the position. The adoption of FASB ASC 740 had no effect on the Company’s financial position or results of operations. At September 30, 2012, the Company has no unrecognized tax benefits.

The Company files a consolidated federal income tax return. Income taxes are accounted for using the asset and liability method under FASB ASC 740 “Income Tax”, whereby deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of assets and liabilities, and their respective tax basis, and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities due to a change in tax rates is recognized as income in the period that includes the enactment date. Estimates of the realization of deferred tax assets are based on the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies.

The Company applies the provisions of FASB ASC 740, which clarifies the accounting for uncertainty in tax positions. FASB ASC 740 requires the recognition of the impact of a tax position in the financial statements if that position is more likely than not to be sustained on a tax return upon examination by the relevant taxing authority, based on the technical merits of the position. At September 30, 2012, the Company has no unrecognized tax benefits.

Stock Based Compensation:

The Company follows Accounting Standards Codification subtopic 718-10, Compensation (ASC 718-10”) which requires that all share-based payments to both employees and non employees be recognized in the income statement based on their fair values at the grant date and recognizes expense over the requisite service period.

Debt Issuance Costs:

Debt issuance costs are capitalized and amortized over the term of the related loan.

Fair Value Measurements:

FASB ASC 820, “Fair Value Measurements and Disclosures”, establishes a framework for measuring fair value. That framework provides a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurements) and the lowest priority to unobservable inputs (level 3 measurements). The three levels of the fair value hierarchy under FASB ASC 820 are described as follows:

Level 1: Inputs to the valuation methodology are unadjusted quoted prices for identical assets or liabilities in active markets that the plan has the ability to access.

If the asset or liability has a specified (contractual) term, the level 2 input must be observable for substantially the full term of the asset or liability.

The asset or liability’s fair value measurement level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. Valuation techniques used need to maximize the use of observable inputs and minimize the use of unobservable inputs.

The following is a description of the valuation methodologies used for assets and liabilities measured at fair value:

The preceding methods described may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, although the Company believes its valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement at the reporting date.

Earnings (loss) per Share:

The Company follows Accounting Standards Codification subtopic 260-10, Earnings Per Share (“ASC 260-10”) specifying the computation, presentation and disclosure requirements of earnings per share information. Basic earnings (loss) per share (“EPS”) is computed by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding during the period, excluding the effects of any potentially dilutive securities. Diluted EPS gives effect to the dilutive potential of shares of common stock outstanding during the period including stock options or warrants, using the treasury stock method (by using the average stock price for the period to determine the number of shares assumed to be purchased from the exercise of stock options or warrants), and convertible debt or convertible preferred stock, using the if-converted method. Diluted EPS excludes the dilutive potential of shares of common stock if their effect is anti-dilutive.

The computation of basic and diluted loss per share for the nine months ended September 30, 2012 and September 30, 2011 is equivalent since the Company reported a net loss and the effect of any common stock equivalents would be anti-dilutive.

Recent Accounting Pronouncements:

Management does not believe that any recently issued, but not yet effective accounting standards, if adopted, will have a material effect on the Company's unaudited condensed consolidated financial statements.

Note 4: Major Customers

Revenues from prime contracts and subcontracts with U.S. Government agency customers in aggregate accounted for 100% of total revenues for the nine months ended September 30, 2012 and 2011.

Contract receivables from prime contracts and subcontracts with U.S. Government agency customers in aggregate accounted for 100% of total contract receivables at September 30, 2012 and December 31, 2011.

Note 7: Line of Credit

On June 14, 2011, Holdings renewed a credit agreement with Eagle Bank under which it may borrow up to $500,000. Borrowings under the agreement are guaranteed by seven individuals, who are directly or indirectly related to Holdings. The borrowings were due on August 26, 2012, if not demanded earlier. Interest is payable monthly at the bank’s prime rate (as defined) plus 1%. At September 30, 2012, the interest rate was 5.25%. The outstanding balance as of September 30, 2012 and December 31, 2011 is $0 and $497,570, respectively. This line of credit was paid in full and cancelled on September 28, 2012.

As of September 30, 2012 and December 31, 2011, there were $718,500 and $897,000 of the notes outstanding, respectively, issued to individuals, trusts, and corporations not related to the Company. For new notes during 2011, the lenders were granted warrants to purchase 4,077,500 shares of Innolog common stock at a strike price ranging from $0.01 per share to $0.50 per share and to be issued 300,000 shares of Series A preferred stock. The value of these warrants and preferred stock was $40,994. The entire amount was charged to expense during the twelve months ended December 31, 2011. During the nine months ended September 30, 2012, the Company issued 300,000 Series A Convertible Preferred Stock valued at $3,000. In addition, for one of the notes in the amount of $100,000, the lender received 452,000 shares of Series A Convertible Preferred Stock and for other notes totaling $150,000 the lender received 500,000 registered shares of common stock from the former sole stockholder of the Company, Galen. In exchange, the Company issued 1,000,000 unregistered shares of its common stock to Galen. The value of these shares was $64,700 on the date of the loan. The entire amount was charged to expense during the twelve months ended December 31, 2011. During the nine months ended September 30, 2012 the lenders were granted warrants to purchase 6,757,000 shares of Innolog common stock at a strike price $0.01 per share and to be issued 625,000 shares of common stock. The value of these warrants and common stock was $433,459. The entire amount was charged to expense during the nine months ended September 30, 2012.

Of these loans, $543,500 and $272,000 have matured as of September 30, 2012 and December 31, 2011, respectively and are in default. Additional interest and late fees are due upon default as defined in each note. Total interest and fees incurred on these notes amounted to $496,738 and $606,936 for the nine months ended September 30, 2012 and 2011, respectively. Total interest and fees accrued on these notes amounted to $492,382 and $532,211 as of September 30, 2012 and December 31, 2011, respectively.

On August 11, 2010 Farzin Ferdowsi loaned the Company $75,000 with a maturity date of October 11, 2010. The loan is unsecured and carries a flat interest rate of $22,500. In addition, on December 12, 2011 Mr. Ferdowsi loaned the Company $200,000 with a maturity date of January 12, 2012. The loan was secured by accounts receivable, guaranteed by Ian Reynolds, a director, and carried a flat interest rate of $25,000. As of September 30, 2012 and December 31, 2011 the total outstanding balance is $13,500 and $237,500 with accrued interest of $73,355 and $57,295, respectively. The loan is in default and carries a default interest rate of 15% per annum.

On August 30, 2010 Isabella Chester loaned the Company $25,000 with a maturity date of December 6, 2010. The loan is unsecured and carried a flat interest rate of $5,000. As of September 30, 2012 and December 31, 2011 the outstanding balance is $25,000 with accrued interest of $63,266 and $40,766, respectively. The loan is in default and carries a default interest rate of 10% per month.

On July 13, 2010 James Warring loaned the Company $100,000 with a maturity date of January 13, 2011. The loan is unsecured and carried a flat interest rate of $30,000. As of September 30, 2012 and December 31, 2011 the outstanding balance is $100,000 with accrued interest of $56,055 and $44,795, respectively. The loan is in default and carries a default interest rate of 15% per annum.

On July 20, 2010 Robert Hacker loaned the Company $65,500 with a maturity date of January 20, 2011. The loan is unsecured and carried a flat interest rate of $19,650. As of September 30, 2012 and December 31, 2011 the outstanding balance is $65,500 with accrued interest of $36,716 and $29,341, respectively. The loan is in default and carries a default interest rate of 15% per annum.

On July 20, 2010 Thomas Jackson loaned the Company $34,500 with a maturity date of January 20, 2011. The loan is unsecured and carried a flat interest rate of $10,350. As of September 30, 2012 and December 31, 2011 the outstanding balance is $19,500 with accrued interest of $18,897 and $14,560, respectively. The loan is in default and carries a default interest rate of 15% per annum.

On July 21, 2010 John Morrison loaned the Company $25,000 with a maturity date of January 21, 2011. The loan is unsecured and carried a flat interest rate of $7,500. As of September 30, 2012 and December 31, 2011 the outstanding balance is $20,000 with accrued interest of $26,058 and $23,806, respectively. The loan is in default and carries a default interest rate of 15% per annum.

On July 29, 2010 BDR Avanti loaned the Company $20,000 with a maturity date of August 27, 2011. The loan is secured with accounts receivable and carried a flat interest rate of $2,000. As of September 30, 2012 and December 31, 2011 the outstanding balance is $0 and $4,500 with accrued interest of $0 and $10,802, respectively. The loan is paid in full.

On August 1, 2010 YG Funding loaned the Company $200,000 with a maturity date of September 14, 2011. The loan is secured by accounts receivable and carried a flat interest rate of $20,000. As of September 30, 2012 and December 31, 2011 the outstanding balance is $0 and $200,000 with accrued interest of $39,033 and $13,346, respectively. The principal of the loan is paid in full.

On August 8, 2011 YG Funding, Briarwood Capital, and Gary Bondi loaned the Company $225,000 with a maturity date of November 8, 2011. The loans are secured and carried a flat interest rate of $50,000. As of September 30, 2012 and December 31, 2011 the outstanding balance is $200,000 and $225,000 with accrued interest of $141,260 and $42,100, respectively. The loans are in default and carry a late fee of 10% per month and a default interest rate of 28% per annum, compounded monthly until paid in full. The loans are guaranteed by Ian Reynolds, a director. The Company was obliged to issue 1,000,000 warrants subsequently to be issued which was valued at $60,022 and charged to operations as interest expense.

On March 22, 2011 Atlas Advisors LLC entered into a line of credit in the amount of up to $200,000 with the Company with a maturity date of October 21, 2011. The loan was secured by accounts receivable and carried a flat interest rate of 10% on each draw. As of March 31, 2012 and December 31, 2011 the outstanding principal balance was $0. On March 9, 2012 the Company entered into a settlement agreement with Atlas, which reduced the remaining accrued interest and fees of $120,000 to $56,250 payable in 3 installments of $18,750 on March 15, 2012, April 15, 2012, and May 15, 2012 plus 500,000 warrants at an exercise price of $0.01 and expires on March 15, 2017. The Company has determined through a Black Scholes analysis that the fair value of the warrants was $21,290 at the time of issue (note 13); the balance of $42,460 was accounted for as gain on legal settlement for nine month ended September 30, 2012. As of September 30, 2012 all obligations had been paid in full.

On February 7, 2012 Kay M. Gumbinner Trust loaned the Company $100,000 with a maturity date of February 22, 2012. The loan was secured by accounts receivable and carried a flat interest rate of $8,000. As of March 31, 2012 the principal and accrued interest is paid in full.

On February 28, 2012 and March 2, 2012 Atlas Advisors LLC loaned the Company a total of $100,000. The loans have matured. The company has agreed to a payment of $12,000 per month in penalties and late fees. As of September 30, 2012 the outstanding balance is $100,000 with accrued interest of $12,841. The loan is guaranteed by Ian Reynolds, a director. The loan is in default and carries a default interest rate of 18% per annum.

On July 6, 2012, the Company borrowed $50,000 from the Kay M. Gumbinner Trust. The loan carried a flat fee of $4,000 and a maturity date of July 31, 2012. In addition, warrants of 100,000 were granted for the purchase of common stock with a strike price of $0.01 and an expiration date of 5 years. A director also guaranteed this loan. This loan has been paid in full.

On July 23, 2012, the Company borrowed $55,000 from the Kay M. Gumbinner Trust. The loan carried a flat fee of $4,500 and a maturity date of August 22, 2012. In addition, warrants of 110,000 were granted for the purchase of common stock with a strike price of $0.01 and an expiration date of 5 years. A director also guaranteed this loan. This loan has been paid in full.

On August 6, 2012, the Company borrowed $75,000 from the Kay M. Gumbinner Trust. The loan carried a flat fee of $6,500 and a maturity date of August 31, 2012. In addition, warrants of 150,000 were granted for the purchase of common stock with a strike price of $0.01 and an expiration date of 5 years. A director also guaranteed this loan. This loan has been paid in full.

On August 21, 2012, the Company borrowed $75,000 from the Kay M. Gumbinner Trust. The loan carried a flat fee of $4,500 and a maturity date of September 14, 2012. In addition, warrants of 150,000 were granted for the purchase of common stock with a strike price of $0.01 and an expiration date of 5 years. A director also guaranteed this loan. This loan has been paid in full.

On September 5, 2012, the Company borrowed $75,000 from the Kay M. Gumbinner Trust. The loan carried a flat fee of $4,500 and a maturity date of September 28, 2012. In addition, warrants of 150,000 were granted for the purchase of common stock with a strike price of $0.01 and an expiration date of 5 years. A director also guaranteed this loan. This loan has been paid in full.

On September 21, 2012, the Company borrowed $75,000 from the Kay M. Gumbinner Trust. The loan carried a flat fee of $4,500 and a maturity date of October 12, 2012. In addition, warrants of 150,000 were granted for the purchase of common stock with a strike price of $0.01 and an expiration date of 5 years. A director also guaranteed this loan. As of September 30, 2012, $75,000 is outstanding with accrued interest of $4,500.

On July 9, 2012, the Company borrowed $100,000 from Atlas Advisors. The loan carried a flat fee of $10,000 and a maturity date of July 24, 2012. A director also guaranteed this loan. This loan is paid in full.

On August 7, 2012, the Company borrowed $100,000 from Atlas Advisors. The loan carried a flat fee of $10,000 and a maturity date of August 22, 2012. In addition, warrants of 100,000 were granted for the purchase of common stock with a strike price of $0.01 and an expiration date of 5 years. A director also guaranteed this loan. This loan is paid in full.

On August 23, 2012, the Company borrowed $100,000 from Atlas Advisors. The loan carried a flat fee of $15,000 and a maturity date of September 14, 2012. In addition, warrants of 200,000 were granted for the purchase of common stock with a strike price of $0.01 and an expiration date of 5 years. A director also guaranteed this loan. The loan is paid in full.

On September 21, 2012, the Company borrowed $100,000 from Atlas Advisors. The loan carried a flat fee of $10,000 and a maturity date of October 14, 2012. In addition, warrants of 100,000 were granted for the purchase of common stock with a strike price of $0.01 and an expiration date of 5 years. A director also guaranteed this loan. As of September 30, 2012, $100,000 is outstanding with accrued interest of $10,000.

Note 9: Related Party Transactions

Notes Payable, affiliates:

At September 30, 2012 and December 31, 2011, notes payable, affiliates consisted of the following:

As of September 30, 2012 and December 31, 2011, $3,008,197 and $2,500,801 were outstanding, respectively, on the notes payable to related parties. In 2011, these parties were granted warrants to purchase 5,655,000 shares of Innolog common stock. The strike price to purchase the common stock ranges from $0.01 to $0.50 per share with a 5-year expiration date. The fair value of these warrants amounted to $46,180 and was amortized to interest expense during the twelve months ended December 31, 2011. Of these notes, $768,197 and $451,417 were in default as of September 30, 2012 and December 31, 2011, respectively. Total interest and fees incurred on these notes amounted to $255,548 and $180,467 during the nine months ended September 30, 2012 and 2011. Total interest and fees accrued on these notes amounted $360,502 and $236,952 as of September 30, 2012 and December 31, 2011, respectively.

On August 4, 2011, Ian Reynolds, a director, entered into a $200,000 unsecured line of credit with the Company. Each advance under the line of credit had a due date of 30 days. Interest was a 10% flat rate of the principal of each advance. The line of credit matured as of December 31, 2011. As of September 30, 2012 and December 31, 2011 the outstanding principal was $52,600 and $87,100. Accrued interest and fees totaled $46,304 at September 30, 2012 and $54,996 at December 31, 2011. The Company is in default and default rate of interest is 15% per annum.

On February 10, 2011, Harry R. Jacobson, a holder of more than 5% of common stock, loaned the Company a total of $150,000. At least 50% of the loan must be repaid by October 31, 2011 with a final maturity of October 31, 2012. As of September 30, 2012 and December 31, 2011, $150,000 remained outstanding. The unsecured note carried a flat interest rate of $15,000. As of September 30, 2012 and December 31, 2011the accrued interest is $15,000.

On March 21, 2011, Harry R. Jacobson, a holder of more than 5% of our common stock, renewed a loan to the Company totaling $50,000. The unsecured note carried a flat interest rate of $10,000 and was to be paid back in monthly installments of $10,000 beginning April 21, 2011 with final payment due on September 21, 2011. The outstanding balance of the loan as of September 30, 2012 and December 31, 2011 was $40,000. As of September 30, 2012 and December 31, 2011the accrued interest is $14,623. The loan has matured and is in default but per the note no late fees or default interest is due.

On March 21, 2011, the Company assumed an unsecured loan from Erich Winkler, a director, in the amount of $325,000. The interest rate on the loan was a flat fee of $32,500 and the loan matured on March 21, 2012. As of September 30, 2012 and December 31, 2011 the outstanding balance was $325,000 with accrued interest of $60,931 and $32,500, respectively. The loan has matured and is in default and carries default rate of interest of 18% per annum.

On October 19, 2011, December 7, 2011 and December 21, 2011, Erich Winkler, a director, loaned the Company additional funds totaling $75,000. As of December 31, 2011, $25,000 in principal amount of these notes has been repaid leaving a remaining balance due of $50,000 and interest in the amount of $5,000 has accrued. As of September 30, 2012 the outstanding balance is $25,000 with accrued interest of $4,265.

On February 13, 2012 and February 22, 2012, Erich Winkler, a director, loaned the Company additional funds totaling $50,000. As of September 30, 2012, the outstanding balance is $31,250 and interest in the amount of $4,401 has accrued. These loans mature on April 29, 2012 and May 7, 2012, respectively and are now in default and carries a default interest rate of 18% per annum.

On June 21, 2011, Galen Capital, a holder of more than 5% of our common stock, loaned the Company a total of $70,000. As consideration for these loans, a fee of $7,000 was expensed. As of September 30, 2012 this unsecured loan has an outstanding balance of $70,000 and has matured and the Company is in default. The loan is accruing interest at 28% per annum and a late fee of 10% of the outstanding balance each month. Total accrued interest and fees amount to $128,412 and $50,699 at September 30, 2012 and December 31, 2011, respectively.

On August 9, 2011 and September 23, 2011, Jacque Barlow, an employee of the Company, loaned the Company a total of $50,000. As of September 30, 2012, all principal and interest has been paid in full.

On October 18, 2011 and December 21, 2011, Bruce Riddle, a director, loaned the Company a total of $50,000. As of September 30, 2012 and December 31, 2011, $0 and $25,000 in principal amount of these notes is outstanding. Interest in the amount of $8,314 and $5,000 has accrued at September 30, 2012 and December 31, 2011, respectively. The principal amount of the loan has been paid in full.

On September 28, 2012, Bruce Riddle, a director, loaned the Company $25,000. As of September 30, 2012, $25,000 in principal amount is outstanding. Interest in the amount of $2,500 has accrued at September 30, 2012. The principal is due on October 28, 2012 and November 28, 2012 in two installments of $12,500 each.

On September 28, 2012, Michael Kane, a director and officer of the company, loaned the Company $65,000. As of September 30, 2012, $65,000 in principal amount is outstanding. Interest was in the form of 132,000 warrants. The principal payments of $15,000 on or before October 8, 2012, $25,000 by November 8, 2012 and $25,000 by December 8, 2012 are due.

Since early 2009 Verle Hammond, a former director and former officer, loaned the Company funds at various dates. As of September 30, 2012 and December 31, 2011, the outstanding balance was $224,347 and $229,317, respectively. Interest in the amount of $67,468 and $41,835 has accrued as of September 30, 2012 and December 31, 2011, respectively. The loans have matured and are in default. The default rate of interest is 15% per annum.

Holdings and Innovative (the “Borrowers”) have entered into an agreement (the “Loan Agreement”) with seven individuals (the “Lenders”) who are directly or indirectly related to Holdings, under which the Borrowers may borrow up to $2,000,000. The total borrowings as of September 30, 2012 and December 31, 2011 amounted to $2,000,000 and $1,499,384, respectively, collateralized by substantially all assets of the Borrowers and guaranteed by Galen. Repayment of the loan is due a on May 31, 2017.. In order to make the loan to the Borrowers, the Lenders borrowed $1,000,000 from Eagle Bank and $1,000,000 from Reliant Bank. The promissory note to Eagle Bank has a maturity date of August 26, 2013 and interest is payable monthly at the bank’s prime rate (as defined) plus 1% with a minimum rate of 7.5%. The promissory note to Reliant Bank has a maturity date of March 28, 2014 and interest is payable monthly at fixed rate of 7.0%. In addition, the Reliant Bank loan is secured by a $250,000 deposit, of which $165,000 was deposited by the Company. Interest is directly paid by the Company to the banks on a monthly basis.

Convertible Notes Payable Long Term, affiliates:

At September 30, 2012 and December 31, 2011, notes payable long term, affiliates consisted of the following:

On March 31, 2012, March 21, 2012, March 29, 2012, April 2, 2012, April 10, 2012, April 12, 2012, and April 16, 2012 Glen Hill Investments, LLC an affiliate of a holder of more than 5% of our common stock, loaned the Company $300,000, $200,000, $300,000, $300,000, $100,000, $100,000, and $400,000 respectively. The unsecured loans had a maturity date of May 31, 2012 and carry a 6% per annum interest rate.

On May 21, 2012 the Company entered into a Convertible Notes Purchase Agreement for up to $6,000,000 collateralized by substantially all assets of the Borrowers (“Holdings and Innovative”) with a maturity date of May 31, 2017 and a 6% per annum rate of interest. The interest accrues and is payable at maturity.  As of September 30, 2012 the accrued interest is $38,260. The convertible promissory notes plus accrued interest under the Note Purchase Agreement are convertible into a Series B Convertible Preferred Stock on a dollar for dollar basis. The Series B has a liquidation preference and is convertible into common shares at a conversion price of $0.076 per share.  The investors have a first lien position on the assets of the Company on a pari passu basis with the holders of other affiliated debt.   Glen Hill Investments, LLC rolled its short-term loans above into this agreement. In addition, the Glen Hill Investments, LLC note is secured by a substantial portion of the directors of the Company stock holdings. Glen Hill Investments, LLC received 8,750,000 warrants for the purchase of the Company common stock at an exercise price of $.069 per share with an expiration date of May 31, 2017.

  In accordance with Accounting Standards Codification 470-20-65, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios (“ASC 470-20-65”), the Company recognized an imbedded beneficial conversion feature present in the notes. The Company recognized a debt discount of $1,360,869, which was equal to the intrinsic value of the imbedded beneficial conversion feature .  The Company also recorded a net of a deferred debt discount of $347,711 based on the relative fair value of the warrants under the Black-Scholes pricing model based on the following assumptions: (1) risk free interest rate of 0.72%; (2) dividend yield of 0%; (3) volatility factor of the expected market price of the Company common stock of 74.85%; and (4) an expected life of the warrants of 5 years. Total debt discount of $1,708,581 is attributed to the beneficial conversion feature were recognized to additional paid in capital and a discount against the Note. The debt discount is being amortized over the Notes maturity period (five years) as interest expense.  During the three and nine months ended September 30, 2012, the Company recorded amortization of the debt discount relating to these notes of $85,429 and $124,010, respectively.

Consulting Agreement:

In 2011, the Company entered into a verbal agreement with a greater than 5% shareholder for advisory services. On July 11, 2011 the shareholder was granted warrants for 10,000,000 common shares at a strike price of $0.06 per share with an expiration date of five years. The fair value of $18,700 on this warrants were charged to expenses during the year 2011.

Legal Fees:

During the nine months ended September 30, 2012 and September 30, 2011, the Company incurred legal fees in the amount of $110,840 and $195,000 respectively on behalf of its executive officer in defense of an investigation by a governmental agency.

Note 10: Commitments and Contingencies

Leases:

The Company leases office space in Washington, D.C. and Fairfax, Virginia under operating leases expiring at various dates through 2016. The premises leases contain scheduled rent increases and require payment of property taxes, insurance and certain maintenance costs. The minimum future commitments under lease agreements existing as of September 30, 2012 are approximately as follows:

Total rent expense amounted to $172,895 and $229,720 for the nine months ended September 30, 2012 and 2011, respectively.

In 2010, Innovative vacated its office space prior to expiration of the lease. The landlord subsequently filed a lawsuit against the Company under which it pursued total damages of approximately $1,000,000, which approximates the rent charges for the remaining term of the lease. On February 14, 2011, Innovative entered into a settlement agreement in which it agreed to a payment of $350,000 on May 31, 2011. In the event Innovative did not make the payment timely, it agreed to a confessed judgment in the amount of $936,510 and this amount was included in other accrued liabilities as of December 31, 2010. In July 2011, the settlement agreement was amended to extend the $350,000 payment till August 8, 2011. The entire $350,000 was paid in full by August 8, 2011. As such, $586,510 was recognized as a gain from legal settlement during the twelve months ended December 31, 2011.

Late Deposit of Payroll Taxes and Employee Income Tax Withholdings:

At September 30, 2012, the Company is delinquent with filing and remitting payroll taxes of approximately $4,140,073 including estimated penalties and interest related to payroll taxes withheld since December 31, 2009. The Company has recorded the delinquent payroll taxes, which are included in accrued expenses on the balance sheet. Although the Company has not entered into any formal repayment agreements with the applicable tax authorities, management plans to make payment as funds become available. Penalties and interest amounts are subject to increase based on a number of factors that can cause the estimated liability to increase further. Interest and penalties were accrued in an amount estimated to cover the ultimate liability As of September 30, 2012 and December 31, 2011, the total of payroll tax accrued and income tax withheld balances including penalties and interest, amounted to $4,140,073 and $3,694,635, respectively. The Company is currently in discussions with the taxing authorities to develop a payment plan. On April 25, 2011 the taxing authorities filed a notice of federal tax lien in the amount of $614,990 in Fairfax, VA.

Employment Agreement:

On April 1, 2009, Innovative entered into an employment agreement with its President and Chief Executive Officer through March 31, 2014, which provides for a minimum annual salary of $198,000. At January 31, 2012 this agreement was cancelled and replaced by a consulting agreement as the President and Chief Executive Officer of Innovative retired.

Contracts:

Substantially all of the Company’s revenues have been derived from prime or subcontracts with the U.S. government. These contract revenues are subject to adjustment upon audit by the Defense Contract Audit Agency. Audits have been finalized through 2005. Management does not expect the results of future audits to have a material effect on the Company’s financial position or results of operations.

Delinquent payables

The Company has been delinquent in numerous payables to different parties of which some filed lawsuits against the Company. All necessary accruals have been made as of September 30, 2012 and December 31, 2011 and are included in accounts payable and other accrued liabilities.

Note 11: Income Taxes

The Company’s effective income tax rate is lower than what would be expected if the federal statutory rate were applied to income from continuing operations primarily because of the deferred tax asset being fully reserved.

Temporary differences giving rise to the deferred tax assets consist primarily of the excess of the goodwill and other intangible assets for tax reporting purposes over the amount for financial reporting purposes, and net operating loss carry forwards. The Company’s ability to utilize the federal and state tax assets is uncertain; therefore the deferred tax asset is fully reserved.

At September 30, 2012, the Company had net operating loss carry forwards of approximately $10 million for federal and Virginia state tax purposes expiring through 2031.

The Company has filed extensions for its 2011 federal and state income tax returns.

The Company recognizes interest and penalties related to income tax matters in interest expense and operating expenses, respectively. As of September 30, 2012, the Company has no accrued interest and penalties related to uncertain tax positions.

Note 12: Employee Benefit Plan

Innovative has a defined contribution employee benefit plan covering all full time employees who elect to participate. The plan provides for elective salary deferrals by employees and annual elective matching contributions. There were no employer contributions for the nine months ended September 30, 2012 and 2011.

Innovative has been late in making deposits of employee deferrals. The Department of Labor has reviewed Innovative’s employee benefit plan document as well as other records to determine the status of compliance. The Department of Labor and the Company have determined that a remaining total of $183,304 is to be deposited in the plan, which includes all principal and any penalties. The Company is working with the Department of Labor on a payment plan. In addition, the Department of Labor has required that the plan be terminated.

Note 13: Capital Stock

Common Stock:

The Company has authorized 200,000,000 shares of common stock, with a par value of $0.001 per share.

As of September 30, 2012 and December 31, 2011, 15,999,538 and 15,129,973 shares, respectively, of the Company common stock were issued and outstanding.

Preferred Stock:

The Company has authorized 50,000,000 shares of preferred stock, with a par value of $0.001 per share (“Preferred Stock”). The Preferred Stock may be issued from time to time in series having such designated preferences and rights, qualifications and to such limitations as the Board of Directors may determine.

The Company has designated 38,000,000 shares of the preferred stock as Series A Convertible Preferred Stock (“Series A Stock”). The holders of Series A Stock have voting rights with a $2.00 liquidation preference per share, and may convert each share of Series A Stock into one share of common stock at any time. Series A Stock converts automatically upon the occurrence of an offering meeting certain criteria and the sale of the Company. Holders of the Series A Stock are entitled to accrue dividends based on the prior fiscal year’s net income equal to 10% of such net income.

As of September 30, 2012 and December 31, 2011, there were 37,194,758 and 36,894,758 shares, respectively, of Series A Convertible Preferred Stock outstanding and no dividends have been accrued.

The Company has designated 7,800,000 shares of the preferred stock as Series B Convertible Preferred Stock (“Series B Stock”). The holders of Series B Stock have voting rights with a two times the original issue price plus any declared or accrued but unpaid dividends liquidation preference to the Company’s Series A Convertible Preferred and Common Stock. Each share of Series B Stock may convert to common stock at any time at the conversion rate. The conversion rate is defined 120% of the average market closing price of the Common Stock as determined for the 30-day period ending two business days prior to the applicable closing under the May 21, 2012 Note Purchase Agreement. Series B Stock converts automatically upon the occurrence of a listing of the common stock on the NASDAQ or American Stock Exchange. Holders of the Series B Stock are entitled to accrue dividends based at a 6% rate per annum.

As of September 30, 2012 and December 31, 2011, there were no shares, of Series B Convertible Preferred Stock issued and outstanding and no dividends have been accrued.

Warrants:

For the three months ended March 31, 2012, the Company granted 2,047,000 warrants to various individuals in conjunction with the individuals lending the Company funds for working capital, renewals of loans and settlement of debt due. The warrants have an exercise price of $0.01 per share and a life of five years. All warrants were fully vested on the date of the grant. The Company has determined through a Black Scholes analysis that the fair value of the warrants was $87,156 at the time of issue.

The following assumptions were used in arriving at the fair value of the above noted warrants:

For the three months ended June 30, 2012, the Company granted 12,296,667 warrants to various individuals in conjunction with the individuals lending the Company funds for working capital, renewals of loans, services, and settlement of debt due. The warrants have an exercise price of $0.01 to $0.069 per share and a life of five years. All warrants were fully vested on the date of the grant. Out of total warrant issued, 2,700,000 warrants that were issued are related to Note holders, the fair value of $178,470 was determined through Black Scholes analysis which was charged as an expense, 846,667 warrants that were issued are related to service providers, the fair value of $26,525 was determined through Black Scholes analysis and was charged as an expense and 8,750,000 warrants were issued in conjunction with Convertible Note Payable (Note 9).

The following assumptions were used in arriving at the fair value of the above noted warrants:

For the three months ended September 30, 2012, the Company granted 2,692,000 warrants to various individuals in conjunction with the individuals lending the Company funds for working capital, renewals of loans, and settlement of debt due. The warrants have an exercise price of $0.01 per share and a life of five years. All warrants were fully vested on the date of the grant. The Company has determined through a Black Scholes analysis that the fair value of the warrants was $160,828 at the time of issue.

The following assumptions were used in arriving at the fair value of the above noted warrants:

A summary of the Company’s warrant activity and related information is as follows:

At September 30, 2012, there were 80,142,718 warrants outstanding and exercisable. These warrants had a weighted average exercise price of $0.28 and a weighted average remaining life of 40.8 months. The intrinsic value is not greater than the grant price.

Stock Option Plan:

The Deferred Stock and Restricted Stock Plan (the “Plan”), under which employees, officers, directors, consultants and other service providers may be granted non-qualified and/or incentive stock options. Generally, all options granted expire five years from the date of grant.  All options have an exercise price equal to or higher than the fair value of the Company’s stock on the date the options are granted.  Options generally vest over three years with the exception of the initial grants of 2010, which vested immediately.

A summary of the status of stock options issued by the Company as of September 30, 2012 is presented in the following table.

These stock options have a weighted average remaining life of 34.8 months. The intrinsic value is not greater than the grant price.

2012 Consultant Stock Plan

The 2012 Consultant Stock Plan (the “Plan”), under which consultants and other service providers may be granted shares of the Company’s Common Stock. The Company has reserved up to 5,000,000 shares under this plan. The plan will expire in 10 years. The stock under this plan has been registered under a S-8. As of the nine months ended September 30, 2012, the Company has granted 869,565 shares valued at $60,000 for services rendered in prior period. The Company issued these shares during the quarter ended September 30, 2012.

Equity Credit Line

On July 25, 2012, the Company entered into an equity credit line with Dutchess Opportunity Fund II, LP for up to $5,000,000 over a three-year term. Under this arrangement the Company may obtain working capital from Dutchess in exchange for common stock. The amount of the put is determined by 200% of the average daily volume for the 3 days prior to the put date and the purchase price is determined 95% of the volume weighted average price during the 5 trading days after the put date. As of the nine months ended September 30, 2012, this line has not been used.