UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

____________

FORM 10-Q

____________

Commission file number: 000-25663

Registrant’s telephone number, including area code: (772) 287-4846

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

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

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

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

TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION

PART II – OTHER INFORMATION

i

PART I – FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS.

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

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

1

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

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

2

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

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

3

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

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

4

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2012

(UNAUDITED)

1.

 DESCRIPTION OF THE BUSINESS, BASIS OF PRESENTATION

Description of the Business

Ecosphere Technologies, Inc. (“Ecosphere” or the “Company”), is a diversified water engineering, technology licensing and environmental services company that designs, develops and manufactures wastewater treatment solutions for industrial markets. The Company provides environmental services and technologies for use in large-scale and sustainable applications across industries, nations and ecosystems. Ecosphere is driving clean water innovation with its patented Ozonix™ advanced oxidation technologies and its mobile, low maintenance water treatment systems. Ecosphere's patented Ozonix™ technology is a high volume, advanced oxidation process designed to recycle water while reducing liquid chemicals used during water treatment applications.

The Company, through its majority-owned subsidiary Ecosphere Energy Services, LLC, ("EES") currently provides energy exploration companies with an onsite, chemical free method to kill bacteria and control microbiologically induced fouling and corrosion that occurs during hydraulic fracturing and flowback operations. The Company has been a water industry innovator since 1998 when Company founders began developing eco-friendly technologies to solve major water remediation challenges on land and at sea.

Material Contract with Hydrozonix

In March 2011, the Company entered into an Exclusive Product Purchase and Sub-License Agreement (the “Agreement”) with Hydrozonix, LLC (a strategic alliance between the principals of Phillips and Jordan, Inc., a private family trust and Siboney Contracting Company) (“Hydrozonix”) to deploy its patented Ecosphere Ozonix® technology in the U.S. onshore oil and gas exploration and production industry. As part of the Agreement, Hydrozonix agreed to advance the direct costs and the manufacturing overhead for each Ozonix™ EF80 unit it ordered. Additionally, Hydrozonix pays a manufacturing fee and a sub-licensing fee to EES. In turn, ETI is the exclusive manufacturer of the Ozonix™ Ecos-Frac® Series and is paid its costs plus a manufacturing fee from EES. In addition, ETI receives profit distributions from EES relating to its ownership percentage of EES. ETI, will also receive a percentage of the royalties paid to EES by Hydrozonix. However, such royalties are not assured. The Ozonix™ EF80 employs the same patented Ozonix™ technology as the units that have successfully processed water for onshore oil and gas exploration companies over the past three years on over 530 oil and natural gas wells. The Ozonix™ EF80 units are capable of processing 80 barrels of water per minute or approximately 3,360 gallons per minute. Ecosphere delivered to Hydrozonix the first four Ozonix™ EF80 units in 2011, two additional units in the first quarter of 2012 and two more units in early July 2012. Concurrent with the acceptance of the two units in July, the Company received an order for production of the next two units pursuant to the terms of the Agreement.

To secure the Company's obligations under the Agreement, the Company assigned a continuing first priority interest in each unit to be manufactured for Hydrozonix (including its components), as well as a continuing first priority interest in twenty-four Ozonix™ EF10 units which are part of the Company's service fleet. The security interest in the assets terminated in July 2012 once the Company delivered the eighth unit to Hydrozonix.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements include the accounts of Ecosphere and its subsidiaries, including its 52.6% owned subsidiary EES. All intercompany account balances and transactions have been eliminated.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with Generally Accepted Accounting Principles (“GAAP”) in the United States of America (“U.S.”) as promulgated by the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) and with the rules and regulations of the U.S Securities and Exchange Commission (“SEC”) for interim financial information. The unaudited condensed consolidated financial statements reflect all normal recurring adjustments, which, in the opinion of management, are considered necessary for a fair presentation of the results for the periods shown. The results of operations for the periods presented are not necessarily indicative of the results expected for the full fiscal year or for any future period. The information included in these unaudited condensed consolidated financial statements should be read in conjunction with Management’s Discussion and Analysis and Results of Operations contained in this report and the audited consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

5

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2012

(UNAUDITED)

The Company has two operating segments that (i) engage in similar operating activities, (ii) have similar economic characteristics and, (iii) can be expected to have essentially the same future prospects. As such, based on guidance provided by the FASB ASC Topic 280 Segment Reporting, the Company has aggregated its operating segments into one reportable segment thus negating the need for the disclosure of segment data.

2.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly and majority-owned subsidiaries. Significant intercompany accounts and transactions have been eliminated in consolidation.

Noncontrolling Interest

The Company accounts for its less than 100% interest in consolidated subsidiaries in accordance with ASC Topic 810, Consolidation, and accordingly the Company presents noncontrolling interests as a component of equity on its condensed consolidated balance sheets and reports noncontrolling interest net income or loss under the heading “Net income applicable to noncontrolling interest in consolidated subsidiary” in the condensed consolidated statements of operations.

Use of Estimates

The preparation of condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosures of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates in the accompanying unaudited condensed consolidated financial statements include the allowance for doubtful accounts receivable, valuation of inventory, estimates of costs to complete and earnings on uncompleted contracts, estimates of depreciable lives and valuation of property and equipment, estimates of amortization periods for intangible assets, restructuring charges, valuation of beneficial conversion features in convertible debt, valuation of equity based instruments issued for other than cash, valuation of derivatives and the valuation allowance on deferred tax assets.

Cash Equivalents

The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents.

Restricted Cash

Restricted cash represents a $25,000 compensating balance held pursuant to certain of the Company's short term financing arrangements along with $378,809 of cash placed in an escrow account pursuant to the Hydrozonix Agreement which was released subsequent to June 30, 2012.

Accounts Receivable and Allowance for Doubtful Accounts

Accounts receivable are stated at their estimated net realizable value. The Company reviews its accounts to estimate losses resulting from the inability of its customers to make required payments. Any required allowance is based on specific analysis of past due accounts and also considers historical trends of write-offs. Past due status is based on how recently payments have been received from customers. The Company’s collection experience has been favorable reflecting a limited number of customers, all of which are in the oil and gas industry. No allowance was deemed necessary at June 30, 2012 and December 31, 2011.

Inventory

Inventory is primarily comprised of raw materials and work-in-process representing water filtration units being manufactured and assembled for sale.  These units are built pursuant to individual order specifications.  The Company has minimal raw materials on hand and once a unit is completed, it is submitted to the customer for acceptance.  Inventory on hand at each respective balance sheet date is stated at the lower of cost or market.  At June 30, 2012 and December 31, 2011, inventory was comprised of raw materials only.

6

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2012

(UNAUDITED)

Property and Equipment

Property and equipment is stated at cost. For equipment manufactured for use by the Company, cost includes direct component parts plus direct labor. Depreciation is computed using the straight-line method based on the estimated useful lives generally ranging from three to seven years. Amortization of leasehold improvements is computed using the straight-line method over the lesser of the useful life of the asset or the remaining term of the lease. Expenditures for maintenance and repairs are expensed as incurred.

Patents

Patents consist of costs related to the development of such patents which have finite lives. Intangible assets with finite lives are amortized over their estimated useful lives on a straight line basis.

Impairment of Long-Lived Assets

The Company reviews long-lived assets and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset or group of assets to undiscounted future net cash flows expected to be generated by the asset or group of assets. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. Fair value is determined through various valuation techniques including discounted cash flow models, quoted market values and third-party independent appraisals, as considered appropriate.

Derivative Instruments

ASC Topic 815, “Derivatives and Hedging” (“ASC Topic 815”), establishes accounting and reporting standards for derivative instruments and for hedging activities by requiring that all derivatives be recognized in the balance sheet and measured at fair value. Gains or losses resulting from changes in the fair value of derivatives are recognized in earnings or recorded in other comprehensive income (loss) depending on the purpose of the derivatives and whether they qualify and have been designated for hedge accounting treatment. The Company does not have any derivative instruments for which it has applied hedge accounting treatment.

Fair Value of Financial Instruments and Fair Value Measurements

The Company measures its financial and non-financial assets and liabilities, as well as makes related disclosures, in accordance with ASC Topic 820, Fair Value Measurements and Disclosures (“ASC Topic 820”). For certain of our financial instruments, including cash, accounts receivable, accounts payable and accrued liabilities, the carrying amounts approximate fair value due to their short maturities. Amounts recorded for notes payable, net of discount, also approximate fair value because current interest rates available to us for debt with similar terms and maturities are substantially the same.

ASC Topic 820 provides guidance with respect to valuation techniques to be utilized in the determination of fair value of assets and liabilities. Approaches include, (i) the market approach (comparable market prices), (ii) the income approach (present value of future income or cash flow), and (iii) the cost approach (cost to replace the service capacity of an asset or replacement cost). ASC Topic 820 utilizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The following is a brief description of those three levels:

7

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2012

(UNAUDITED)

Revenue Recognition

For each of our revenue sources we have the following policies:

Equipment and Component Sales

Revenues and related costs on production type contracts are recognized using the “percentage of completion method” of accounting in accordance with ASC 605-35, “Accounting for Performance of Construction-Type and Certain Production Type Contracts.” Under this method, contract revenues and related expenses are recognized over the performance period of the contract in direct proportion to the costs incurred as a percentage of total estimated costs for the entirety of the contract. Costs include direct material, direct labor, subcontract labor and any allocable indirect costs. All unallocable indirect costs and corporate general and administrative costs are charged to the periods as incurred. However, in the event a loss on a contract is foreseen, the Company will recognize the loss as it is determined. Contract costs plus recognized profits are accumulated as deferred assets, and billings and/or cash received are recorded to a deferred revenue liability account. The net of these two accounts for any individual project is presented as "Costs and estimated earnings in excess of billings on uncompleted contracts," an asset account, or "Billings in excess of costs and estimated earnings on uncompleted contracts," a liability account.

Through March 31, 2012 and prospectively for production type contracts that do not qualify for use of the percentage of completion method, the Company accounts for these contracts using the “completed contract method” of accounting in accordance with ASC 605-35-25-57. Under this method, contract costs are accumulated as deferred assets, and billings and/or cash received is recorded to a deferred revenue liability account, during the periods of construction, but no revenues, costs, or profits are recognized in operations until the period upon completion of the contract. Costs include direct material, direct labor, subcontract labor and any allocable indirect costs. All unallocable indirect costs and corporate general and administrative costs are charged to the periods as incurred. However, in the event a loss on a contract is foreseen, the Company will recognize the loss as it is determined. The deferred asset (accumulated contract costs) in excess of the deferred liability (billings and/or cash received) is classified as a current asset under "Costs in excess of billings on uncompleted contracts". The deferred liability (billings and/or cash received) in excess of the deferred asset (accumulated contract costs) is classified under current liabilities as "Billings in excess of costs on uncompleted contracts".

A contract is considered complete when all costs except insignificant items have been incurred and the equipment is operating according to specifications and has been accepted by the customer.

Field Services

Revenue from water treatment contracts is earned based upon the volume of water processed plus additional period based contractual charges and is recognized in the period the service is provided. Payments received in advance of the performance of services or of the delivery of goods are deferred as liabilities until the services are performed or the goods are delivered.

Some projects the Company undertakes are based upon our providing water processing services for fixed periods of time. Revenue from these projects is recognized based upon the number of days the service has been provided during the reporting period.

Royalties

Revenue from technology license royalties will be recorded as the royalties are earned.

The Company includes shipping and handling fees billed to customers in revenues and handling costs in cost of revenues.

Product Warranties

The Company accrues for product warranties when the loss is probable and can be reasonably estimated. At June 30, 2012 and December 31, 2011, the Company has no product warranty accrual given its lack of historical warranty experience.

8

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2012

(UNAUDITED)

Equity-based Compensation

Compensation expense for all stock-based employee and director compensation awards granted is based on the grant date fair value estimated in accordance with the provisions of ASC Topic 718, Compensation – Stock Compensation (“ASC Topic 718”). The Company recognizes these compensation costs on a straight-line basis over the requisite service period of the award, which is generally the option vesting term. Vesting terms vary based on the individual grant terms.

The Company estimates the fair value of stock-based compensation awards on the date of grant using the Black-Scholes-Merton (“BSM”) option pricing model, which was developed for use in estimating the value of traded options that have no vesting restrictions and are freely transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. The BSM option pricing model considers, among other factors, the expected term of the award and the expected volatility of the Company’s stock price. Expected terms are calculated using the Simplified Method, volatility is determined based on the Company's historical stock price trends and the discount rate is based upon treasury rates with instruments of similar expected terms. Warrants granted to non-employees are accounted for in accordance with the measurement and recognition criteria of ASC Topic 505-50, Equity Based Payments to Non-Employees.

Income Taxes

The Company uses the asset and liability method in accounting for income taxes. Under this method, deferred income tax assets and liabilities are determined based on difference between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. A valuation allowance is provided to offset any net deferred tax assets for which management believes it is more likely than not that the net deferred asset will not be realized.

Accounting for Uncertainty in Income Taxes

The Company applies the provisions of ASC Topic 740-10-25 Income Taxes – Overall – Recognition (“ASC Topic 740-10-25”) with respect to the accounting for uncertainty of income tax positions. ASC Topic 740-10-25 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC Topic 740-10-25 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. As of June 30, 2012, tax years 2009, 2010 and 2011 remain open for IRS audit. The Company has received no notice of audit from the Internal Revenue Service for any of the open tax years.

New Standards

No ASUs have been issued impacting the Company.

3.

PROPERTY AND EQUIPMENT

Property and equipment consists of the following at June 30, 2012:

In the six months ended June 30, 2012, additions to property and equipment were de minimis. Depreciation expense amounted to approximately $1.1 million for the six month period ended June 30, 2012.

9

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2012

(UNAUDITED)

4.

NOTES PAYABLE AND OTHER DEBT

Long-term debt, other than debt held by related parties (see Note 5), consists of the following at June 30, 2012:

———————

A summary of convertible notes payable and the related discounts as of June 30, 2012:

10

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2012

(UNAUDITED)

5.

RELATED PARTY NOTES PAYABLE

Related party debt consists of the following at June 30, 2012:

———————

6.

BILLINGS IN EXCESS OF COSTS AND ESTIMATED EARNINGS ON UNCOMPLETED CONTRACTS

Billings in excess of costs and estimated earnings on uncompleted contracts represents billings and/or cash received that exceeded accumulated revenues recognized on uncompleted contracts accounted for under the percentage of completion method. (See Note 2)

At June 30, 2012, billings in excess of costs and estimated earnings on uncompleted contracts consisted of the following for contracts accounted for using the percentage of completion method of accounting:

7.

RESTRUCTURING RESERVE

In June 2009, the Board of Directors approved an exit strategy to close the Company’s New York office in order to reduce operating costs. The Company recognized aggregate restructuring charges related to the office closing in the amount of $548,090 consisting of future lease commitments and employee severance costs in the amount of $246,920 and $301,170, respectively. The Company entered into a sublease agreement with a tenant that provides for monthly sublease payments of approximately $11,300 through April 2013. As of June 30, 2012, the restructuring reserve liability consists of the present value of the future minimum rental payments due, net of the sublease income payments to be received.

The following table summarizes the activity in the restructuring reserve for the six months ended June 30, 2012:

8.

DERIVATIVE FINANCIAL INSTRUMENTS

The Company applies the provisions of ASC Topic 815-40, Contracts in Entity’s Own Equity (“ASC Topic 815-40”) under which convertible instruments and warrants, which contain terms that protect holders from declines in the stock price (reset provisions), may not be exempt from derivative accounting treatment. As a result, warrants are recorded as a liability and are revalued at fair value at each reporting date. Further, under derivative accounting, the warrants are recorded at their fair value. If the fair value of the warrants exceeds the face value of the related debt, the excess is recorded as change in fair value in operations on the issuance date. The Company has approximately 1.0 million warrants with repricing options outstanding at June 30, 2012.

11

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2012

(UNAUDITED)

The Company calculates the estimated fair values of the liabilities for warrant derivative instruments at each quarter-end using the BSM option pricing model. The closing price of the Company’s common stock at June 30, 2012 was $0.50. Volatility, expected term and risk free interest rates used are indicated in the table that follows. The volatility was based on historical volatility, the expected term is equal to the remaining term of the warrants and the risk free rate is based upon rates for treasury securities with the same term.

During the six month periods ended June 30, 2012, based upon the estimated fair value, the Company increased its liability for warrant derivative instruments by $85,995 which was recorded as "Loss from change in derivative liability" in the other expense section of the Company's condensed consolidated statement of operations. This increase was offset by conversions of warrant instruments with fair values totaling $106,224 at the time of conversion resulting in a net reduction of the liability of $20,229.

9.

FAIR VALUE MEASUREMENTS

The Company measures and reports at fair value the liability for price adjustable warrant derivative instruments. The fair value liabilities for price adjustable warrants have been recorded as determined utilizing the BSM option pricing model. The following table summarizes our financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2012:

The following is a roll-forward for the six months ended June, 2012 of the fair value liability of price adjustable warrant derivative instruments:

The Company had no non-financial assets or liabilities measured at fair value at June 30, 2012.

10.

REDEEMABLE CONVERTIBLE CUMULATIVE PREFERRED STOCK

Series A

At June 30, 2012 and December 31, 2011, there were 6 shares of Series A Redeemable Convertible Cumulative Preferred Stock (“Series A Preferred Shares”) outstanding. The shares are redeemable at the option of the Company at $27,500 per share plus accrued dividends or redeemable at the option of the holder upon a change of control ("CoC") event at $25,000 per share plus accrued dividends. A CoC event means a transfer of greater than fifty percent of the shares of common stock of the Company. The shares are convertible each into 24,000 common shares. Accrued dividends totaled $1,019,744 and $1,008,494 at June 30, 2012 and December 31, 2011, respectively. There was no Series A Preferred Shares activity during the six months ended June 30, 2012. Annual dividends accrue at a rate of $3,750 per share.

12

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2012

(UNAUDITED)

Series B

At June 30, 2012 and December 31, 2011, there were 321 and 322 shares, respectively, of Series B Redeemable Convertible Cumulative Preferred Stock (“Series B Preferred Shares”) outstanding. The shares are redeemable at the option of the Company at $3,000 per share plus accrued dividends or at the option of the holder upon a CoC event at $2,500 per share plus accrued dividends. The shares are convertible each into 835 common shares. Accrued dividends totaled $2,057,489 and $2,017,301 at June 30, 2012 and December 31, 2011, respectively. One Series B Preferred Share was converted during the six months ended June 30, 2012. Annual dividends accrue at a rate of $250 per share.

11.

COMMON STOCK

Shares issued and issuable during the six months ended June 30, 2012 are summarized below.

———————

12.

RESTRICTED STOCK

The Company recognized share-based compensation expense of $42,500 for the six months ended June 30, 2012, related to restricted stock grants issued per the terms of the 2006 Equity Incentive Plan (the "Plan"). The following table summarizes non-vested restricted stock and the related activity for the six months ended June 30, 2012:

Total unrecognized share-based compensation expense from unvested restricted stock as of June 30, 2012 was $25,000 which is expected to be recognized over the next 0.5 years.

In accordance with the Plan, in 2011 the Company granted the directors restricted shares of the Company’s common stock that vested on June 30, 2012. A similar grant was made to directors on July 1, 2012 in accordance with the Plan. See Note 19.

13.

NET INCOME (LOSS) PER SHARE

The Company’s outstanding options and warrants to acquire common stock, shares of common stock which may be issued upon conversion of outstanding redeemable convertible cumulative preferred stock, unvested shares of restricted stock and shares of common stock which may be issued upon conversion of convertible notes total 70,859,514 as of June 30, 2012. These common stock equivalents may dilute future earnings per share.

13

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2012

(UNAUDITED)

For the six months ended June 30, 2012, basic net income per common share applicable to common stockholders was computed on the basis of the weighted average number of common shares outstanding during the period. Diluted net income per common share applicable to common stockholders was computed on the basis of the weighted average number of common shares and dilutive securities outstanding. Dilutive securities having an anti-dilutive effect on diluted net income per share were excluded from the calculation.

Basic and diluted net income per share for the three and six months ended June 30, 2012 were calculated as follows:

There were 21,176,481 out-of-the-money stock options and warrants and 1,750,000 shares upon conversion of convertible debt excluded from the computation of diluted earnings per share for the six months ended June 30, 2012.

14.

STOCK OPTIONS AND WARRANTS

The fair value of each option is estimated on the date of grant using the BSM option-pricing model. The Company used the following assumptions for options issued during the six months ended June 30, 2012:

Stock-based compensation expense related to options for the six months ended June 30, 2012 was $0.9 million. At June 30, 2012, total unrecognized compensation cost related to unvested options granted under the Company’s option plans totaled $0.8 million. This unrecognized compensation cost is expected to be recognized over the next 33 months.

Activity in the Company’s options for the six month period ended June 30, 2012 is as follows:

Option Grants

In January 2012, the Company granted five year options to purchase 1,060,000 shares of common stock to certain employees at an exercise price of $0.44 per share. The fair value of these options amounted to $224,816, calculated using the BSM method, and will be expensed over a three year period, one-third per year.

In February 2012, the Company granted 2,560,000 unvested five-year stock options exercisable at $0.64 per share to a director of the Company's 52.6% owned subsidiary, EES. The director is not a director or officer or affiliated with Ecosphere. The options were granted as part of a finder's fee agreement relating to a potential future transaction not in the ordinary course of business. We have no agreement with any other party relating to this future transaction and unless it is consummated, the options will never vest. The potential future transaction will be subject to future approval of the Company's Board of Directors. The future transaction would only occur if significant shareholder value were delivered by the transaction. Given the absence of a measurement date, no fair value has been established for these option grants.

14

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2012

(UNAUDITED)

In March 2012, upon the effective date of our new board member, the Company granted five year options to purchase 123,076 shares of common stock at an exercise prices of $0.65 per share. The fair value of these options amounted to $39,027, calculated using the BSM method, and will be expensed over a three year period, one-third per year.

Option and Warrant Exercises

Cash Exercises

During the first six months of 2012, the Company issued 1,280,332 shares of common stock in exchange for cash of $249,300 upon the exercise of options and warrants with an exercise prices ranging from $0.15 to $0.60 per share.

Cashless Exercises

During the first six months of 2012, the Company issued 300,675 shares of common stock in connection with the cashless exercise of 1,000,000 options to purchase the Company’s common stock exercisable at $0.36 to $0.60 per share and based upon the market value of the Company’s common stock ranging from $0.60 to $0.65 per share.

Warrant Extensions or Cashless Exercises for Warrants Expiring on March 31, 2012

In March of 2012, the Company provided an option to extend the expiration date of certain warrants for a period of one year, or surrender the warrants in a cashless exercise. The arrangement called for holders of warrants at exercise prices of $0.60 and $0.75 to extend such warrants for one year at a cost of $0.20 and $0.14, respectively. Holders of 320,000 and 310,000 $0.60 warrants and $0.75 warrants, respectively opted to extend their expiration date for one year at an aggregate cost of $107,400. Given the stock closing price at quarter-end of $0.61, the remainder of the $0.60 warrants were converted in cashless exercises, resulting in the issuance of 69,914 shares of common stock, while the $0.75 warrants expired.

15.

RELATED PARTY TRANSACTIONS

See Note 5 for discussion of related party notes payable.

In January 2012, the Company granted five year options to purchase 1,060,000 shares of common stock to certain employees at an exercise price of $0.44 per share. 910,000 of these grants were made to related parties. See Note 14.

In March 2012, upon the effective appointment date of our new board member, the Company granted five year options to purchase 123,076 shares of common stock at an exercise prices of $0.65 per share. See Note 14.

16.

COMMITMENTS AND CONTINGENCIES

Legal Matters

From time to time, we may be involved in litigation relating to claims arising out of our operations in the normal course of business. To our knowledge, except as described below, no legal proceedings, government actions, administrative actions, investigations or claims are currently pending against us or involve us that, in the opinion of our management, could reasonably be expected to have a material adverse effect on our business and financial condition.

The Company had a long term relationship with Kamimura International Associates (“KIA”), a Washington D.C. based organization, whereby the principals at KIA agreed to assist the Company in developing the coating removal market in the Far East. The relationship resulted in the establishment of UltraStrip Japan, Ltd. (“USJ”), a company whose purpose was to market and deliver ship stripping services in Japan. The agreement with KIA was never formalized. In February 2007, KIA filed a lawsuit against the Company. In March 2007, the Company filed a Motion to Dismiss, Motion to Strike, and Motion for More Definite Statement. The Company intends to vigorously defend itself in this litigation; the Company believes that the plaintiff will not prevail. In 2008, the Company filed a counterclaim to which KIA responded by filing a motion to dismiss. The motion to dismiss was rejected by the court. Depositions were taken in the Spring and Summer of 2011. Since those depositions there have been no further actions taken by either party and the matter remains in dispute. The Company has expensed and accrued an amount it reasonably estimates may be required to resolve any outstanding issues between the Company and KIA and management does not expect this matter to have any future impact on the liquidity or results of operations of the Company.

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ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2012

(UNAUDITED)

In March 2011, a court adjudicated against the Company for a number of disputed billings by a former vendor. As of June 30, 2012, the Company has accrued $70,000 which is anticipated to be the amount of payment due to the vendor plus attorney’s fees. The Company filed an appeal which was rejected by the appeal court. The Company continues to attempt to settle this matter, but believes that the amount accrued represents a reasonable estimate as to the ultimate amount to be paid.

Warranties on EF80 Units

Each Ozonix™ EF80 unit carries a 24 month warranty with the individual component vendors passing through their individual warranties to the client. Ecosphere warranties construction and build quality for the aforementioned period and all repairs would be carried out by the manufacturing team including the fabrication of any pipes and fittings as necessary. No warranty liability is accrued at June 30, 2012 or December 31, 2011 given the Company's lack of historical experience resulting in its inability to estimate such future costs.

17.

NONCONTROLLING INTEREST

In July 2009, the Company formed EES and contributed the assets and liabilities of EES, Inc. in exchange for a 67% ownership interest in EES. In November 2009 EES received $7.9 million in exchange for a 21.5% interest in EES. After the November transaction, the Company owned 52.6% of EES. EES is a limited liability company operating under a Limited Liability Company Agreement, as amended ("LLC Operating Agreement") which among other things specifies profit and loss allocations and distribution allocations.

For the years ended December 31, 2009 and 2010, the Company allocated 100% of the net loss of EES, $743,417 and $528,277, respectively, to the noncontrolling interests of EES as stipulated in the LLC operating agreement. For fiscal 2011, EES had net income of $3,217,407 of which the first $1,271,694 was allocated entirely to the noncontrolling interest to allow them recovery of previously allocated losses, in accordance with the LLC operating agreement, after which income was allocated to ETI and certain noncontrolling interests based on a formula stipulated in the LLC operating agreement, as amended. On a net basis, $1,690,075 of income was allocated to noncontrolling interests in fiscal 2011. During the six months ended June 30, 2012, the Company allocated $744,631 of EES net income to its noncontrolling members.

In a March 2011 side agreement to the Hydrozonix Agreement, the EES operating agreement was amended to defer the Company’s right to preferential distributions and profit allocation, outlined under the original operating agreement, until such time as the noncontrolling members have received distributions equal to their original investments. In addition, so long as Hydrozonix maintains its exclusivity, the EES minority members will receive a 5% royalty while the remaining royalties of 15% are distributed by EES as part of a normal distribution in accordance with the LLC operating agreement to the Company and the minority members in accordance with their percentage interests in EES.

Pursuant to an EES Board of Members resolution in February 2012, a cash distribution of $1.9 million was made in accordance with membership interests in EES. Of this amount, $0.9 million was paid to members comprising the noncontrolling interest and $1.0 million was due to the Company and, accordingly, was eliminated in consolidation. The cash distribution was paid in full out of retained earnings of the subsidiary during March of 2012. See note 19 for July 2012 cash distribution.

The following provides a summary of activity in the noncontrolling interest in consolidated subsidiary account for the six months ended June 30, 2012:

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ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2012

(UNAUDITED)

18.

CONCENTRATIONS

Concentration of Accounts Receivable and Revenues

At June 30, 2012 accounts receivable of approximately $3.7 million was comprised primarily of two major customer balances amounting to 47% and 48% of the total receivable balance. In addition, two customers accounted for 67% and 29% of revenues.

Concentration of Credit Risk

Financial instruments that potentially subject the Company to significant concentrations of credit risk consist primarily of cash and cash equivalents and accounts receivable. The Company maintains its cash in bank and financial institution deposits that at times may exceed federally insured limits. The Company has not experienced any losses in such accounts through June 30, 2012. As of June 30, 2012, the Company had no cash equivalent balances held in a corporate checking account that were not insured. The Company performs ongoing credit evaluations of its customers and generally does not require collateral for accounts receivable. The Company’s payment terms are generally upon receipt or 30 days from delivery of products, but may fluctuate depending on the terms of each specific contract. The Company’s customers are in the oil and gas industry.

Major Suppliers

The Company purchases products from a limited number of manufacturers, however, management believes that other suppliers could adapt to provide similar products or components on comparable terms.

19.

SUBSEQUENT EVENTS

Director and Advisor Grants

In July 2012, in accordance with the 2006 Equity Incentive Plan (the “Plan”), the Company’s non-employee directors received an automatic grant of options and restricted stock for board service for the upcoming year. In connection with the automatic grants, non-employee directors were granted a total of 380,000 five-year stock options at an exercise price of $0.50 per share and 80,000 shares of restricted common stock. The options and restricted stock vest on June 30, 2013, subject to the continued service of each applicable person as a director. The value of the options, $70,018, calculated using the BSM option pricing model and the value of the restricted stock, $40,000, based upon the market value of the Company's common stock on the date of the grant, will be recognized as expense over the one-year vesting period.

In July 2012, in accordance with the Plan, the Company’s advisory board member received an automatic grant of 30,000 five-year stock options with an exercise price of $0.50 per share for service as an advisory board member for the upcoming year. The options vest on June 30, 2013, subject to the continued service as an advisory board member. The value of the options, $5,528, calculated using the BSM option pricing model, based upon the market value of the Company's common stock on the date of the grant, will be recognized as expense over the one-year vesting period.

On July 3, 2012, in connection with a non employee board member’s appointment to the compensation committee, the committee member received an automatic grant under the Plan of 41,666 five-year stock options at an exercise price of $0.48 per share. The options vest in three equal annual increments over a three year period with the first vesting date being one year from the date of the automatic grant. The value of the options, $8,410, calculated using the BSM option pricing model, based upon the market value of the Company's common stock on the date of the grant, will be recognized as expense over a three-year vesting period.

EES Cash Distribution

Pursuant to an EES Board of Members resolution in July 2012, a cash distribution of $1.5 million was made in accordance with membership interests in EES. Of this amount, $0.7 million was paid to members comprising the noncontrolling interest and $0.8 million was due to the Company and, accordingly, will be eliminated in future consolidated results of operations. The cash distribution was paid in full out of retained earnings of the subsidiary during July of 2012.

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ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2012

(UNAUDITED)

Cashless Option Exercises

In July 2012, the Company issued 188,280 shares of common stock to its Chief Operating Officer upon the cashless exercise of 285,667 options with an exercise price of $0.15 per share based upon a market price of the Company's common stock of $0.44 per share.

In July 2012, the Company issued 199,777 shares of common stock upon the cashless exercise of 300,000 options with an exercise price of $0.15 per share based upon a market price of the Company's common stock of $0.449 per share.

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ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

ITEM 2:

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis should be read in conjunction with our unaudited consolidated financial statements and related notes appearing elsewhere in this report. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including but not limited to those set forth under “Risk Factors” in our Form 10-K for the year ended December 31, 2011.

Company Overview

Ecosphere Technologies, Inc. is a diversified water engineering, technology licensing and environmental services company that designs, develops and manufactures wastewater treatment solutions for industrial markets. The Company provides environmental services and technologies for use in large-scale and sustainable applications across industries, nations and ecosystems. Ecosphere is driving clean water innovation with its patented Ozonix™ advanced oxidation technologies and its mobile, low maintenance water treatment systems. Ecosphere's patented Ozonix™ technology is a high volume, advanced oxidation process designed to recycle water while reducing liquid chemicals used during water treatment applications.

The Company’s Open Innovation Network is a business model that was created to invent, develop, commercialize and sell green technologies using water treatment as a key component. Ecosphere manufacturers its Ozonix™ units at its Stuart, Florida facility; all material components are also made in the United States. The business model is used to:

1. Identify a major environmental water challenge

2. Invent technologies and file new patents

3. Partner with industry leaders

4. Commercialize and prove technologies with ongoing services paid for by customers and industry leaders

5. License the patented, commercialized technologies to well capitalized partners

6. Create reoccurring revenues and increase shareholder value

At present, Ecosphere is focusing its efforts on EES, its 52.6% owned subsidiary. In 2011, EES made a strategic re-positioning of its business by signing a multi-year licensing agreement with Hydrozonix LLC. This agreement moved the Company into the final stages of the Open Innovation Network in the Energy field of use by licensing the patented, commercialized technologies to a well capitalized partner in the oil and gas sector. The agreement contains numerous provisions for creating recurring revenues based on minimum order quantities and ongoing royalties based on the business results of Hydrozonix. EES will also continue to be engaged in operating high volume mobile water treatment equipment to treat energy exploration related wastewaters. EES has been successfully providing water recycling services to major energy exploration companies utilizing our patented Ecosphere Ozonix® technology. The industry acceptance of this technology is demonstrated by the three-year history of expanded service and increasing revenue from the services provided to customers by EES and the Exclusive Sublicense and Manufacturing Agreement signed with Hydrozonix for U.S. onshore oil and gas exploration and production. These agreements prove that the Ecosphere Ozonix® technology is commercially viable and have fueled the continuing development of Ozonix™ technologies and the identification of additional applications where our technologies will allow industrial companies to optimize revenues. We believe our contracts with energy oil and gas exploration companies and our sublicense agreement with Hydrozonix, LLC demonstrate the substantial value of our intellectual property above and beyond the amounts recorded in our financial statements using the historical cost basis of accounting under GAAP.

Ecosphere’s patented Ozonix™ technology has the ability to clean and recycle water without liquid chemicals in a variety of industries. While EES has an exclusive license for the global energy market, Ecosphere owns 100% of all non-energy Ozonix™ applications. These industries include, but are not limited to, mining and minerals, municipal wastewater, industrial wastewater, marine wastewater, food processing and agriculture. The Company continues to seek financial partners and licensees to expand its Ozonix™ technology into other industries and applications.

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ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

2012 Highlights

·

The Company continues to successfully service the Hydrozonix Agreement as evidenced by the completion of the manufacturing of units 7 and 8 and the acceptance and delivery of such Ozonix™ EF80 units on July 10, 2012. Following the delivery of units 7 and 8, Ecosphere received the purchase order for units 9 and 10 to be delivered in Q3 of 2012.

·

The Company, its majority-owned subsidiary, Ecosphere Energy Services LLC, and its sub-licensee, Hydrozonix LLC (collectively, the "Ecosphere Partners") have signed a Letter of Commitment with the Blackfeet Nation to provide Ecosphere's Ozonix™ water treatment services to oil and gas companies conducting hydraulic fracturing ("fracking" or "fracing") operations on the 3,000 square mile Blackfeet reservation in Montana. The Ecosphere Partners will be the exclusive provider of water treatment services on the Blackfeet reservation. The Ecosphere-Blackfeet commitment will make available to operators a chemical-free approach for treating and reusing 100% of their flowback and produced waters on the reservation. Use of Ecosphere's Ozonix™ technology will not only help preserve the Blackfeet Nation's water resources, but will also eliminate the need to truck wastewater to disposal sites off reservation, thereby improving the economics of shale oil and gas exploration on the reservation. This exclusive services agreement is part of a broad effort by the Blackfeet Nation to sustainably develop their heritage lands, bring jobs to tribal members and improve the economic well being of the tribe.

·

The Company was awarded the Frost & Sullivan’s 2012 "North American Product Leadership Award in Disinfection Equipment for Shale Oil and Gas Wastewater Treatment." The Excellence in Best Practices Awards are presented each year to companies that are predicted to encourage significant growth in their industries, have identified emerging trends before they became the standard in the marketplace, and have created advanced technologies that will catalyze and transform industries in the near future. Frost & Sullivan's Product Leadership Award is a prestigious recognition of the Company's accomplishments in wastewater treatment for the U.S. oil and natural gas industry. As demand for disinfection equipment grows within the oil and natural gas industry, having the best available technology and leading environmentally-safe solution we believe will enhance Ecosphere's overall growth, serving the rapidly growing unconventional oil and natural gas market. We are currently in discussions to expand the adoption of our Ozonix™ technology in other countries and in additional applications for non-chemical wastewater treatment. The 2012 Product Leadership Award recognizes Ecosphere's leadership in the field of advanced water treatment, specifically in providing energy exploration and production companies with a non-chemical solution that allows them to recycle flowback and produced water with an ozone-based advanced oxidation process. To benchmark Ecosphere's performance against key competitors, Frost & Sullivan's industry analyst compared product features and functionality, innovative elements of the product, product acceptance in the marketplace, customer value enhancements and product quality to competitive solutions that address microbial control and eliminate chemical usage at a lower cost.

CRITICAL ACCOUNTING ESTIMATES

Below the Company will provide a discussion of its more subjective accounting estimation processes for purposes of (i) explaining the methodology used in calculating the estimates, (ii) the inherent uncertainties pertaining to such estimates, and (iii) the possible effects of a significant variance in actual experience, from that of the estimate, on the Company’s financial condition. Estimates involve the employ of numerous assumptions that, if incorrect, could create a material adverse impact on the Company’s results of operations and financial condition.

Revenue Recognition

In general we comply with ASC Topic 605-10, “Revenue – Overall” where revenue is recognized when persuasive evidence of an arrangement exists, products are delivered to and accepted by the customer, economic risk of loss has passed to the customer, the price is fixed or determinable, collection is reasonably assured, and any future obligations of the Company are insignificant.

For each of our revenue sources we have the following additional policies:

Equipment and Component Sales

Revenues and related costs on production type contracts are recognized using the “percentage of completion method” of accounting in accordance with ASC 605-35, formerly Statement of Position 81-1, “Accounting for Performance of Construction-Type and Certain Production Type Contracts.” Under this method, contract revenues and related expenses are recognized over the performance period of the contract in direct proportion to the costs incurred as a percentage of total estimated costs for the entirety of the contract. Costs include direct material, direct labor, subcontract labor and any allocable indirect costs. All unallocable indirect costs and corporate general and administrative costs are charged to the periods as incurred. However, in the event a loss on a contract is foreseen, the Company will recognize the loss as it is incurred. Contract costs plus recognized profits are accumulated as deferred assets, and billings and/or cash received are recorded to a deferred revenue liability account. The net of these two accounts for any individual project is presented as "Costs and recognized profit in excess of billings on uncompleted contracts," an asset account, or "Billings in excess of cost and recognized profit on uncompleted contracts," a liability account.

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ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

Through April 1, 2012 and prospectively for production type contracts that do not qualify for use of the percentage completion method, the Company accounts for these contracts using the “completed contract method” of accounting in accordance with ASC 605-35-25-57. Under this method, contract costs are accumulated as deferred assets, and billings and/or cash received are recorded to a deferred revenue liability account, during the periods of construction, but no revenues, costs, or profits are recognized in operations until the period upon completion of the contract. Costs include direct material, direct labor, subcontract labor and any allocable indirect costs. All unallocable indirect costs and corporate general and administrative costs are charged to the periods as incurred. However, in the event a loss on a contract is foreseen, the Company will recognize the loss as it is determined. The deferred asset (accumulated contract costs) in excess of the deferred liability (billings and/or cash received) is classified as a current asset under "Costs in excess of billings on uncompleted contracts". The deferred liability (billings and/or cash received) in excess of the deferred asset (accumulated contract costs) is classified under current liabilities as "Billings in excess of costs on uncompleted contracts".

A contract is considered complete when all costs except insignificant items have been incurred and the equipment is operating according to specifications and has been accepted by the customer.

Field Services

Revenue from water treatment contracts is earned based upon the volume of water processed plus additional period based contractual charges and is recognized in the period the service is provided. Payments received in advance of the performance of services or of the delivery of goods are deferred as liabilities until the services are performed or the goods are delivered.

Some projects the Company undertakes are based upon our providing water processing services for fixed periods of time. Revenue from these projects is recognized based upon the number of days the service has been provided during the reporting period.

Royalties

Revenue from technology license royalties will be recorded as the royalties are earned.

The Company includes shipping and handling fees billed to customers in revenues and handling costs in cost of revenues.

Stock-Based Compensation

The Company follows the provisions of ASC Topic 718-20-10 Compensation – Stock Compensation which establishes standards surrounding the accounting for transactions with employees in which an entity exchanges its equity instruments for services. Under ASC 718-20-10, we recognize an expense for the fair value of our outstanding stock options generally over the requisite service period of the employee service. We follow the measurement and recognition provisions of ASC 505-50 Equity Based Payments to Non-Employees for non-employee stock-based transactions.

We estimate the fair value of each stock option at the grant date by using the Black-Scholes option pricing model based upon certain assumptions which are contained in Note 14 to our unaudited condensed consolidated financial statements contained in this report. The Black-Scholes-Merton ("BSM") option pricing model requires the input of highly subjective assumptions including the expected stock price volatility.

Fair Value of Liabilities for Warrant Derivative Instruments

We estimate the fair value of each warrant liability with a repricing feature at the issuance date and at each subsequent reporting date by using the BSM option pricing model based upon certain assumptions which are contained in Note 8 to our unaudited condensed consolidated financial statements contained in this report. The BSM model requires the input of highly subjective assumptions including the expected stock price volatility.

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ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

Comparison of the Three Months ended June 30, 2012 with the Three Months Ended June 30, 2011

The following table sets forth a modified version of our unaudited Condensed Consolidated Statements of Operations that is used in the following discussions of our results of operations: