Not applicable for smaller reporting companies.

As a Development Stage company, we present aPlan of Operation for the next twelve months. We have four full-time employees and no part-time employees.

The accompanying financial statements have been prepared in conformity with generally accepted accounting principles which contemplate continuation of the Company as a going concern. The Company has not generated significant revenue and from January 29, 2007, (inception) through June 30, 2012 recorded cumulative revenue of $777,142 and a cumulative net loss of $18,597,791. To date, cumulative negative cash flow from operations of $3,652,351 was funded largely with $2.8 million in equity. Total Stockholder's Deficit at June 30, 2012 was $1,963,972.

Management's plan is to generate income from operations by licensing our technology globally through our strategic partner, the Desmet Ballestra Group. WeDesmet has agreed to provide us limited advance against sales payments. As of June 30 and August 30, 2012, cumulative advances received amounted to $125,000 and $375,000 respectively. These funds pay maturing debt plus a portion of operational expenses on a monthly basis. Desmet shall be entitled to immediately terminate the present agreement in case the claims of current US Patent Application Number 12/484,981 are not granted as such or are cancelled. In addition, Desmet may terminate the agreement on August 1 of any particular year if they have not installed at least 6 Nano Reactor® devices in the previous 12 month period. CTi may terminate the Agreement for material default. This Agreement supersedes a previous agreement dated November 1, 2010, amended on June 1, 2011 and on September 2, 2011. In addition to these advances, we anticipate that we will alsoneed additional funding, and we will attempt to raise additional debt and/or equity financing to fund future operations and to provide additional working capital. However, there is no assurance that such financing will be consummated or obtained in sufficient amounts necessary to meet the Company’sCompany's needs, or that the Company will be able to meet its future contractual obligations. Should management fail to obtain such financing, the Company may curtail its operations.

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses. The accounting policies and estimates described below are those CTi considers most critical in preparing its consolidated financial statements. The following is a review of the accounting policies and estimates that include significant judgments made by management using information available at the time the estimates are made. However, these estimates could change materially if different information or assumptions were used instead.

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Note 3 to the financial statements includes a summary of the CTi’s significant accounting policies, estimates, and methods used in the preparation of CTi’sCTi's financial statements.

Management believes that the accounting estimate related to the recoverability of its intangible and long-lived assets is a “critical"critical accounting estimate”estimate" because significant changes in the assumptions used to develop the estimates could materially affect key financial measures, including net income and non-current assets.

Testing intangible and long-lived assets for impairment involves a high degree of judgment due to the assumptions that underlie the undiscounted cash flows analysis. In accordance with ASC 350-30, we evaluateevaluated long-lived assets for impairment whenever events or changes in circumstances indicate that theirthe net book value may not be recoverable. When such factors and circumstances exist, we compare the projected undiscounted future cash flows associated with the related asset or group of assets over their estimated useful lives against their respective carrying amount. Impairment, if any, is based on the excess of the carrying amount over the fair value based on market value when available or discounted expected cash flows of those assets and is recorded in the period in which the determination is made. Management believes there is no impairment of its long-lived assets. There can be no assurance, however, that market conditions will not change or demand for our products under development will continue. Either of these could result in future impairment of long-lived assets.

We account for our share-based compensation in accordance ASC 718-20. Stock-based compensation cost is measured at the grant date based on the estimated fair value of the award and is recognized as an expense over the requisite vesting period. 

Determining the fair value of share-based awards at the measurement date requires judgment, including estimating the expected term that stock options and warrants will be outstanding prior to exercise, the associated volatility, and the expected dividends. CTi estimates the fair value of options granted using the Black-Scholes valuation model. The expected life of the options used in this calculation is the period of time the options are expected to be outstanding and has been determined based on historical exercise experience. Expected stock price volatility is based on the historical volatility of CTi’sCTi's stock for a period approximating the expected life, and the risk-free interest rate is based on the implied yield available on US Treasury zero-coupon issues approximating the expected life. Judgment is also required in estimating the amount of share-based awards that will be forfeited prior to vesting. CTi believes that these assumptions are “critical"critical accounting estimates”estimates" because significant changes in the assumptions used to develop the estimates could materially affect key financial measures including net income.

Management believes that the accounting estimate related to income taxes is a “critical"critical accounting estimate”estimate" because significant judgment is required in interpreting tax regulations in the US, evaluating CTi’sCTi's uncertain tax positions, and assessing the likelihood of realizing certain tax benefits. Actual results could differ materially from those judgments, and changes in judgments could materially affect CTi’sCTi's consolidated financial statements.

We account for income taxes in accordance with ASC 740-10. We recognize deferred tax assets and liabilities to reflect the estimated future tax effects, calculated at expected future tax rates, of future deductible or taxable amounts attributable to events that have been recognized on a cumulative basis in the financial statements. A valuation allowance related to a deferred tax asset is recorded when it is more likely than not that some portion of the deferred tax asset will not be realized. Deferred tax assets and liabilities are adjusted for the effects of the changes in tax laws and rates on the date of enactment. 

ASC 740-10 prescribes a recognition threshold that a tax position is required to meet before being recognized in the financial statements and provides guidance on recognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition issues. We measure and record uncertain tax positions by establishing a threshold for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  Only tax positions meeting the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized.

In the normal course of business, CTi may be audited by federal and state tax authorities. The ultimate settlement of any particular issue with the applicable taxing authority could have a material impact on CTi’sCTi's financial statements.

As a Development Stage Enterprise, we have provided aPlan of Operation herein. Although there is no obligation for a comparisonDevelopment Stage Company to provide a discussion of Results of Operations, below is an abbreviated summary comparing fiscal 2012 and analysisfiscal 2011.

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Revenue

During fiscal 2012, revenue consisted primarily of our resultspartial payments of operations for the years ended June 30, 2011 and 2010.

Operating expenses for a NANO Neutralization System for $341,326 as well as a licensing agreement that we completed in December 2010 with a customer located in North Carolina for a 10 gallons/minute NANO Neutralization System for $187,600.  In addition, we recognized revenue of $35,000 associated with the rental of a NANO Neutralization System and $26,000 related to the sale of a Bioforce 9000 Reactor Skid System.  We recognized no revenue during the year ended June 30, 2010.

Interest expense and other consists of interest expense and change in value of derivatives.

During the year ended June 30, 2011, we issued convertible notes payable amounting to a gross face value of $151,212.  By virtue of the variable conversion ratios contained in the provisions of the agreements, the conversion features of the notes are a derivative under ASC 815-40,Derivatives and Hedging.  Accordingly, the value of the beneficial conversion feature has been classified as a derivative liability on the accompanying balance sheet.  On a quarterly basis, the value of the beneficial conversion feature is adjusted and reflected in derivative liability on the balance sheet. As of June 30, 2011, the aggregate value of the Derivative Liability associated with the above notes amounted to $121,679.  The initial aggregate Derivative Liability value upon the issuance dates amounted to $102,482.  The increase of $19,197 is recorded in Interest Expense and Other for the year ended June 30, 2011.  There was no such expense in 2010.

For fiscal 2012 gross financing of liquidity have been issuances$543,771 less $136,834 in payments on the bank loan resulted in net financing of restricted$406,937. Funding included short term loans of $214,521 which are expected to be invested in convertible promissory notes to be issued by the company. We also received $125,000 in advances against future sales from our partner, Desmet Ballestra. We sold $35,000 in common stock and warrants to service providers, salereceived net proceeds of common stock for cash, issuances of$85,000 from convertible promissory notes, and short-termnotes. Net short term loans from related parties and a strategic partner.

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Our ability to continue to issue restricted common stock and warrants in exchange for services mayaccess these sources of financing can be adversely affected by the performance of our stock price. Additionally, CTi’s ability to issue long-term debt and obtain short-term loans may be negatively impacted by domestic economic conditions that create a tight credit environment, particularlymany factors. See Note 7, "Convertible Notes Payable," Note 8 "Related Party Short-Term Loans," Note 9, "Short-Term Loans," and Note 10, "Stockholder's Equity" for development stage companies.

During fiscal 2011, we generated a gross profit2012, net use of $498,782 compared with $0 in fiscal 2010. During fiscal 2011, our net loss amounted to $3,295,428 including non-cash operating expenses of $2,711,135 arising primarily from common stock and warrants issued for services. Net cash used in operating activities in 2011 of $614,188amounted to $230,895, a 62% reduction over fiscal 2011.

This cash was used largely to pay salary and related expenses of $377,037,fixed operating costs, professional fees to attorneysservice providers such as auditors and accountants, of $124,721, R&D of $111,267, consultant fees of $88,100, as well asand interest expense on the bank debt of $39,973.

Net cash used in investing activities during fiscal 20112012 amounted to $53,574 including $22,552 for property, plant, and equipment and $31,022 for expenses related to patent filings and $123,366 in fiscal 2011 including $81,038 for the customization of demonstration systemsproperty and equipment and $42,328 for patent filing costs.  This was comparable to fiscal 2010 when we invested $187,787 including $23,820 for property

Fiscal 2012 net cash provided by financing activities of $406,939 included short term loans of $214,521, advances against sales of $125,000, related party payables/loan of $84,250, sale of common stock of $35,000, and equipment, $71,683 for$85,000 in net proceeds from the customizationissuance of systems, and $92,284convertible notes ($132,500 in patent filing costs.

Fiscal 2011 net cash provided by financing activities of $752,063 included proceeds from the sale of common stock of $572,741, convertible notes payable of $151,212, and short-term loans of $90,750. These proceeds were offset by $38,640 in payments on borrowings from our bank loan as well as a repayment of $24,000 for short term loans. Fiscal 2010 net cash provided by financing activities of $1,208,780 included proceeds from the sale of common stock of $1,231,947 and short-term loans of $109,000.  These proceeds were offset by $112,167 in payments on borrowings from our bank loan as well as repayment of $20,000 in convertible notes payable.  

The Company has no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on its financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

Not applicable for smaller reporting companies.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders

We have audited the accompanying consolidated balance sheets of Cavitation Technologies, Inc. (a development stage company) as of June 30, 20112012 and 2010,2011, and the related consolidated statements of operations, changes in stockholders’stockholders' deficit, and cash flows for the years ended June 30, 20112012 and 2010,2011, and the period from January 29, 2007 (inception date) through June 30, 2011.2012. These financial statements are the responsibility of the Company’sCompany's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’sCompany's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cavitation Technologies, Inc. as of June 30, 20112012 and 2010,2011, and the results of its operations and its cash flows for the years ended June 30, 20112012 and 20102011 and the period from January 29, 2007 (inception date) through June 30, 2011,2012, in conformity with accounting principles generally accepted in the United States of America.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company has incurred losses in developing its business and further losses are anticipated. The Company requires additional funds to meet its obligations and the costs of operations. These factors, among others, raise substantial doubt about the Company’sCompany's ability to continue as a going concern. Management’sManagement's plans in this regard are described in Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

/s/ Rose, Snyder & Jacobs

Rose, Snyder & Jacobs,

Encino, California