The accompanying notes are an integral part of these consolidated financial statements.

IsoRay, Inc. and Subsidiaries

 Consolidated Statements of Cash Flows

 (Unaudited)

IsoRay, Inc.

Notes to the Unaudited Consolidated Financial Statements

For the three and sixnine months ended DecemberMarch 31, 20132014 and 20122013

The accompanying consolidated financial statements are those of IsoRay, Inc., and its wholly-owned subsidiaries (IsoRay or the Company). All significant intercompany accounts and transactions have been eliminated in consolidation. Certain amounts in the prior-year financial statements have been reclassified to conform to the current year presentation.

In the opinion of management, the accompanying unaudited interim consolidated financial statements and notes to the interim consolidated financial statements contain all adjustments, consisting of normal recurring items, necessary to present fairly, in all material respects, the financial position of IsoRay, Inc. and its wholly-owned subsidiaries.  These unaudited interim consolidated financial statements should be read in conjunction with our audited consolidated financial statements and related footnotes as set forth in the Company’s annual report filed on Form 10-K for the year ended June 30, 2013, as it may be amended from time to time.

The results of operations for the periods presented may not be indicative of those which may be expected for a full year.  The unaudited consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) have been condensed or omitted pursuant to those rules and regulations, although we believe that the disclosures are adequate for the information not to be misleading.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements, the reported amounts of revenues and expenses during the reporting period and the disclosures of contingent liabilities.  Accordingly, ultimate results could differ materially from those estimates.

From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board (the “FASB”) or other standards setting bodies that are adopted by us as of the specified effective dates. Unless otherwise discussed, we believe the impact of recently issued standards that are not yet effective will not have a material impact on our consolidated financial position, results of operations and cash flows upon adoption.

Basic earnings per share is calculated by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding, and does not include the impact of any potentially dilutive common stock equivalents. Common stock equivalents, including warrants and options to purchase the Company's common stock, are excluded from the calculations when their effect is antidilutive. At DecemberMarch 31, 20132014 and 2012,2013, the calculation of diluted weighted average shares did not include preferred stock, common stock warrants, or options that are potentially convertible into common stock as those would be antidilutive due to the Company’s net loss position.

Securities presented on an as-converted to common stock basis, not considered in the calculation of diluted weighted average shares, but that could be dilutive in the future as of DecemberMarch 31, 20132014 and 2012,2013, were as follows:

Inventory consisted of the following at DecemberMarch 31, 20132014 and June 30, 2013:

The following table presents the share-based compensation expense recognized during the three and sixnine months ended DecemberMarch 31, 20132014 and 2012:2013:

As of DecemberMarch 31, 2013,2014, total unrecognized compensation expense related to stock-based options was $42,626$29,192 and the related weighted-average period over which it is expected to be recognized is approximately 0.820.87 years.

The Company currently provides stock-based compensation under threefour equity incentive plans approved by the Board of Directors. Options granted under each of the plans have a ten year maximum term, an exercise price equal to at least the fair market value of the Company’s common stock on the date of the grant, and varying vesting periods as determined by the Board. For stock options with graded vesting terms, the Company recognizes compensation cost on a straight-line basis over the requisite service period for the entire award.

A summary of stock options within the Company’s share-based compensation plans as of DecemberMarch 31, 20132014 was as follows:

There were no26,333 options exercised during the sixnine months ended DecemberMarch 31, 20132014 and 31,700 options exercised during the sixnine months ended DecemberMarch 31, 2012.2013. The Company’s current policy is to issue new shares to satisfy option exercises. The intrinsic value of the employee options exercised during the sixnine months ended DecemberMarch 31, 20122014 was $15,130 and the nine months ended March 31, 2013 was $13,866.

There were 65,000 stock option awards granted and no stock option awards granted during the sixnine months ended DecemberMarch 31, 20132014 and 2012,2013, respectively.

ThereOf the 65,000 options, 50,000 were 50,000 director stock options issued to the Chief Executive Officer and Chairman on September 5, 2013 with an exercise price of $0.58 per share which was the closing price of the Company common stock on the day of issuance. The fair value of the stock options issued on September 5, 2013 using a Black Scholes model is $25,150 utilizing the closing price on the day of grant of $0.58 per share as the grant and exercise price, a five year term, volatility of 132.31% and a discount rate of 1.85%.

ThereThe remaining 15,000 were 15,000 employee stock options issued to three members of management on September 6, 2013 with an exercise price of $0.59 per share which was the closing price of the Company common stock on the day of issuance. The fair value of the stock options issued on September 6, 2013 using a Black Scholes model is $6,906 utilizing the closing price on the day of grant of $0.59 per share as the grant and exercise price, a five year term, volatility of 132.31% and a discount rate of 1.77%.

Patent and Know-How Royalty License Agreement

The Company is the holder of an exclusive license to use certain “know-how” developed by one of the founders of a predecessor to the Company and licensed to the Company by the Lawrence Family Trust, a Company shareholder. The terms of this license agreement require the payment of a royalty based on the Net Factory Sales Price, as defined in the agreement, of licensed product sales. Because the licensor’s patent application was ultimately abandoned, only a 1% “know-how” royalty based on Net Factory Sales Price, as defined in the agreement, remains applicable. To date, management believes that there have been no product sales incorporating the “know-how” and therefore no royalty is due pursuant to the terms of the agreement. Management believes that ultimately no royalties should be paid under this agreement as there is no intent to use this “know-how” in the future.

The licensor of the “know-how” has disputed management’s contention that it is not using this “know-how”. On September 25, 2007 and again on October 31, 2007, the Company participated in nonbinding mediation regarding this matter; however, no settlement was reached with the Lawrence Family Trust. After additional settlement discussions, which ended in April 2008, the parties failed to reach a settlement. The parties may demand binding arbitration at any time.

The table below sets forth the Company’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of DecemberMarch 31, 20132014 and June 30, 2013, respectively, and the fair value calculation input hierarchy level the Company has determined applies to each asset and liability category. 

On December 19, 2013, the Board of Directors declared a dividend on the Series B Preferred Stock of all currently payable and accrued outstanding and cumulative dividends through December 31, 2013 in the amount of $10,632. Dividends on the Series B Preferred Stock were last paid on December 31, 2012 as declared by the Board of Directors on December 21, 2012 in the amount of $10,632. The dividends outstanding and cumulative through December 31, 2013 of $10,632 and through December 31, 2012 of $10,632 were paid as of those dates.

Common and preferred stock transactions

Series D

On August 29, 2013, the Company entered into an agreement to sell 3,800,985 common units, each consisting of 1 share of common stock and a warrant to purchase 0.816 shares of common stock (the “Common Units”), and 1,670 preferred units, each consisting of 1 share of Series D Convertible Preferred Stock and a warrant to purchase 1,525.23 shares of common stock (the “Preferred Units”) on a firm commitment underwritten basis. The Common Units were sold at an initial per unit purchase price of $0.535 and the Preferred Units were sold at an initial per unit purchase price of $1,000. The warrants arewere all exercisable at $0.72 per share are callable, and havehad a twenty-four month term, with the exercise price and term subject to reduction if shareholder approval is obtained, and are not exercisable until March 1, 2014.term. Each share of the Series D Convertible Preferred Stock iswas convertible into 1,869.15 shares of common stock at any time at the option of the holder, subject to adjustment provided that the holder will be prohibited from converting Series D Convertible Preferred Stock into shares of the Company's common stock if, as a result of such conversion, the holder, together with affiliates, would own more than 9.99% of the total shares of the Company's common stock then issued and outstanding.certain ownership percentage restrictions. The preferred shares which arewere convertible into shares of common stock containcontained a beneficial conversion feature of $726,378 which was recognized as a deemed dividend to the Series D preferred shareholders on the date of issuance. This public offering resulted in gross proceeds of $3.7 million. The offering yielded approximately $3,279,292 in cash after expenses.

Series D

Series D convertible preferredDuring January 2014, the holder of the 1,670 shares are entitled to dividends in the same form as dividends actually paid on shares of common stock. Series D convertible preferred shares are convertible into shares of common stock at the rate of 1,869.15 shares of common stock for each share of Series D convertible preferred stock (subjectfully exercised its right to adjustment as provided inconvert the certificate of designation for the Series D Convertible Preferred Stock), and are subject to conversion limitations if the conversion would result in the holder together with its affiliates, beneficially owning more than 9.99% of the total number of1,670 shares of our common stock then issued and outstanding. Series D convertible preferred shareholders shall not havestock into 3,121,480 shares of common stock which at the righttime of conversion resulted in an increase in shares of common stock outstanding from 38,419,502 to vote on any matter other than those set forth in41,540,982. Subsequent to the Certificateconversion, no shares of DesignationSeries D convertible preferred stock remain outstanding.

Common Stock

On March 21, 2014, the Company entered into a Securities Purchase Agreement with certain investors providing for the potentialsale of a total of 5,644,300 shares of common stock for an aggregate purchase price of $14,675,180 at a price per share of $2.60 (the “Registered Direct Offering”). The Company received net proceeds from the offering of approximately $13,818,927 from the Registered Direct Offering which will be used to specifically adversely affectmeet the Company’s working capital needs and general corporate purposes.

Warrant exercises

During the month of March 2014, the holder of the Series D Convertible Preferred Stock.warrants issued in November 2010 exercised its right to purchase 1,050,000 shares of common stock. Each warrant had an exercise price of $1.56 per share of Company common stock and the exercise contributed $1,638,000 in total additional cash and equity.

UponDuring the executionmonth of a fundamental transaction which effects a merger or other change of control transactionMarch 2014, certain holders of the warrants to purchase Company a holder will havecommon stock issued in the October and December 2011 equity transaction exercised their right to receive, upon anypurchase 37,574 shares of common stock. Each warrant had an original exercise price of $1.053 that was reduced in accordance with the terms of the warrant for dilution as the result of subsequent conversionofferings to a revised exercise price of a$0.944 per share of Series D Convertible Preferred Stock (in lieuCompany common stock. This created a liability of conversion shares)$35,470 as the stock had not been issued by the transfer agent as of the end of March, however, shares of common stock were issued during April in compliance with the contractual terms of the warrant.

During the month of March 2014, certain holders of the warrants to purchase Company common stock issued in the October and December 2011 equity transaction exercised their right to purchase 271,091 shares of common stock. Each warrant had an original exercise price of $1.053 that was reduced in accordance with the terms of the warrant for each issuable conversiondilution as the result of subsequent offerings to a current exercise price of $0.944 per share of Company common stock and the same kindexercise contributed $255,910 in total additional cash and amountequity.

During the month of securities,March 2014, the holders of the warrants to purchase Company common stock issued in the August 2013 equity transaction exercised their right to purchase 5,648,738 shares of common stock. Each warrant had an exercise price of $0.72 per share of Company common stock and the exercise contributed $4,067,091 in total additional cash or property as it would have been entitled to receive uponand equity.

The gross proceeds from the occurrenceexercise of such fundamental transaction if it had been, immediately prior to such fundamental transaction, the holdercommon stock warrants exercised were $5,961,001 during the nine months ended March 31, 2014, net of the $35,470 liability for the shares of common stock into which such holder's shares of Series D Convertible Preferred Stock is then convertible.were not issued until April 2014.

Warrant liability and related offering cost deferral

Based on the guidance contained in ASC 815 “Derivatives and Hedging”, management has concluded that the warrants issued in the October 13,and December 2011 underwritten registered offering of 2,500,000 shares of common stock should be classified as a derivative liability and has recorded a liability at fair value. The Company determined the fair value of the warrants using the Black-Scholes fair value model. The Company determined the fair value of the warrants on the date of the offering to be as disclosed in the tables below. The Company has recognized a change in fair value as described in the tabletables below:

Change in fair value of the derivative warrant liability for the three months ended DecemberMarch 31, 20132014 and 2012,2013, respectively.

Change in fair value of the derivative warrant liability for purchaser warrants and underwriter warrants contained in an equity transaction on October 19, 2011.

Change in fair value of the derivative warrant liability for purchaser warrants and underwriter warrants contained in an equity transaction on December 7, 2011.

Change in fair value of the derivative warrant liability for the sixnine months ended DecemberMarch 31, 20132014 and 2012,2013, respectively.

Change in fair value of the derivative warrant liability for purchaser warrants and underwriter warrants contained in an equity transaction on October 19, 2011.

Change in fair value of the derivative warrant liability for purchaser warrants and underwriter warrants contained in an equity transaction on December 7, 2011.

¹ Quantity of warrants either issued or outstanding as of the date of valuation.

Warrants

The following table summarizes the warrants outstanding as of the beginning of the fiscal year, warrants exercised and warrants issued during the year and weighted average prices for each category.

Warrants outstanding as of DecemberMarch 31, 20132014

During the sixnine months ended DecemberMarch 31, 20132014 and 2012,2013, the Company continued to engage the services of APEX Data Systems, Inc., owned by Dwight Babcock, the Company’s Chairman and Chief Executive Officer, to modify and maintain the Company’s web interfaced data collection application to aggregate patient data in a controlled environment. The Audit Committee and Board of Directors approved the use of the ongoing services of APEX Data Systems. Mr. Babcock recused himself from the Board vote due to his conflict of interest. The cost recorded during the sixnine months ended DecemberMarch 31, 20132014 and 20122013 from APEX Data Systems, Inc. for the maintenance of the web interfaced data collection application was $9,720$12,720 and $8,960, respectively.$10,960. An additional $6,000$9,000 was spent on the implementation of Customer Relationship Management software in the sixnine months ended DecemberMarch 31, 2013.2014.

In January 2014, the holder of the 1,670 shares of Series D convertible preferred stock fully exercised its right to convert the 1,670 shares of Series D convertible preferred stock into 3,121,480 shares of common stock which resulted in an increase in shares of common stock outstanding from 38,419,502 to 41,540,982. Subsequent to the conversion, no shares of Series D convertible preferred stock remain outstanding.

ITEM 2 – MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Caution Regarding Forward-Looking Information

In addition to historical information, this Form 10-Q contains certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (“PSLRA”). This statement is included for the express purpose of availing IsoRay, Inc. of the protections of the safe harbor provisions of the PSLRA.

All statements contained in this Form 10-Q, other than statements of historical facts, that address future activities, events or developments are forward-looking statements, including, but not limited to, statements containing the words "believe," "expect," "anticipate," "intends," "estimate," "forecast," "project," and similar expressions. All statements other than statements of historical fact are statements that could be deemed forward-looking statements, including any statements of the plans, strategies and objectives of management for future operations; any statements concerning proposed new products, services, developments or industry rankings; any statements regarding future economic conditions or performance; any statements of belief; and any statements of assumptions underlying any of the foregoing. These statements are based on certain assumptions and analyses made by us in light of our experience and our assessment of historical trends, current conditions and expected future developments as well as other factors we believe are appropriate under the circumstances. However, whether actual results will conform to the expectations and predictions of management is subject to a number of risks and uncertainties described under “Risk Factors” under Part II, Item 1A below and in the “Risk Factors” section of our Form 10-K for the fiscal year ended June 30, 2013 that may cause actual results to differ materially.

Consequently, all of the forward-looking statements made in this Form 10-Q are qualified by these cautionary statements and there can be no assurance that the actual results anticipated by management will be realized or, even if substantially realized, that they will have the expected consequences to or effects on our business operations. Readers are cautioned not to place undue reliance on such forward-looking statements as they speak only of the Company's views as of the date the statement was made. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Critical Accounting Policies and Estimates

The discussion and analysis of the Company’s financial condition and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. On an on-going basis, management evaluates past judgments and estimates, including those related to bad debts, inventories, accrued liabilities, and contingencies. Management bases its estimates on historical experience and on various other assumptions that are believed 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 under different assumptions or conditions. The accounting policies and related risks described in the Company’s annual report on Form 10-K as filed with the Securities and Exchange Commission on September 30, 2013 are those that depend most heavily on these judgments and estimates. As of DecemberMarch 31, 2013,2014, there had been no material changes to any of the critical accounting policies contained therein.

Results of Operations

Three months ended DecemberMarch 31, 20132014 compared to three months ended DecemberMarch 31, 2012.2013.

Revenues.During the three months ended DecemberMarch 31, 2013,2014, total revenue increased from the three months ended December 31, 2012. Revenue generated by prostate brachytherapy and non-prostate related treatments which is described below as Product Sales – (Other) both increased. The increase in revenue from prostate brachytherapy treatments is the result of a new physician being added to a key physician group that resulted in nearly doubling of revenue at an existing treatment facility and the addition of a new treatment facility at which the new physician treated a significant volume of patients as well. While the overall revenue produced by Product Sales – (Other) continued to increase in the three months ended December 31, 2013decreased approximately nine (9%) percent when compared to the three months ended DecemberMarch 31, 2012, there continued to be significant variances2013. Revenue produced by prostate brachytherapy decreased in utilizationthe three months ended March 31, 2014 by approximately 6%. Prostate seed brachytherapy contributed 82% of the GliaSite^® Radiation Therapy System (the “GliaSite RTS”) and in treating brain cancer and lung cancer with brachytherapy seeds. The newer brachytherapyoverall product sales reported as “other” represent more developmental applicationsduring the three months ended March 31, 2014 compared to 79% of ouroverall product which may not leadsales during the three months ended March 31, 2013. Management continues work with physicians to either a long-term revenue source or a significant product line and therefore revenue fluctuation in this segment is expected to be subject to more significant variation from quarter to quarter. Company management intends to actively pursue alternative uses forutilize the Company’s brachytherapy seedsFDA cleared products, sometimes in treatments consistenttandem with the FDA clearance granted permitting the Company to utilize other FDA cleared devices or application methods, as a meansto develop innovative methods to provide alternative treatments for cancers in various other body sites, which contributed the balance of administeringproduct sales, which were 18% of product sales during the treatments. New treatments such as those being initiated bythree months ended March 31, 2014 compared to 21% of product sales during the three months ended March 31, 2014. During the three months ended March 31, 2014, the Company can be expected to experience a staged entry to market in which primary adopters demonstrate the suitability of a treatment, after which wider adoption is possible. The products being implemented by the Company are very dependent on first adopters as a source of revenue which assists in offsetting some of the developmental cost,primarily treated five body sites including brain, gynecological, head and there is initially a significant change in revenue period over period that is expected to reach a plateau due to treatment capacityneck, lung and quantity of cases available to the first adopters until the mainstream adoption occurs, when and if there is favorable publication of the experiences and treatment outcomes of the first adopters. However, to date the Company has only experienced minimal sales to first adopters.prostate cancers. Management believes that the overall market for prostate brachytherapy has continued to receive increased pressure from other treatment options with higher reimbursement rates such as Intensity –Modulated Radiation Therapy (IMRT) and Robotics, buthowever, management believes that the treatment strategy of combining treatments incorporatingwhich incorporate brachytherapy with other modalities in the prostate, the addition of new treatment facilities and treatment of additional other body sites with brachytherapy havehas the potential to continue to increase revenue. During the three months ended December 31, 2013 and 2012, respectively, all product sales were generated by the brachytherapy seeds and the related methods of application except for the revenue generated by the sales of GliaSite RTS which include the sale of the Iotrex solution, catheter trays and access trays. The conversion of prospects to new GliaSite RTS customers has been a longer process than originally anticipated by the Company. The Company has experienced lengthy timelines in the internal processes of the medical facilities in reviewing and approving the use of the product at the request of their physician(s). These longer than anticipated internal processes are compounded by uncertain timelines and delays in receiving the approval for the requested modification of each facility's nuclear materials license, which is required to begin using GliaSite RTS and is dependent on external government regulators.

Key operating factors

Cost of product sales.

Cost of product sales nominally decreasedincreased during the three months ended DecemberMarch 31, 20132014 compared to the three months ended DecemberMarch 31, 2012.

2013. The two key operating factors that changed significantly in the three months ended DecemberMarch 31, 20132014 as compared to the three months ended DecemberMarch 31, 20122013 were the additionincrease in materials expense related to seed production which was primarily created by the price increase in isotope received from Russia in combination with one additional shipment of isotope during the medical device taxthree months ended March 31, 2014 when compared to the three months ended March 31, 2013 and an increasea decrease in production costs of the GliaSite RTS. The addition of the medical device tax expense^®Radiation Therapy System (the “GliaSite RTS”) which was primarily the result of the implementationimproved timing of the Affordable Care Act in calendar year 2013. The increase in the GliaSite RTS production costs was the resultcases which allowed for a greater volume of additional Iotrex solution requiredproduced to meet the increased revenue. Additionally, there was a reductionbe utilized in overall pre-loading costs through a reduction in third-party loading cost, as the Company is loading nearly 100% of its orders in-house, and an improved utilization of pre-loading materials. There was a reduction in other expense as the result of six months property tax expense being recordedtreating patients during the three months ended DecemberMarch 31, 2012 while there was three months2014 and the non-recurrence of an expense recordedrelated to expired catheters which occurred during the three months ended DecemberMarch 31, 2013. Nominal cost changes which occurred in other categories of seed production expenses are summarized as Other cost of product sales (Seeds). which as a group were insignificant.

Key operating factors

Gross loss.profit.  Gross lossprofit for the three months ended DecemberMarch 31, 20132014 decreased compared to the three month period ended DecemberMarch 31, 20122013 as a result of increaseddecreased revenue from product sales which was further reduced by a minimalnominal increase in total cost of product sales. Management continued to seek to control variable costs, however, at this time most remaining production costs are of a fixed nature and related to minimum personnel costs required to meetsatisfy peak demand orders.orders, however, during the three months ended March 31, 2014, there was an additional increase in the cost of some materials that could not be controlled as the result of limited sources for these materials.

Key operating factor

Research and development.Research and development costs increased duringdecreased by a nominal amount for the three months ended DecemberMarch 31, 20132014 compared to the three months ended DecemberMarch 31, 2012. The2013. No single category whichcost factor changed materially was protocol expense assignificantly during the Company continuesthree months ended March 31, 2014 when compared to invest in aggregating data regarding the performance of the Company products which was offset by a combination of immaterial changes in other cost categories.three months ended March 31, 2013.

Key operating factors

Sales and marketing expenses.Sales and marketing expenses were virtually flatdecreased in the three months ended DecemberMarch 31, 20132014 compared to the three months ended DecemberMarch 31, 2012.2013. The single category which changed materiallysignificantly was travel expense as the Company continues to manage its travel costs as actively as possible which was offset by a combination of nominal changes in other cost categories.possible.

Key operating factors