UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

þ		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2008

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

Psychemedics Corporation

Delaware		58-1701987
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)
125 Nagog Park
Acton, Massachusetts		01720
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number including area code: (978) 206-8220

Securities registered pursuant to Section 12(b) of the Act:

Common Stock, $0.005 par value
(Title of class)

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by a check mark if the registrant is a well-known seasoned issuer (as defined in Rule 405 of the Securities Exchange Act of 1934). Yes o No þ

Indicate by a check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Exchange Act of 1934). Yes o No þ

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Securities Exchange Act of 1934.

Large accelerated filer o		Accelerated filer o		Non-accelerated filer o (Do not check if smaller reporting Company)		Smaller Reporting Company þ

Indicate by a check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Securities and Exchange Act of 1934). Yes o No þ

As of June 30, 2008, there were 5,233,366 shares of Common Stock of the Registrant outstanding. The aggregate market value of the Common Stock of the Registrant held by non-affiliates (assuming for these purposes, but not conceding, that all executive officers, directors and 5% shareholders are “affiliates” of the Registrant) as of June 30, 2008 was approximately $50 million, computed based upon the closing price of $16.40 per share on June 29, 2008.

As of March 23, 2009, there were 5,178,544 shares of Common Stock of the Registrant outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Part III of this Annual Report on Form 10-K incorporates by reference portions of the Registrant’s definitive proxy statement, to be filed with the Securities and Exchange Commission no later than 120 days after the close of its fiscal year; provided that if such proxy statement is not filed with the Commission in such 120-day period, an amendment to this Form 10-K shall be filed no later than the end of the 120-day period.

 

 

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Some of the statements under “Business,” “Risk Factors,” “Legal Proceedings,” “Market for Registrant’s Common Stock and Related Stockholder Matters” and “Management Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this Annual Report on Form 10-K (this “Form 10-K”) constitute forward-looking statements under Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements made with respect to future earnings per share, future revenues, future operating income, future cash flows, competitive and strategic initiatives, potential stock repurchases and future liquidity needs. These statements involve known and unknown risks, uncertainties and other factors that may cause results, levels of activity, growth, performance, earnings per share or achievements to be materially different from any future results, levels of activity, growth, performance, earnings per share or achievements expressed or implied by such forward-looking statements.

The forward-looking statements included in this Form 10-K and referred to elsewhere are related to future events or our strategies or future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “should,” “believe,” “anticipate,” “future,” “potential,” “estimate,” “encourage,” “opportunity,” “growth,” “leader,” “could”, “expect,” “intend,” “plan,” “expand,” “focus,” “through,” “strategy,” “provide,” “offer,” “allow,” “commitment,” “implement,” “result,” “increase,” “establish,” “perform,” “make,” “continue,” “can,” “ongoing,” “include” or the negative of such terms or comparable terminology. All forward-looking statements included in this Form 10-K are based on information available to us as of the filing date of this report, and the Company assumes no obligation to update any such forward-looking statements. Our actual results could differ materially from the forward-looking statements. Important factors that could cause actual results to differ materially from expectations reflected in our forward-looking statements include those described in Item 1A, “Risk Factors.”

PSYCHEMEDICS CORPORATION

Form 10-K
Annual Report
For the Year Ended December 31, 2008

TABLE OF CONTENTS

		Page
PART I
Item 1. Business			3
Item 1A. Risk Factors			9
Item 1B. Unresolved Staff Comments			12
Item 2. Properties			13
Item 3. Legal Proceedings			13
Item 4. Submission of Matters to a Vote of Security Holders			13
PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities			14
Item 6. Selected Financial Data			17
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations			18
Item 7A. Quantitative and Qualitative Disclosures About Market Risk			23
Item 8. Financial Statements and Supplementary Data			24
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure			41
Item 9A. (T.) Controls and Procedures			41
Item 9B. Other Information			41
PART III
Item 10. Directors, Executive Officers and Corporate Governance			42
Item 11. Executive Compensation			43
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters			43
Item 13. Certain Relationships and Related Transactions, and Director Independence			43
Item 14. Principal Accounting Fees and Services			43
PART IV
Item 15. Exhibits, Financial Statement Schedules			44
OTHER ITEMS
Signatures			45
Power of Attorney			45
Exhibit 10.13
Exhibit 10.14
Exhibit 10.15
Exhibit 23.1
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1
Exhibit 32.2

PART I

AVAILABLE INFORMATION; BACKGROUND

Psychemedics Corporation (“the Company”) maintains executive offices located at 125 Nagog Park, Acton, MA 01720. Our telephone number is (978) 206-8220. Our stock is traded on the NASDAQ Stock Exchange Market under the symbol “PMD”. Our Internet address is www.psychemedics.com. The Company makes available, free of charge, on the Investor Information section of its website, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with the Securities and Exchange Commission (the “SEC”). Copies are also available, without charge, from Psychemedics Corporation, Attn: Investor Relations, 125 Nagog Park, Acton, MA 01720. Alternatively, reports filed with the SEC may be viewed or obtained at the SEC Public Reference Room in Washington, D.C., or the SEC’s Internet site at www.sec.gov. We do not intend for information contained in our website to be part of this Annual Report on Form 10-K.

ITEM 1. BUSINESS

General

Psychemedics Corporation is a Delaware corporation organized on September 24, 1986 to provide testing services for the detection of abused substances through the analysis of hair samples. The Company’s testing methods utilize a patented technology to perform radioimmunoassays on enzymatically dissolved hair samples with confirmation testing by mass spectrometry.

The Company’s primary application of its patented technology is as a testing service that analyzes hair samples for the presence of certain drugs of abuse. Employing radioimmunoassay procedures to drug test hair samples differs from the more commonly used approach in which immunoassay procedures are employed to test urine samples. The Company’s tests provide quantitative information that can indicate the approximate amount of drug ingested as well as historical data, which can show a pattern of individual drug use over a period of time. This information is useful to employers for both applicant and employee testing, as well as to physicians, treatment professionals, law enforcement agencies, school administrators, parents concerned about their children’s drug use and other individuals or entities engaged in any business where drug use or potential drug use is an issue. The Company provides commercial testing and confirmation by mass spectrometry using industry-accepted practices for cocaine, marijuana, PCP, methamphetamine (including Ecstasy, which is difficult to detect in urine due to sporadic use patterns and rapid clearance from the body) and opiates (including heroin, hydrocodone, hydromorphone and oxycodone).

Testing services are currently performed at the Company’s laboratory at 5832 Uplander Way, Culver City, California. The Company’s services are marketed under the name RIAH (Radioimmunoassay of Hair), a registered service mark.

Development of Radioimmunoassay of Hair

The application of unique radioimmunoassay procedures to the analysis of hair was initially developed in 1978 by the founders of the Company, Annette Baumgartner and Werner A. Baumgartner, Ph.D. The Baumgartners demonstrated that when certain chemical substances enter the bloodstream, the blood carries these substances to the hair where they become “entrapped” in the protein matrix in amounts approximately proportional to the amount ingested. The Company’s patented drugs of abuse testing procedure involves direct analysis of liquefied hair samples by radioimmunoassay procedures utilizing effective reagents and antibodies. The antibodies detect the presence of a specific drug or drug metabolite in the liquefied hair sample by reacting with the drug present in the sample solution, as well as an added radioactive analog of the drug. The resulting antibody-drug complex is precipitated and analyzed. The amount of drug present in the sample is inversely proportional to the amount of radioactive analog in the precipitate. RIA positive results are then confirmed by Mass Spectrometry. Depending upon the length of head hair, the Company is able to provide historical information on drug use by the person from whom the sample was obtained. Since head hair grows approximately 1.3 centimeters per month, a 3.9 centimeter head hair sample can reflect drug ingestion over the approximate several months prior to the collection of the sample. Another testing option involves sectional analysis of the head hair sample. In this procedure, the hair is sectioned lengthwise to approximately correspond to certain time periods. Each section corresponds to a time period, which allows the Company to provide information on patterns of drug use.

Validation of the Company’s Proprietary Testing Method

The process of analyzing human hair for the presence of drugs using the Company’s patented method has been the subject of numerous peer-reviewed, scientific field studies. Results from the studies that have been published or accepted for publication in scientific journals are generally favorable to the Company’s technology. Some of these studies were performed with the following organizations: Boston University School of Public Health; Citizens for a Better Community Court, Columbia University; Connecticut Department of Mental Health and Addictive Services; Koba Associates-DC Initiative, Harvard Cocaine Recovery Project, Hutzel Hospital, ISA Associates (Interscience America)-NIDA Workplace Study, University of California-Sleep State Organization, Maternal/Child Substance Abuse Project, Matrix Center, National Public Services Research Institute, Narcotic and Drug Research Institute, San Diego State University-Chemical Dependency Center, Spectrum Inc., Stapleford Centre (London), Task Force on Violent Crime (Cleveland, Ohio); University of Miami-Department of Psychiatry, University of Miami-Division of Neonatology, University of South Florida-Operation Par Inc., University of Washington, VA Medical Center-Georgia, U.S. Probation Parole-Santa Ana and Wayne State University. The above studies include research in the following areas: effects of prenatal drug use, treatment evaluation, workplace drug use, the criminal justice system and epidemiology. Many of the studies have been funded by the National Institute of Justice or the National Institute on Drug Abuse (“NIDA”). Several hundred research articles written by independent researchers have been published supporting the general validity and usefulness of hair analysis.

Some of the Company’s customers have also completed their own testing to validate the Company’s proprietary hair testing method as a prelude to utilizing the Company’s services. These studies have consistently confirmed the Company’s superior detection rate compared to urinalysis testing. When results based on the Company’s patented hair testing method were compared to urine results in side-by-side evaluations, 4 to 10 times as many drug abusers were accurately identified by the Company’s proprietary method. In addition to these studies, the Company’s proprietary method is validated through the services it offers to the thousands of clients for whom it has performed testing.

In 1998, the National Institute of Justice, utilizing Psychemedics hair testing, completed a Pennsylvania Prison study where hair analysis revealed an average prison drug use level of approximately 7.9% in 1996. Comparatively, urinalysis revealed virtually no positives. After measures to curtail drug use were instituted (drug-sniffing dogs, searches and scanners), the use level fell to approximately 2% according to the results of hair analysis in 1998. Again, the urine tests showed virtually no positives. The study illustrates the usefulness of hair analysis to monitor populations and the weakness of urinalysis.

The Company has received 510k clearance from the United States Food and Drug Administration (“FDA”) on all five of its assays used to test human hair for drugs of abuse. As of the date of this report, Psychemedics has received FDA clearance for a five-drug panel test that is not restricted to head hair samples for drugs of abuse. See Government Regulation.

Advantages of Using the Company’s Patented Method

The Company asserts that hair testing using its patented method confers substantive advantages relative to existing means of drug detection through urinalysis. Although urinalysis testing can provide accurate drug use information, the scope of the information is short-term and is generally limited to the type of drug ingested within a few days of the test. Studies published in many scientific publications have indicated that most drugs disappear from urine within a few days.

In contrast to urinalysis testing, hair testing using the Company’s patented method can provide long-term historical drug use information resulting in a significantly wider “window of detection.” This “window” may be several months or longer depending on the length of the hair sample. The Company’s standard test offering, however, uses a 3.9 centimeter length head hair sample cut close to the scalp which measures use for approximately the previous several months.

This wider window enhances the detection efficiency of hair analysis, making it particularly useful in pre-employment and random testing. Hair testing not only identifies more drug users, but it may also uncover patterns and severity of drug use (information most helpful in determining the scope of an individual’s involvement with drugs), while serving as a deterrent against the use of drugs. Hair testing employing the Company’s patented method greatly reduces the incidence of “false negatives” associated with evasive measures typically encountered with urinalysis testing. For example, urinalysis test results are adversely impacted by excessive fluid intake prior to testing and by adulteration or substitution of the urine sample. Moreover, a drug user who abstains from use for a few days prior to urinalysis testing can usually escape detection. Hair testing is effectively free of these problems, as it cannot be thwarted by evasive measures typically encountered with urinalysis testing. Hair testing is also attractive to customers since sample collection is typically performed under close supervision yet is less intrusive and less embarrassing for test subjects.

Hair testing using the Company’s patented method (with mass spectrometry confirmation) further reduces the prospects of error in conducting drug detection tests. Urinalysis testing is more susceptible to problems such as “evidentiary false positives” resulting from passive drug exposure or poppy seeds. To combat this problem, in federally mandated testing, the opiate cutoff levels for urine testing were raised 667% (from 300 to 2,000 ng/ml) on December 1, 1998 and testing for the presence of a heroin metabolite, 6-AM, was required. These requirements, however, effectively reduced the detection time frame for confirmed heroin with 6-AM in urine down to several hours post drug use. In contrast, the metabolite 6-AM is stable in hair and can be detected for months.

In the event a positive urinalysis test result is challenged, a test on a newly collected urine sample is not a viable remedy. Unless the forewarned individual continues to use drugs prior to the date of the newly collected sample, a re-test may yield a negative result when using urinalysis testing because of temporary abstinence. In contrast, when the Company’s hair testing method is offered on a repeat hair sample, the individual suspected of drug use cannot as easily affect the results because historical drug use data remains locked in the hair fiber.

When compared to other hair testing methods, not only are the Company’s assays cleared by the FDA, they also employ a unique patented method of enzyme digestion that the Company believes allows for the most efficient release of drugs from the hair without destroying the drugs. The Company’s method of releasing drugs from hair is a key advantage and results in superior detection rates.

Disadvantages of Hair Testing

There are some disadvantages of hair testing as compared to drug detection through urinalysis. Because hair starts growing below the skin surface, drug ingestion evidence does not appear in hair above the scalp until approximately five to seven days after use.

Thus, hair testing is not suitable for determining drug presence in “for cause” testing as is done in connection with an accident investigation. It does, however, provide a drug history which can complement urinalysis information in “for cause” testing.

Currently, radioimmunoassay testing using hair samples under the Company’s patented method is only practiced by Psychemedics Corporation.

The Company’s prices for its tests are generally somewhat higher than prices for tests using urinalysis, but the Company believes that its superior detection rates provide more value to the customer. This pricing policy could, however, adversely impact the growth of the Company’s sales volume.

Patents

In 1994, the Company was issued its first patent, U.S. Patent No. 5,324,642 (the “642 Patent”) by the United States Patent and Trademark Office. This patent pertains to the Company’s universal drug extraction procedure and radioimmunoassay technology for the detection of drugs in hair specimens. Some of the research on the inventions covered by the 642 Patent was conducted at the Veteran’s Administration Hospital (“VA”). Therefore, the U.S. government has been granted a nonexclusive, irrevocable, royalty-free license to use the basic invention covered by the 642 Patent, for all governmental purposes. In 1995, the Company was granted a second patent pertaining to the immuno-chemical screening assay for marijuana, which is the most difficult drug to detect.

In 1996, the Company was issued its first European patent on the base hair analysis method. The Company was also issued a European patent in 1996 on another aspect of the Company’s technology, related to the use of detergents to enhance the hair digestion portion of the methodology.

In October 1998, the Japanese Patent Office informed the Company that it had allowed the pending Japanese patent application containing broad claims to the Company’s proprietary hair test for drugs of abuse.

In August 1999, the Canadian Patent Office issued the Company a patent containing broad claims to the Company’s proprietary basic hair analysis method.

In December 1999, the Company was issued European patents related to the analysis of marijuana analyte in hair. As a result of the issuance of this patent, national patents are in effect in Germany, France, Italy, the United Kingdom and Spain.

In February 2000, a third U.S. patent was issued which extends protection to yet another aspect of the Company’s methodology. This patent provides for the use of metal salt to deactivate certain reagents used in the method, thus enhancing efficiency.

In December 2001, a Japanese certificate of patent was issued related to the use of detergents in the Psychemedics hair analysis process.

In January 2002, a second Canadian patent was issued, which relates to the use of ion exchange resins in the marijuana assay.

In February 2002, a fourth U.S. patent was issued that covers the base hair analysis method and broadens considerably the scope of the original U.S. patent.

In June 2003, a fifth U.S. patent was issued which covers degradation of a keratin structure, filtering to remove particulate substances present in the digest solution that may interfere with the screen methods, and analysis of the digest to determine the identity and amount of the drug present.

A sixth U.S. patent, issued in September 2005, describes the use of biological detergents with our hair analysis methods to aid in the digestion of hair without damaging the drug analytes trapped in the original hair structure.

Certain aspects of the Company’s hair analysis method are based on trade secrets owned by the Company. The Company’s ability to protect the confidentiality of these trade secrets is dependent upon the Company’s internal safeguards and upon the laws protecting trade secrets and unfair competition. In the event that patent protection or protection under the laws of trade secrets was not sufficient and the Company’s competitors succeeded in duplicating the Company’s products, the Company’s business could be materially adversely affected.

Target Markets

1. Workplace

The Company focuses its primary marketing efforts on the private sector, with particular emphasis on job applicant and employee testing.

Most businesses use drug testing to screen job applicants and employees. The American Management Association (AMA) survey from 2004 indicated that 62% of surveyed firms were engaged in some form of drug testing. The prevalence of drug screening programs reflects a concern that drug use contributes to employee health problems and costs (increased absenteeism, workers’ compensation claims and reduced productivity, etc.) and in certain industries, safety hazards. It has been estimated that the cost to American businesses is more than $100 billion annually.

The principal criticism of employee drug testing programs centers on the effectiveness of the testing program. Most private sector testing programs use urinalysis. Such programs are susceptible to evasive maneuvers and the inability to obtain confirmation through repeat samples in the event of a challenged result. An industry has developed over the Internet, and through direct mail, marketing a wide variety of adulterants, dilutants, clean urine and devices to assist drug users in falsifying urine test results.

Moreover, scheduled tests such as pre-employment testing and some random testing programs provide an opportunity for many drug users to simply abstain for a few days in order to escape detection by urinalysis.

The Company presents its patented hair analysis method to potential clients as a better technology well suited to employer needs. Field studies and actual client results support the accuracy and effectiveness of the Company’s patented technology and its ability to detect varying levels of drug use. This information provides an employer with greater flexibility in assessing the scope of an applicant’s or an employee’s drug problem.

The Company performs a confirmation test of all presumptive positive results through mass spectrometry. The use of mass spectrometry is an industry accepted practice used to confirm positive drug test results of an initial screen. In an employment setting, mass spectrometry confirmation is typically used prior to the taking of any disciplinary action against an employee. The Company offers its clients a five-drug screen with mass spectrometry confirmation of cocaine, PCP, marijuana, amphetamines (including Ecstasy), and opiates (including heroin and oxycodone).

2. Schools

The Company currently serves hundreds of schools throughout the United States and in several foreign countries. The Company offers its school clients the same five-drug screen with mass spectrometry confirmation that is used with the Company’s workplace testing service.

3. Parents

The Company also offers a personal drug testing service, known as “PDT-90"â , for parents concerned about drug use by their children. It allows parents to collect a small sample from their child in the privacy of the home, send it to the Company’s laboratory and have it tested for drugs of abuse by the Company. The PDT-90 testing service uses the same patented method that is used with the Company’s workplace testing service.

4. Research

The Company is involved in ongoing studies involving use of drugs of abuse in various populations, including the following: National Development and Research Institute; Human metabolic studies with ecstasy at the Chemistry and Drug Metabolism Section, NIDA, Baltimore, MD; Addiction health evaluation and disease management at Boston Medical Center; Studies of motivational intervention with drug users at Boston University School of Public Health; Perinatal drug use at Wayne State University; Teens at risk: Prenatal and Postnatal Challenges at Wayne State University Health Center.

Sales and Marketing

The Company markets its corporate drug testing services primarily through its own sales force. Sales offices are located in several major cities in the United States in order to facilitate communications with corporate employers. The Company markets its home drug testing service, PDT-90, through the Internet and retail distributors.

Competition

The Company competes directly with numerous commercial laboratories that test for drugs primarily through urinalysis testing. Most of these laboratories, such as Laboratory Corporation of America and Quest Diagnostics, have substantially greater financial resources, market identity, marketing organizations, facilities, and numbers of personnel than the Company. The Company has been steadily increasing its base of corporate customers and believes that future success with new customers is dependent on the Company’s ability to communicate the advantages of implementing a drug program utilizing the Company’s patented hair analysis method.

The Company’s ability to compete is also a function of pricing. The Company’s prices for its tests are generally somewhat higher than prices for tests using urinalysis. However, the Company believes that its superior detection rates, coupled with the customer’s ability to test less frequently due to hair testing’s wider window of detection (several months versus approximately three days with urinalysis) provide more value to the customer. This pricing policy could, however, lead to slower sales growth for the Company.

Although other laboratories have begun offering hair testing, the Company is the only laboratory with FDA clearance for a five-drug panel test that is not limited to head hair samples for drugs of abuse. To date, no other laboratory engaged in hair testing has received approval or clearance from the FDA on all of its assays for the testing of both head and body hair samples (two other laboratories have either partial FDA clearance or clearance specific to head hair samples only). Additionally, several of these laboratories that purport to test hair samples use a method that the Company presumes includes the use of a form of immunoassay procedures. The Company, however, does not believe that immunoassay testing of hair samples is as effective on a commercial basis without using the Company’s unique patented method, which allows for the efficient release of drugs from the hair through enzyme digestion without destroying the drugs.

Government Regulation

The Company is licensed as a clinical laboratory by the State of California as well as certain other states. All tests are performed according to the laboratory standards established by the Department of Health and Human Services, through the Clinical Laboratories Improvement Amendments (“CLIA”), and various state licensing statutes.

A substantial number of states regulate drug testing. The scope and nature of such regulations varies greatly from state to state and is subject to change from time to time. The Company addresses state law issues on an ongoing basis.

In 2000 the FDA issued regulations under the Federal Food, Drug and Cosmetic Act, as amended (the “FDC Act”) with respect to companies that market “drugs of abuse test sample collection systems”. Under the regulations, companies engaged in the business of testing for drugs of abuse using a test (screening assay) not previously recognized by the FDA are required to submit their assay to the FDA for recognition prior to marketing. In addition, the laboratory performing the tests is required to be certified by a recognized agency. The regulations included a transitional period in order for companies not immediately in compliance with the proposed requirements to obtain the necessary data they needed for submission to the FDA.

By May 3, 2002, the Company had received 510k clearance to market all five of its assays.

In December 2003, the FDA issued revised draft guidance for manufacturers of drug screening tests, clarifying the FDA’s position on laboratory and non-laboratory tests. The FDA indicated its intent to enforce the FDC Act. In June 2005, the FDA issued a public message confirming the need for FDA clearance of screening tests used by businesses and consumers to detect the presence of drugs of abuse.

In June 2008, Psychemedics also received the first CAP (College of American Pathologists) certification specifically including hair testing.

Research and Development

The Company is continuously engaged in research and development activities. During the years ended December 31, 2008, 2007 and 2006, $474,622, $489,007 and $444,532, respectively, were expended for research and development. The Company continues to perform research activities to develop new products and services and to improve existing products and services utilizing the Company’s proprietary technology. The Company also continues to evaluate methodologies to enhance its drug screening capabilities. Additional research using the Company’s proprietary technology is being conducted by outside research organizations through government-funded studies.

Additional research has been conducted in the measurement of concentrations of marijuana by Gas Chromatography/Mass Spectrometry/Mass Spectrometry (GC/MS/MS). This has been the most challenging, and requires the most sensitive of equipment for its accurate measurement and qualitative identification.

Research has continued on the interactions of different types of hair with drugs in the environment and from actual drug usage. This work has concentrated on assessments of various published methods for removal of externally deposited drug from hair surfaces and on methods of extraction of metabolically deposited drugs from the solid hair matrix. Some of the work has been presented at meetings of the Society of Forensic Toxicologists and the European Society of Hair Testing. A chapter on Hair Analysis by Psychemedics scientists is included in a 2006 book, Analytical and Practical Aspects of Drug Testing in Hair, CRC Press.

Sources and Availability of Raw Materials

Since its inception, the Company has purchased raw materials for its laboratory services from outside suppliers. The most critical of these raw materials are the radio-labeled drugs which the Company purchases from a single supplier, although other suppliers of radio-labeled drugs exist. The Company has entered into an agreement with its principal supplier to purchase certain proprietary information regarding the manufacture of such radio-labeled drugs owned by the supplier in the event that the supplier ceases to be able to supply such radio-labeled drugs to the Company.

Employees

As of December 31, 2008, the Company had 92 full-time equivalent employees, of whom 3 full-time employees were in research and development. None of the Company’s employees is subject to a collective bargaining agreement.

ITEM 1A. RISK FACTORS

In addition to other information contained in this Form 10-K, the following risk factors should be carefully considered in evaluating Psychemedics Corporation and its business because such factors could have a significant impact on our business, operating results and financial condition. These risk factors could cause actual results to materially differ from those projected in any forward-looking statements.

Companies may develop products that compete with our products and some of these companies may be larger and better capitalized than we are.

Many of our competitors and potential competitors are larger and have greater financial resources than we do and offer a range of products broader than our products. Some of the companies with which we now compete or may compete in the future may develop more extensive research and marketing capabilities and greater technical and personnel resources than we do, and may become better positioned to compete in an evolving industry. Failure to compete successfully could harm our business and prospects.

Our results of operations are subject in part to variation in our customers’ hiring practices and other factors beyond our control.

Our results of operations have been and may continue to be subject to variation in our customers’ hiring practices, which in turn is dependent, to a large extent, on the general condition of the economy. Results for a particular quarter may vary due to a number of factors, including:

•

economic conditions in our markets in general;

•

economic conditions affecting our customers and their particular industries;

•

the introduction of new products and product enhancements by us or our competitors; and

•

pricing and other competitive conditions.

Our business could be harmed if we are unable to protect our proprietary technology.

We rely primarily on a combination of trade secrets, patents and trademark laws and confidentiality procedures to protect our technology. Despite these precautions, unauthorized third parties may infringe or copy portions of our technology. In addition, because patent applications in the United States are not publicly disclosed until either (1) 18 months after the application filing date or (2) the publication date of an issued patent wherein applicant(s) seek only US patent protection, applications not yet disclosed may have been filed which relate to our technology. Moreover, there is a risk that foreign intellectual property laws will not protect our intellectual property rights to the same extent as United States intellectual property laws. In the absence of significant patent protection, we may be vulnerable to competitors who attempt to copy our products, processes or technology.

Our business could be affected by a computer or other IT System failure.

A computer or IT system failure could affect our ability to perform tests, report test results or properly bill customers. Failures could occur as a result of the standardization of our IT systems and other system conversions, telecommunications failures, malicious human acts (such as electronic break-ins or computer viruses) or natural disasters.

Our future success will depend on the continued services of our key personnel.

The loss of any of our key personnel, could harm our business and prospects. We may not be able to attract and retain personnel necessary for the development of our business. We do not have key personnel under contract other than 3 officers who have agreements providing for severance and non compete covenants in the event of termination of employment following a change of control. Further, we do not have any key man life insurance for any of our officers or other key personnel.

We are exposed to potential risks and we will incur costs as a result of the internal control assessment and attestation process mandated by Section 404 of the Sarbanes-Oxley Act of 2002.

We have evaluated, tested and implemented internal controls over financial reporting to enable management to report on such internal controls as required by Section 404 of the Sarbanes-Oxley Act of 2002. In connection with the filing of our annual report for 2009, we are currently required to provide an auditor attestation on internal controls. The additional testing and the auditor attestation could cause us to incur significant costs, including increased accounting fees and staffing levels. While we believe that we are compliant with the management evaluation requirements of Section 404, if our independent registered public accounting firm cannot attest in a timely manner to our evaluation, we could be subject to regulatory scrutiny and a loss of public confidence in our internal controls. In addition, any failure to implement required new or improved controls, or difficulties encountered in their implementation, could harm our operating results or cause us to fail to meet our reporting obligations. We intend to devote substantial time and incur substantial costs, as necessary, to ensure ongoing compliance.

Our reliance on one supplier for certain raw materials used in our testing procedures could harm our business and prospects.

Since its inception, the Company has purchased raw materials for its laboratory services from outside suppliers. The most critical of these raw materials are the radio-labeled drugs, which the Company purchases from a single supplier, although other suppliers of radio-labeled drugs exist. The Company has entered into an agreement with its principal supplier to purchase certain proprietary information regarding the manufacture of such radio-labeled drugs owned by the supplier in the event that the supplier ceases to be able to supply such radio-labeled drugs to the Company. Obtaining alternative sources of supply of the radio-labeled drugs could involve delays and other costs; however, the Company maintains a surplus supply. The failure of the Company’s primary or any alternative supplier of radio-labeled drugs to provide such radio-labeled drugs at an acceptable price, or an interruption of supplies from such a supplier and the exhaustion of the Company’s current supply on hand could result in lost or deferred sales. The Company was unsuccessful in the arbitration proceeding it brought against the supplier involving restrictions on the supplier’s ability to sell to third parties portions of its inventory of antibodies. However, other antibody suppliers exist.

There is a risk that our insurance will not be sufficient to protect us from errors and omissions liability or other claims, or that in the future errors and omissions insurance will not be available to us at a reasonable cost, if at all.

Our business involves the risk of claims of errors and omissions and other claims inherent to our business. We maintain errors and omissions and general liability insurance subject to deductibles and exclusions. There is a risk that our insurance will not be sufficient to protect us from all such possible claims. An under-insured or uninsured claim could harm our operating results or financial condition.

Our research and development capabilities may not produce viable new services or products.

We are attempting to develop further capabilities in the drug testing arena. It is uncertain whether we will be able to develop services that are more efficient, effective or that are suitable for our customers. Our ability to create viable products or services depends on many factors, including the implementation of appropriate technologies, the development of effective new research tools, the complexity of the chemistry and biology, the lack of predictability in the scientific process and the performance and decision-making capabilities of our scientists.

Further, some of our existing patents are due to expire within the next 2-5 years. Our research and development teams are working to develop improved processes with the aim of gaining additional patent protection. There is no guarantee that they will be successful in developing these improvements or gaining such additional patent protection. If all of our patents expire, there may be increased competition in the marketplace for our service or we might be required to rely on trade secret protection.

We may not be able to recruit and retain the experienced scientists and management we need to compete in our industry.

Our future success depends upon our ability to attract, retain and motivate highly skilled scientists and management. Our ability to achieve our business strategies depends on our ability to hire and retain high caliber scientists and other qualified experts. We compete with other testing companies, research companies and academic and research institutions to recruit personnel and face significant competition for qualified personnel. We may incur greater costs than anticipated, or may not be successful, in attracting new scientists or management or in retaining or motivating our existing personnel.

Our future success also depends on the personal efforts and abilities of the principal members of our senior management and scientific staff to provide strategic direction, to manage our operations and maintain a cohesive and stable environment.

Our facilities and practices may fail to comply with government regulations.

Our testing facilities and processes must be operated in conformity with current government regulations. These requirements include, among other things, quality control, quality assurance and the maintenance of records and documentation. If we fail to comply with these requirements, we may not be able to continue our services to certain customers, or we could be subject to fines and penalties, suspension of production, or withdrawal of our certifications. We operate a facility that we believe conforms to all applicable requirements. This facility and our testing practices are subject to periodic regulatory inspections to ensure compliance.

If our use of chemical and hazardous materials violates applicable laws or regulations or causes personal injury we may be liable for damages.

Our drug testing activities, including the analysis and synthesis of chemicals, involve the controlled use of chemicals, including flammable, combustible, toxic and radioactive materials that are potentially hazardous. Our use, storage, handling and disposal of these materials is subject to federal, state and local laws and regulations, including the Resource Conservation and Recovery Act, the Occupational Safety and Health Act and local fire codes, and regulations promulgated by the Department of Transportation, the Drug Enforcement Agency, the Department of Energy, and the California Department of Public Health and Environment. We may incur significant costs to comply with these laws and regulations in the future. In addition, we cannot completely eliminate the risk of accidental contamination or injury from these materials, which could result in material unanticipated expenses, such as substantial fines or penalties, remediation costs or damages, or the loss of a permit or other authorization to operate or engage in our business. Those expenses could exceed our net worth and limit our ability to raise additional capital.

Our operations could be interrupted by damage to our specialized laboratory facilities.

Our operations are dependent upon the continued use of our highly specialized laboratories and equipment in Culver City, California. Catastrophic events, including earthquakes, fires or explosions, could damage our laboratories, equipment, scientific data, work in progress or inventories of chemicals and may materially interrupt our business. We employ safety precautions in our laboratory activities in order to reduce the likelihood of the occurrence of certain catastrophic events; however, we cannot eliminate the chance that such events will occur. The availability of laboratory space in these locations is limited, and rebuilding our facilities could be time consuming and result in substantial delays in fulfilling our agreements with our customers. We maintain business interruption insurance to cover continuing expenses and lost revenue caused by such occurrences. However, this insurance does not compensate us for the loss of opportunity and potential harm to customer relations that our inability to meet our customers’ needs in a timely manner could create.

Agreements we have with our employees, consultants and customers may not afford adequate protection for our trade secrets, confidential information and other proprietary information.

In addition to patent protection, we also rely on copyright and trademark protection, trade secrets, know-how, continuing technological innovation and licensing opportunities. In an effort to maintain the confidentiality and ownership of our trade secrets and proprietary information, we require our employees, consultants and advisors to execute confidentiality and proprietary information agreements. However, these agreements may not provide us with adequate protection against improper use or disclosure of confidential information and there may not be adequate remedies in the event of unauthorized use or disclosure. Furthermore, we may from time to time hire scientific personnel formerly employed by other companies involved in one or more areas similar to the activities we conduct. In some situations, our confidentiality and proprietary information agreements may conflict with, or be subject to, the rights of third parties with whom our employees, consultants or advisors have prior employment or consulting relationships. Although we require our employees and consultants to maintain the confidentiality of all proprietary information of their previous employers, these individuals, or we, may be subject to allegations of trade secret misappropriation or other similar claims as a result of their prior affiliations. Finally, others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets. Our failure or inability to protect our proprietary information and techniques may inhibit or limit our ability to compete effectively, or exclude certain competitors from the market.

Risks Related To Our Stock

Our quarterly operating results could fluctuate significantly, which could cause our stock price to decline.

Our quarterly operating results have fluctuated in the past and are likely to fluctuate in the future. Our results are impacted by the extent to which we are able to gain new customers and on the hiring practices of our existing customers, which are, in turn, impacted by general economic conditions. Entering into new customer contracts can involve a long lead time. Accordingly, negotiation can be lengthy and is subject to a number of significant risks, including customers’ budgetary constraints and internal reviews. Due to these and other market factors, our operating results could fluctuate significantly from quarter to quarter. In addition, we may experience significant fluctuations in quarterly operating results due to factors such as general and industry-specific economic conditions that may affect the budgets and the hiring practices of our customers.

Due to the possibility of fluctuations in our revenue and expenses, we believe that quarter-to-quarter comparisons of our operating results are not necessarily a good indication of our future performance. Our operating results in some quarters may not meet the expectations of stock market analysts and investors. If we do not meet analysts’ and/or investors’ expectations, our stock price could decline.

Our stock price could experience substantial volatility.

The market price of our common stock has historically experienced and may continue to experience extensive volatility. Our quarterly operating results, the success or failure of future development efforts, changes in general conditions in the economy or the financial markets and other developments affecting our customers, our competitors or us could cause the market price of our common stock to fluctuate substantially. This volatility may adversely affect the price of our common stock. In the past, securities class action litigation has often been instituted following periods of volatility in the market price of a company’s securities. A securities class action suit against us could result in potential liabilities, substantial costs and the diversion of management’s attention and resources, regardless of whether we win or lose.

Payment of a dividend could decline or cease.

Because we have historically paid dividends, any cessation of our program or reduction in our quarterly dividend could affect our stock price. We have paid dividends on our common stock for 50 consecutive quarters. It is our intent to continue this practice as long as we are able. However, if we are forced to cease this practice or reduce the amount of the regular dividend, due to operating or economic conditions, our stock price could suffer. In December 2008, the Company also paid a special dividend. Investors should not anticipate or expect any future or recurring special dividends. Further, if the Company ceases its future dividends, a return on investment in our common stock would depend entirely upon future appreciation. There is no guarantee that our common stock will appreciate in value or even maintain the price at which stockholders have purchased their shares.

The general economic condition could continue to deteriorate

Our business is dependent upon new hiring and the supply of new jobs created by overall economic conditions. If the economy continues to deteriorate, leading to high unemployment and the lack of new job creation, our business and stock price could be adversely affected.

ITEM 1B. UNRESOLVED STAFF COMMENTS

Not applicable.

ITEM 2. PROPERTIES

The Company maintains its corporate office and northeast sales office at 125 Nagog Park, Acton, Massachusetts; the office consists of 3,971 square feet and is leased through November 2009.

The Company leases 18,000 square feet of space in Culver City, California, for laboratory purposes. This facility is leased through December 31, 2012 with an option to renew for an additional three years. The Company also leases an additional 5,400 square feet of space in Culver City, California for customer service and information technology purposes. This office space is leased through December 31, 2010 with an option to renew for an additional two years.

ITEM 3. LEGAL PROCEEDINGS

The Company is involved in various suits and claims in the ordinary course of business. The Company does not believe that the disposition of any such suits or claims will have a material adverse effect on the continuing operations or financial condition of the Company.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Not applicable.

PART II

The Company’s common stock is traded on the NASDAQ Stock Market under the symbol “PMD”. As of March 23, 2009, there were 268 record holders of the Company’s common stock. The number of record owners was determined from the Company’s stockholder records maintained by the Company’s transfer agent and does not include beneficial owners of the Company’s common stock whose shares are held in the names of various security holders, dealers and clearing agencies. The Company believes that the number of beneficial owners of the Company’s common stock held by others as or in nominee names exceeds 2,000.

The following table sets forth for the periods indicated the range of prices for the Company’s common stock as reported by the NASDAQ Stock Exchange and dividends declared by the Company.

		High				Low				Dividends
FISCAL 2007:
First Quarter		$	19.25			$	16.32			$	0.125
Second Quarter			20.50				16.30				0.150
Third Quarter			21.05				16.72				0.150
Fourth Quarter			17.35				13.92				0.150
FISCAL 2008:
First Quarter		$	17.80			$	14.12			$	0.150
Second Quarter			19.10				14.95				0.170
Third Quarter			16.30				13.62				0.170
Fourth Quarter*			15.00				5.91				0.670

The Company has paid dividends over the past twelve years. It most recently declared a dividend in February 2009, which was paid in March 2009. The Company’s current intention is to continue to declare dividends to the extent funds are available and not required for operating purposes or capital requirements, and only then, upon approval by the Board of Directors.

Issuer Purchases of Equity Securities

During 2008, the Company repurchased 61,107 common shares for treasury. See Item 7 for more detail.

Unregistered Sales of Equity Securities and Use of Proceeds

The following table presents the aggregate monthly purchases during the fourth quarter of 2008:

										Total number of
										shares purchased as				Maximum number
		Total				Average				part of publicly				of shares that may
		number of				price				announced				yet be purchased
		shares				paid per				repurchase				under the
Month		purchased				share				programs				programs (1),(2)
October			9,426			$	10.52				9,426				231,172
November			2,010			$	8.63				2,010				229,162
December			9,020			$	6.24				9,020				220,142
Total			20,456			$	8.44				20,456				220,142

EQUITY COMPENSATION PLAN INFORMATION

The following table provides information as of December 31, 2008, with respect to shares of the Company’s common stock that were issuable under the Company’s 2006 Equity Incentive Plan (the “2006 Equity Incentive Plan”).

The table does not include information with respect to shares subject to outstanding options granted under other equity compensation plans that were no longer in effect on December 31, 2008. Footnote (2) to the table sets forth the total number of shares of common stock issuable upon the exercise of options under such expired or discontinued plans as of December 31, 2008, and the weighted average exercise price of those options. No additional options may be granted under such other expired or discontinued plans.

Number of Securities to

Weighted average

be issued upon exercise

exercise price of

Number of securities that

of outstanding options,

outstanding options,

remained available for

Plan category

warrants and rights

warrants and rights

future issuance

(a)

(b)

(c)

Equity compensation plans approved by security holders (1)

67,600

$

0.00

158,100

Equity compensation plans not approved by security holders

—

—

—

Total

67,600

$

0.00

158,100

Performance Graph

		2003				2004				2005				2006				2007				2008
PSYCHEMEDICS CORPORATION			100.00				142.16				155.61				221.50				192.18				88.38
RUSSELL 2000 INDEX			100.00				117.00				120.88				141.43				137.55				76.82
NASDAQ COMPOSITE INDEX			100.00				108.59				110.08				120.56				132.39				78.72

ITEM 6. SELECTED FINANCIAL DATA

The selected financial data presented below is derived from our financial statements and should be read in connection with those statements.

		As of and for the Years Ended
		December 31,
		2008				2007				2006				2005				2004
		(In thousands, except for per share data)
Revenue		$	22,949			$	24,569			$	23,425			$	21,389			$	18,937
Gross profit			13,350				14,677				14,056				12,576				10,448
Income from operations			4,707				7,139				7,563				6,326				4,331
Net income			2,969				4,484				4,902				4,049				2,764
Basic net income per share			0.57				0.86				0.95				0.79				0.54
Diluted net income per share			0.57				0.85				0.94				0.78				0.54
Total assets			12,628				15,561				13,261				11,145				8,434
Working capital			9,516				12,773				10,534				7,832				5,126
Shareholders’ equity			10,560				13,878				11,504				8,895				6,234
Cash dividends declared per common share		$	1.16			$	0.575			$	0.475			$	0.36			$	0.32

The Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read together with the more detailed business information and financial statements and related notes that appear elsewhere in this annual report on Form 10-K. This annual report may contain certain “forward-looking” information within the meaning of the Private Securities Litigation Reform Act of 1995. This information involves risks and uncertainties. Actual results may differ materially from the results discussed in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in “Item 1A — Risk Factors.”

Overview

Psychemedics Corporation is the world’s largest provider of hair testing for drugs of abuse, utilizing a patented hair analysis method involving radioimmunoassay technology and confirmation by mass spectrometry to analyze human hair to detect abused substances. The Company’s customers include Fortune 500 companies, as well as small to mid-size corporations, schools and governmental entities located primarily in the United States. During the year ended December 31, 2008, the Company generated $22.9 million in revenue, while maintaining a gross margin of 58% and pre-tax margins over 20%. At December 31, 2008, the Company had $6.6 million of cash and cash equivalents. During 2008, the Company had operating cash flow of $3.7 million and it distributed over $6.0 million or $1.16 per share of cash dividends to its shareholders. To date, the Company has paid fifty consecutive quarterly cash dividends.

The following table sets forth, for the periods indicated, selected statements of operations data as a percentage of total revenue:

		Year Ended December 31,
		2008				2007				2006
Revenue			100.0	%			100.0	%			100.0	%
Cost of revenue			41.8	%			40.3	%			40.0	%
Gross profit			58.2	%			59.7	%			60.0	%
Operating expenses:
General and administrative			19.7	%			16.1	%			14.0	%
Marketing and selling			15.9	%			12.5	%			11.8	%
Research and development			2.1	%			2.0	%			1.9	%
Total operating expenses			37.7	%			30.6	%			27.7	%
Operating income			20.5	%			29.1	%			32.3	%
Other income
Interest income			1.3	%			1.7	%			1.3	%
Other income			—				—				—
Total other income			1.3	%			1.7	%			1.3	%
Income before taxes			21.8	%			30.8	%			33.6	%
Tax provision			8.9	%			12.5	%			12.6	%
Net income			12.9	%			18.2	%			21.0	%

Results for the Year Ended December 31, 2008 Compared to Results for the Year Ended December 31, 2007

Revenue decreased $1.6 million or 7% to $22.9 million in 2008 compared to $24.6 million in 2007. This decrease was due in part to decreased testing volume, which decreased 6% compared to 2007. Average revenue per sample was unchanged between 2008 and 2007. Testing volume from existing and new customers fell 3% and 26%, respectively. Revenue included the recognition of deferred revenue relating to the sale of PDT-90 products was $0.1 and $0.2 million, respectively, for each of the years ended December 31, 2008 and 2007.

Gross profit decreased $1.3 million to $13.4 million in 2008 compared to $14.7 million in 2007. Direct costs decreased by 3% from 2007 to 2008, mainly due to lower labor and associated costs. The gross profit margin fell from 59.7% in 2007 to 58.2% in 2008 because the decline in revenue was greater than the reduction in direct costs.

General and administrative (“G&A”) expenses were $4.5 million for the year ended December 31, 2008 compared to $3.9 million for the year ended December 31, 2007, representing an increase of 14%. As a percentage of revenue, G&A expenses were 19.7% and 16.1% for the years ended December 31, 2008 and 2007, respectively. The increase in general and administrative expenses in 2008 was due primarily to an increase in legal fees defending our technology on behalf of our customers of approximately $270,000, salaries and stock compensation of approximately $144,000, bad debt expense of approximately $85,000 and consulting fees of approximately $84,000.

Marketing and selling expenses were $3.6 million for the year ended December 31, 2008, compared to $3.1 million for the year ended December 31, 2007, an increase of 18%. The variation in marketing and selling expenses was primarily due to higher staffing levels in the marketing area and related benefits in 2008. Total marketing and selling expenses represented 15.9% and 12.5% of revenue for the years ended December 31, 2008 and 2007, respectively.

Research and development (“R&D”) expenses for 2008 were $0.5 million compared to $0.5 million for 2007. R&D expenses represented 2.1% and 2.0% of revenue for the years ended December 31, 2008 and 2007, respectively.

Interest income decreased $0.1 million to $0.3 million for the year ended December 31, 2008 compared to $0.4 million for the year ended December 31, 2007. Interest income in both periods represented interest and dividends earned on cash equivalents and short-term investments. Lower average investment balances along with a decrease in the yield on investment balances in 2008 as compared to 2007 caused the decrease in interest income.

During the year ended December 31, 2008, the Company recorded a tax provision of $2.0 million, representing an effective tax rate of 40.8%. During the year ended December 31, 2007, the Company recorded a tax provision of $3.1 million, representing an effective tax rate of 40.7%.

Results for the Year Ended December 31, 2007 Compared to Results for the Year Ended December 31, 2006

Revenue increased $1.2 million or 5% to $24.6 million in 2007, compared to $23.4 million in 2006. This increase was due in part to increased testing volume, which increased 4% over 2006, along with an increase of 1% in the average revenue per sample. Testing volume increased as a result of volume from new customers in 2007, while volume for existing customers decreased. Revenue included the recognition of deferred revenue relating to the sale of PDT-90 products of $0.2 million for each of the years ended December 31, 2007 and 2006.

Gross profit increased $0.6 million to $14.7 million in 2007, compared to $14.1 million in 2006. Direct costs increased by 6% from 2006 to 2007, mainly due to increased labor and associated costs. The gross profit margin remained relatively unchanged at 59.7% in 2007 compared to 60.0% in 2006.

General and administrative (“G&A”) expenses were $3.9 million for the year ended December 31, 2007, compared to $3.3 million for the year ended December 31, 2006, representing an increase of 20%. As a percentage of revenue, G&A expenses were 16.1% and 14.0% for the years ended December 31, 2007 and 2006, respectively. The increase in general and administrative expenses in 2007 was due primarily to an increase in legal fees and audit fees, along with an increase in stock-based compensation, attributable to a full-year expense of stock-based awards issued in May 2006 and additional expense related to stock-based awards issued in May 2007.

Marketing and selling expenses were $3.1 million for the year ended December 31, 2007, compared to $2.8 million for the year ended December 31, 2006, an increase of 12%. The variation in marketing and selling expenses was primarily due to higher sales staffing levels, related staffing expenses and higher commissions in 2007. Total marketing and selling expenses represented 12.5% and 11.8% of revenue for the years ended December 31, 2007 and 2006, respectively.

Research and development (“R&D”) expenses for 2007 were $0.5 million, compared to $0.4 million for 2006, an increase of 10%. The increased R&D expense was due to the cost of supplies for several scientific research projects. R&D expenses represented 2.0% and 1.9% of revenue for the years ended December 31, 2007 and 2006, respectively.

Other income increased $0.1 million to $0.4 million for the year ended December 31, 2007, compared to $0.3 million for the year ended December 31, 2006. Other income in both periods represented interest and dividends earned on cash equivalents and short-term investments. Higher average investment balances along with an increase in the yield on investment balances in 2007 as compared to 2006 caused the increase in interest and dividend income.

During the year ended December 31, 2007, the Company recorded a tax provision of $3.1 million, representing an effective tax rate of 40.7%. During the year ended December 31, 2006, the Company recorded a tax provision of $3.0 million, representing an effective tax rate of 37.6%. The increase in the effective tax rate from 2006 to 2007 was mainly due to an increase in the amount of state income taxes.

Liquidity and Capital Resources

At December 31, 2008, the Company had $6.6 million of cash and cash equivalents, compared to $10.0 million at December 31, 2007. The Company’s operating activities generated net cash of $3.7 million in 2008, $4.9 million in 2007 and $4.6 million in 2006. Investing activities provided $3.5 million in 2008, used $0.6 million in 2007 and used $1.4 million in 2006. Financing activities used $6.7 million in 2008, $2.3 million in 2007 and $2.4 million in 2006.

Operating cash flow of $3.7 million in 2008 primarily reflected net income of $3.0 million adjusted for depreciation and amortization of $0.3 million, stock compensation expense of $0.4 million and an increase in prepaid expenses of $0.6 million, offset by an increase in accrued expenses of $0.3 million. Operating cash flow of $4.9 million in 2007 primarily reflected net income of $4.5 million adjusted for depreciation and amortization of $0.3 million, stock compensation expense of $0.2 million and a decrease in prepaid expenses of $0.3 million, offset by an increase in accounts receivable of $0.4 million. Operating cash flow in 2006 of $4.6 million consisted of $4.9 million in net income, adjusted for depreciation and amortization of $0.3 million, stock compensation expense of $0.1 million, offset by an increase in prepaid expenses of $0.4 million and an increase in accrued expenses of $0.4 million.

Investing cash flow principally reflected the purchase and redemption of short-term investments and capital expenditures. During 2008, the Company redeemed at par value short term investments of $3.9 million. During 2007, the Company purchased a net of $0.2 million in short-term investments, while in 2006 the Company purchased $1.1 million. Capital expenditures were $0.3 million, $0.4 million and $0.3 million in 2008, 2007 and 2006, respectively. The expenditures related principally to new equipment, including laboratory and computer equipment.

During 2008, the Company repurchased 61,107 shares for treasury. In 2007, the Company repurchased 2,400 shares of common stock for treasury. The Company has authorized 750,000 shares for repurchase since June of 1998, of which 250,000 shares of common stock were authorized in March of 2008 for repurchase. Since 1998, a total of 529,858 shares have been repurchased. The Company also distributed $6.1 million, $3.0 million, and $2.5 million of cash dividends to its shareholders in 2008, 2007, and 2006 respectively.

At December 31, 2008, the Company’s principal sources of liquidity included approximately $6.6 million of cash and cash equivalents. Management currently believes that such funds, together with future operating profits, should be adequate to fund anticipated working capital requirements and capital expenditures in the near term. Depending upon the Company’s results of operations, its future capital needs and available marketing opportunities, the Company may use various financing sources to raise additional funds. Such sources could include joint ventures, issuance of common stock or debt financing, although there is no assurance that such financings will be available to the Company on terms it deems acceptable, if at all. At December 31, 2008, the Company had no long-term debt.

The Company has paid dividends over the past fifty quarters. In December 2008, the Company paid a special dividend of $0.50 per share. The dividend was paid with the intent of enabling the Company’s shareholders to benefit under the current tax structure. Despite the payment of this special dividend, the Company has no plans as of the date of this annual report to change its current dividend rate. It most recently declared a dividend in February 2009 which was paid in March 2009 and amounted to $883,280. The Company’s current intention is to continue to declare dividends to the extent funds are available and not required for operating purposes or capital requirements, and only then, upon approval by the Board of Directors. There can be no assurance that in the future the Company will declare dividends.

Contractual obligations as of December 31, 2008 were as follows:

		Payments Due By Period
		Less												Greater
		Than 1				1 – 3				3 – 5				Than 5
Contractual Obligation		Year				Years				Years				Years				Total
		(Amounts in thousands)
Operating leases		$	543			$	1,093			$	—			$	—			$	1,636
Purchase commitment			578				—				—				—				578
Total		$	1,121			$	1,093			$	—			$	—			$	2,214

Purchase Commitment

The Company has a supply agreement with a vendor which requires the Company to purchase isotopes used in its drug testing procedures from this sole supplier at prices based upon prior year purchase levels. Purchases amounted to $606,484, $587,964, and $543,832 in 2008, 2007 and 2006 respectively. The Company expects to purchase $578,000 in 2009. In exchange for exclusivity, the supplier has provided the Company with the right to purchase the isotope technology at fair market value under certain conditions, including the failure to meet the Company’s purchase commitments. This agreement does not include a fixed termination date; however, it is cancelable upon mutual agreement by both parties or after six months termination notice by the Company of its intent to use a different technology in connection with its drug testing procedures.

Critical Accounting Policies

The Company’s significant accounting policies are described in Note 2 to the financial statements included in Item 8 of this Form 10-K. Management believes the most critical accounting policies are as follows:

Revenue Recognition

The Company is in the business of performing drug testing and reporting the results thereof. The Company’s drug testing services include training for collection of samples and storage of positive samples for its customers for an agreed-upon fee per unit tested of samples. The revenues are recognized when the predominant deliverable, drug testing, is provided and reported to the customer.

In 2003, the Company adopted Emerging Issue Task Force (“EITF”) Issue No. 00-21, Revenue Arrangements with Multiple Deliverables, which was effective for all transactions entered into subsequent to June 15, 2003. The Company applied the consensus reached under EITF 00-21 and concluded that the testing, training and storage elements are considered one unit of accounting for revenue recognition purposes as the training and storage costs are de minimis and do not have stand-alone value to the customer. The Company has concluded that the predominant deliverable in the arrangement is the testing of the units and has recognized revenue as that service is performed and reported to the customer.

The Company also provides expert testimony, when and if necessary, to support the results of the tests, which is generally billed separately and recognized as the services are provided.

Deferred revenue represents payments received in advance of the performance of drug testing procedures, generally in relation to the personal drug testing kits PDT-90. Deferred revenue is recognized as revenue when the underlying test results are delivered. With respect to a portion of these transactions, there may be instances where the customer ultimately does not require performance. Revenue is then recognized when the Company can reasonably, reliably and objectively determine that it is remote that performance will be required for an estimable portion of transactions. The Company recorded $89,714 and $189,628 of revenue in the results of operations for the years ended December 31, 2008 and 2007 related to test kits that were sold for which the Company’s obligations to provide service were deemed remote.

Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates, including bad debts and income taxes, and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and 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.

Allowance for Doubtful Accounts

The allowance for doubtful accounts is based on management’s assessment of the ability to collect amounts owed to it by its customers. Management reviews its accounts receivable aging for doubtful accounts and uses a methodology based on calculating the allowance using a combination of factors including the age of the receivable along with management’s judgment to identify accounts that may not be collectible. The Company routinely assesses the financial strength of its customers and, as a consequence, believes that its accounts receivable credit risk exposure is limited. In 2008, the reserve balance was increased slightly as the Company decided, because of economic conditions, to expand its reserve for potential non-payment of receivables. The Company maintains an allowance for potential credit losses but historically has not experienced any significant losses related to individual customers or groups of customers in any particular industry or geographic area. Bad debt expense has been within management’s expectations.

Income Taxes

The Company accounts for income taxes using the liability method, which requires the Company to recognize a current tax liability or asset for current taxes payable or refundable and a deferred tax liability or asset for the estimated future tax effects of temporary differences between the financial statement and tax reporting bases of assets and liabilities to the extent that they are realizable. Deferred tax expense (benefit) results from the net change in deferred tax assets and liabilities during the year. A deferred tax valuation allowance is required if it is more likely than not that all or a portion of the recorded deferred tax assets will not be realized.

The Company had net deferred tax assets in the amount of $588,419 at December 31, 2008, which the Company believes are fully realizable based upon expected future taxable income, which the Company believes is reasonably attainable in light of previous operating results during the past three years.

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109. FIN 48 contains a two-step approach to recognizing and measuring uncertain tax positions (tax contingencies) accounted for in accordance with SFAS No. 109. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on an audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately forecast actual outcomes.

The Company adopted the provisions of FIN 48, effective January 1, 2007, without material effect in the financial statements. The Company’s evaluation was performed for the tax years ended December 31, 2003, 2004, 2005 and 2006, the tax years which remained subject to examination by major tax jurisdictions as of January 1, 2007 and 2008.

The Company operates within multiple taxing jurisdictions and could be subject to audit in these jurisdictions. These audits may involve complex issues, which may require an extended period of time to resolve. The Company has provided for its estimated taxes payable in the accompanying financial statements. Interest and penalties related to income tax matters are recognized as a general and administrative expense. The Company did not have any unrecognized tax benefits and did not have any interest or penalties accrued as of December 31, 2008 or 2007. The Company does not expect the unrecognized tax benefits to change significantly over the next twelve months.

The above listing is not intended to be a comprehensive list of all of the Company’s accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for management’s judgment in their application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result.

Recent Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 provides guidance for using fair value to measure assets and liabilities. It also responds to investors’ requests for expanded information about the extent to which companies’ measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value, and does not expand the use of fair value in any new circumstances. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and has been adopted by the Company in 2008 without material effect on the Company’s financial position or results of operations.

In February 2008, the FASB issued Staff Position No. FAS 157-2 (“FSP 157-2”) that defers the effective date of applying the provisions of SFAS 157 to the fair value measurement of non-financial assets and non-financial liabilities until fiscal years beginning after November 15, 2008. The Company is currently evaluating the effect that the adoption of FSP 157-2 will have on its results of operations and financial condition but does not expect it to have a material impact.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, (“SFAS 159”) including an amendment of FASB Statement No. 115. SFAS 159 permits companies to choose to measure certain financial instruments and certain other items at fair value. The standard requires that unrealized gains and losses on items for which the fair value option has been elected be reported in earnings. The Company adopted SFAS 159 beginning in the first quarter of 2008, without material effect on the Company’s financial position or results of operations.

In December 2007, the FASB issued SFAS No. 141 (revised), Business Combinations (“SFAS 141(R)”). The statement retains the fundamental requirements of SFAS No. 141, but requires the recognition of all assets acquired and liabilities assumed in a business combination at their fair values as of the acquisition date. It also requires the recognition of assets acquired and liabilities assumed arising from contractual contingencies at their acquisition date fair values. Additionally, SFAS No. 141(R) supersedes FASB Interpretation No. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method, which required research and development assets acquired in a business combination that have no alternative future use to be measured at their fair values and expensed at the acquisition date. SFAS No. 141(R) now requires that purchased research and development be recognized as an intangible asset. The Company is required to adopt SFAS No. 141(R) prospectively for any acquisition on or after January 1, 2009 and is currently evaluating the impact this new standard will have on the Company’s future results of operations and financial condition.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not Required.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

		Page
(a) Financial Statements:
Report of Independent Registered Public Accounting Firm			25
Balance Sheets as of December 31, 2008 and 2007			26
Statements of Income for the Years Ended December 31, 2008, 2007 and 2006			27
Statements of Shareholders’ Equity for the Years Ended December 31, 2008, 2007 and 2006			28
Statements of Cash Flows for the Years Ended December 31, 2008, 2007 and 2006			29
Notes to Financial Statements			30
(b) Not Covered by Above Report:
Unaudited Supplementary Quarterly Financial Information			40

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and
Shareholders of Psychemedics Corporation
Acton, Massachusetts:

We have audited the accompanying balance sheets of Psychemedics Corporation as of December 31, 2008 and 2007 and the related statements of income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Psychemedics Corporation at December 31, 2008 and 2007 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America.

/s/ BDO Seidman, LLP

Boston, Massachusetts
March 25, 2009

PSYCHEMEDICS CORPORATION

		December 31,
		2008				2007
ASSETS
Current assets:
Cash and cash equivalents		$	6,630,119			$	6,096,734
Short-term investments			—				3,875,000
Accounts receivable, net of allowance of $246,462 in 2008 and $235,337 in 2007			3,398,455				3,555,342
Prepaid expenses and other current assets			1,105,886				498,919
Deferred tax assets			449,398				429,472
Total current assets			11,583,858				14,455,467
Property and equipment, net;
Computer software			1,205,840				1,205,840
Office furniture and equipment			1,955,054				2,146,269
Laboratory equipment			6,807,970				6,545,889
Leasehold improvements			908,615				894,659
			10,877,479				10,792,657
Less – Accumulated depreciation and amortization			(10,047,755	)			(9,977,315	)
			829,724				815,342
Deferred tax assets			139,021				231,346
Other assets			75,183				58,613
Total assets		$	12,627,786			$	15,560,768
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	644,894			$	488,640
Accrued expenses			1,268,924				951,242
Deferred revenue			154,080				242,955
Total current liabilities			2,067,898				1,682,837
Commitments and contingencies (Note 10)
Shareholders’ equity:
Preferred stock, $0.005 par value; 872,521 shares authorized, no shares issued or outstanding			—				—
Common stock, $0.005 par value; 50,000,000 shares authorized, 5,843,068 shares issued in 2008 and 5,811,982 shares issued in 2007			29,216				29,060
Paid-in capital			27,118,743				26,539,764
Treasury stock, at cost, 647,304 shares in 2008 and 586,197 shares in 2007			(9,973,957	)			(9,163,624	)
Accumulated deficit			(6,614,114	)			(3,527,269	)
Total shareholders’ equity			10,559,888				13,877,931
Total liabilities and shareholders’ equity		$	12,627,786			$	15,560,768

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

PSYCHEMEDICS CORPORATION

		Year Ended December 31,
		2008				2007				2006
Revenue		$	22,948,604			$	24,568,824			$	23,425,090
Cost of revenue			9,598,515				9,892,226				9,369,257
Gross profit			13,350,089				14,676,598				14,055,833
Operating expenses:
General and administrative			4,520,074				3,948,642				3,278,826
Marketing and selling			3,648,584				3,099,909				2,769,310
Research and development			474,622				489,007				444,532
Total operating expenses			8,643,280				7,537,558				6,492,668
Operating income			4,706,809				7,139,040				7,563,165
Interest income			308,034				416,647				294,036
Income before taxes			5,014,843				7,555,687				7,857,201
Provision for income taxes			2,046,054				3,072,000				2,955,000
Net income		$	2,968,789			$	4,483,687			$	4,902,201
Basic net income per share		$	0.57			$	0.86			$	0.95
Diluted income per share		$	0.57			$	0.85			$	0.94
Dividends declared per share		$	1.160			$	0.575			$	0.475
Weighted average common shares outstanding, basic			5,219,141				5,205,032				5,170,258
Weighted average common shares outstanding, diluted			5,245,713				5,301,620				5,240,155

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

PSYCHEMEDICS CORPORATION

		Common Stock												Treasury Stock
						$0.005				Paid-In												Accumulated
		Shares				Par Value				Capital				Shares				Cost				Deficit				Total
BALANCE, December 31, 2005			5,750,894				28,754				25,446,781				583,797				(9,122,691	)			(7,458,280	)			8,894,564
Exercise of stock options			5,150				26				69,057				—				—				—				69,083
Stock compensation expense			—				—				93,962				—				—				—				93,962
Cash dividends declared ($0.475 per share)			—				—				—				—				—				(2,456,305	)			(2,456,305	)
Net income			—				—				—				—				—				4,902,201				4,902,201
BALANCE, December 31, 2006			5,756,044				28,780				25,609,800				583,797				(9,122,691	)			(5,012,384	)			11,503,505
Exercise of stock options			50,479				253				691,564				—				—				—				691,817
Shares issued — vested			5,459				27				(27	)															—
Stock compensation expense			—				—				238,427				—				—				—				238,427
Acquisition of treasury stock															2,400				(40,933	)							(40,933	)
Cash dividends declared ($0.575 per share)			—				—				—				—				—				(2,998,572	)			(2,998,572	)
Net income			—				—				—				—				—				4,483,687				4,483,687
BALANCE, December 31, 2007			5,811,982			$	29,060			$	26,539,764				586,197			$	(9,163,624	)		$	(3,527,269	)		$	13,877,931
Exercise of stock options			17,931				90				199,114				—				—				—				199,204
Shares issued-vested			13,155				66				(66	)			—				—				—				—
Stock compensation expense			—				—				379,931				—				—				—				379,931
Acquisition of treasury stock			—				—				—				61,107				(810,333	)			—				—
Cash dividends declared ($1.16 per share)			—				—				—				—				—				(6,055,634	)			(6,055,634	)
Net income			—				—				—				—				—				2,968,789				2,968,789
BALANCE, December 31, 2008			5,843,068			$	29,216			$	27,118,743				647,304			$	(9,973,957	)		$	(6,614,114	)		$	10,559,888

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

PSYCHEMEDICS CORPORATION

		Year Ended December 31,
		2008				2007				2006
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income		$	2,968,789			$	4,483,687			$	4,902,201
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			331,393				347,125				287,443
Deferred income taxes			72,399				(64,777	)			170,000
Stock compensation expense			379,931				238,427				93,962
Changes in operating assets and liabilities:
Accounts receivable			156,887				(358,958	)			75,894
Prepaid expenses and other assets			(606,967	)			319,774				(431,267	)
Accounts payable			156,254				(10,780	)			131,885
Accrued expenses			317,682				85,667				(426,682	)
Deferred revenue			(88,875	)			(149,448	)			(198,267	)
Net cash provided by operating activities			3,687,493				4,890,717				4,605,169
CASH FLOWS FROM INVESTING ACTIVITIES:
Redemptions of short-term investments			3,875,000				3,500,055				—
Purchases of short-term investments			—				(3,691,863	)			(1,133,192	)
Increase in other long-term assets			(17,811	)			(18,783	)			—
Purchases of property and equipment			(344,534	)			(415,939	)			(257,039	)
Net cash provided by (used in) investing activities			3,512,655				(626,530	)			(1,390,231	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Dividends paid			(6,055,634	)			(2,998,572	)			(2,456,305	)
Proceeds from employee stock plans and stock option exercises			189,891				665,221				8,983
Acquisition of treasury stock			(810,333	)			(40,933	)			—
Tax benefit associated with exercise of options			9,313				26,596				60,100
Net cash used in financing activities			(6,666,763	)			(2,347,688	)			(2,387,222	)
Net increase in cash and cash equivalents			533,385				1,916,499				827,716
CASH AND CASH EQUIVALENTS, beginning of year			6,096,734				4,180,235				3,352,519
CASH AND CASH EQUIVALENTS, end of year		$	6,630,119			$	6,096,734			$	4,180,235
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for income taxes		$	2,553,537			$	2,781,023			$	3,244,599
NON-CASH INVESTING AND FINANCING ACTIVITIES:
Issuance of restricted stock awards		$	66			$	27			$	—

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

PSYCHEMEDICS CORPORATION

1. Nature of Business and Basis of Presentation

Psychemedics Corporation is the world’s largest provider of hair testing for drugs of abuse, utilizing a patented hair analysis method involving radioimmunoassay technology and confirmation by mass spectrometry to analyze human hair to detect abused substances. The Company’s customers include Fortune 500 companies, as well as small to mid-size corporations, schools and governmental entities located primarily in the United States.

2. Summary of Significant Accounting Policies

Risks and Uncertainties

The Company is subject to a number of risks and uncertainties similar to those of other companies, such as those associated with the continued expansion of the Company’s sales and marketing network, development of markets for new products and services offered by the Company, the economic health of principal customers of the Company, financial and operational risks associated with possible expansion of testing facilities used by the Company, government regulation (including, but not limited to, Food and Drug Administration regulations), competition and general economic conditions.

Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates, including bad debts and income taxes, and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and 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. Changes in estimates are recorded in the period in which they become known.

Cash Equivalents and Short Term Investments

The Company considers all highly liquid investments with original maturities of 90 days or less to be cash equivalents. Cash equivalents consist of cash savings and U.S. government reserve money market accounts at December 31, 2008 and 2007. While the money market account contains U.S. federal government backed issues, the account itself is not federally insured.

In 2007, the Company maintained a short-term investment portfolio consisting principally of Taxable Auction Rate Preferred, 7 and 28 day Dutch Auction securities and government obligations. During 2008, these investments were liquidated at par. The Company accounts for investment securities in accordance with Statement of Financial Accounting Standards SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (“SFAS 115”). Under SFAS 115, investments that the Company has the positive intent and ability to hold to maturity are classified as held-to-maturity and are reported at amortized cost, which approximates fair market value. All short-term investments were classified as held-to-maturity at December 31, 2007. The Company does not use derivative financial instruments for speculative or trading purposes.

Inventory

The Company expenses all consumables such as chemicals and antibodies as they are purchased.

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS

2. Summary of Significant Accounting Policies (Continued)

Property and Equipment

Property and equipment are stated at cost. Depreciation and amortization are provided over the estimated useful lives of the assets, using the straight-line method. Repair and maintenance costs are expensed as incurred. The estimated useful lives of the assets are as follows:

Computer software		5 years
Office furniture and equipment		3 to 7 years
Laboratory equipment		5 to 7 years
Leasehold improvements		Lesser of term of lease or estimated useful life

The Company recorded depreciation and amortization related to property and equipment of $331,393, $347,125, and $287,443 in 2008, 2007 and 2006, respectively.

Other Assets

Other assets primarily consist of capitalized legal costs relating to patent applications. The Company amortizes these costs over 10 years from the date of grant of the applicable patent. The Company recorded a de-minimus amount of amortization in 2008, and none in 2007 or 2006. As of December 31, 2008 and 2007, the Company had capitalized legal costs relating to an outstanding patent application of $37,236 and $18,973 respectively. The Company’s issued patents, with an original cost of $517,587, were fully amortized as of December 31, 2008 and 2007. The amount of amortization related to patent applications is expected to remain below $10,000 per year for the next 5 years.

Impairment of Long-Lived Assets

In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company reviews the carrying values of its long-lived assets for possible impairment whenever events or changes in circumstances indicate that the carrying amounts of the assets may not be recoverable. The Company believes that the carrying value of its long-lived assets is fully realizable at December 31, 2008.

Revenue Recognition

The Company is in the business of performing drug testing services and reporting the results thereof. The Company’s drug testing services include training for collection of samples and storage of positive samples for its customers for an agreed-upon fee per unit tested of samples. The revenues are recognized when the predominant deliverable, drug testing, is provided and reported to the customer.

In 2003, the Company adopted Emerging Issue Task Force (“EITF”) Issue No. 00-21, Revenue Arrangements with Multiple Deliverables, which was effective for all transactions entered into subsequent to June 15, 2003. The Company applied the consensus reached under EITF 00-21 and concluded that the testing, training and storage elements are considered one unit of accounting for revenue recognition purposes as the training and storage costs are de minimis and do not have stand-alone value to the customer. The Company has concluded that the predominant deliverable in the arrangement is the testing of the units and has recognized revenue as that service is performed and reported to the customer.

The Company also provides expert testimony, when and if necessary, to support the results of the tests, which is generally billed separately and recognized as the services are provided.

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS

2. Summary of Significant Accounting Policies (Continued)

Deferred revenue represents payments received in advance of the performance of drug testing procedures, generally in relation to the personal drug testing kits PDT-90. Deferred revenue is recognized as revenue when the underlying test results are delivered. With respect to a portion of these transactions, there may be instances where the customer ultimately does not require performance. Revenue is then recognized when the Company can reasonably, reliably and objectively determine that it is remote that performance will be required for an estimable portion of transactions. The Company recorded $89,714, $189,628 and $244,000 of revenue in the results of operations for the years ended December 31, 2008, 2007 and 2006 related to test kits that were sold for which the Company’s obligations to provide service were deemed remote.

At December 31, 2008 and 2007, the Company had deferred revenue of approximately $154,000 and $243,000, respectively, reflecting sales of its personal drug testing service for which the performance of the related test had not yet occurred and future obligations were not deemed remote.

Research and Development Expenses

The Company charges all research and development expenses to operations as incurred.

Income Taxes

The Company accounts for income taxes using the liability method, which requires the Company to recognize a current tax liability or asset for current taxes payable or refundable and a deferred tax liability or asset for the estimated future tax effects of temporary differences between the financial statement and tax reporting bases of assets and liabilities to the extent that they are realizable. Deferred tax expense (benefit) results from the net change in deferred tax assets and liabilities during the year. A deferred tax valuation allowance is required if it is more likely than not that all or a portion of the recorded deferred tax assets will not be realized.

The Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), on January 1, 2007, as described in Note 5. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken. The adoption of FIN 48 did not have a material effect on the Company’s financial position or results of operations.

Concentration of Credit Risk and Off-Balance Sheet Risk

The Company has no significant off-balance-sheet risk such as foreign exchange contracts, option contracts, or other foreign hedging arrangements. Financial instruments that potentially subject the Company to concentrations of credit risk are principally cash and cash equivalents, short-term investments and accounts receivable. The Company places its cash and cash equivalents and short-term investments in highly rated institutions. These include money market accounts holding U.S. federal government reserve securities. While the underlying securities are federally issued, the account itself is not insured. Concentration of credit risk with respect to accounts receivable is limited to certain customers to whom the Company makes substantial sales. To reduce risk, the Company routinely assesses the financial strength of its customers and, as a consequence, believes that its accounts receivable credit risk exposure is limited. The Company maintains an allowance for potential credit losses but historically has not experienced any significant losses related to individual customers or groups of customers in any particular industry or geographic area. The Company does not require collateral.

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS

2. Summary of Significant Accounting Policies (Continued)

Comprehensive Income (Loss)

SFAS No. 130, Reporting Comprehensive Income, requires disclosure of all components of comprehensive income (loss) on an annual and interim basis. Comprehensive income (loss) is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. The Company’s comprehensive income is the same as its reported net income for the years ended December 31, 2008, 2007 and 2006.

Stock-Based Compensation

The Company adopted SFAS No. 123 (revised 2004), Share-Based Payment, (“SFAS 123R”) effective January 1, 2006. SFAS 123R requires the recognition of the fair value of stock-based compensation as a charge against earnings. The Company recognizes stock-based compensation expense over the requisite service period of the individual grantees, which generally equals the vesting period. Based on the provisions of SFAS 123R, the Company’s stock-based compensation is accounted for as equity instruments. Prior to January 1, 2006, the Company followed Accounting Principles Board (“APB”) Opinion 25, Accounting for Stock Issued to Employees, and related interpretations in accounting for stock-based compensation. The Company elected the modified prospective transition method for adopting SFAS 123R. Under this method, the provisions of SFAS 123R apply to all awards granted or modified after the date of adoption, as well as to the future vesting of awards granted and not vested as of the date of adoption. Prior period amounts have not been restated.

Under the provisions of SFAS 123R, the Company recorded $379,931, $238,427 and $93,962 of stock-based compensation in the accompanying statements of income for the years ended December 31, 2008, 2007 and 2006, respectively.

SFAS 123R requires the measurement of compensation cost at fair value on the date of grant and recognition of compensation expense over the service period for awards expected to vest.

See Note 7 for additional information relating to the Company’s stock plans and the adoption of SFAS 123R.

Basic and Diluted Net Income per Share

Basic net income per share is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income by the weighted average number of common shares and dilutive common stock equivalents outstanding during the period. The number of dilutive common stock equivalents outstanding during the period has been determined in accordance with the treasury-stock method. Common equivalent shares consist of common stock issuable upon the exercise of outstanding options and the unvested portion of stock unit awards (“SUAs”).

Basic and diluted weighted average common shares outstanding are as follows:

		2008				2007				2006
Weighted average common shares outstanding			5,219,141				5,205,032				5,170,258
Dilutive common equivalent shares			26,572				96,588				69,897
Weighted average common shares outstanding, assuming dilution			5,245,713				5,301,620				5,240,155

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS

2. Summary of Significant Accounting Policies (Continued)

For the years ending December 31, 2008, 2007, and 2006, options to purchase 331,292, 140,647, and 183,419 common shares, respectively, were outstanding but not included in the dilutive common equivalent share calculation as their effect would have been antidilutive.

Financial Instruments

Financial instruments principally consist of cash equivalents, accounts receivable and accounts payable. The estimated fair values of these financial instruments approximate their carrying values due to their short-term nature.

Segment Reporting

The Company manages its operations as one segment, drug testing services. As a result, the financial information disclosed herein materially represents all of the financial information related to the Company’s principal operating segment. Substantially all of the Company’s revenues are generated in the United States. All of the Company’s assets are located in the United States.

Recent Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 provides guidance for using fair value to measure assets and liabilities. It also responds to investors’ requests for expanded information about the extent to which companies’ measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value, and does not expand the use of fair value in any new circumstances. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and has been adopted by the Company in 2008 without material effect on the Company’s financial position or results of operations.

In February 2008, the FASB issued Staff Position No. FAS 157-2 (“FSP 157-2”) that defers the effective date of applying the provisions of SFAS 157 to the fair value measurement of non-financial assets and non-financial liabilities until fiscal years beginning after November 15, 2008. The Company is currently evaluating the effect that the adoption of FSP 157-2 will have on its results of operations and financial condition but does not expect it to have a material impact.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, (“SFAS 159”) including an amendment of FASB Statement No. 115. SFAS 159 permits companies to choose to measure certain financial instruments and certain other items at fair value. The standard requires that unrealized gains and losses on items for which the fair value option has been elected be reported in earnings. The Company adopted SFAS 159 beginning in the first quarter of 2008, without material effect on the Company’s financial position or results of operations, as it did not elect the fair value option for any items.

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS

2. Summary of Significant Accounting Policies (Continued)

In December 2007, the FASB issued SFAS No. 141 (revised), Business Combinations (“SFAS 141(R)”). The statement retains the fundamental requirements of SFAS No. 141, but requires the recognition of all assets acquired and liabilities assumed in a business combination at their fair values as of the acquisition date. It also requires the recognition of assets acquired and liabilities assumed arising from contractual contingencies at their acquisition date fair values. Additionally, SFAS No. 141(R) supersedes FASB Interpretation No. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method, which required research and development assets acquired in a business combination that have no alternative future use to be measured at their fair values and expensed at the acquisition date. SFAS No. 141(R) now requires that purchased research and development be recognized as an intangible asset. The Company is required to adopt SFAS No. 141(R) prospectively for any acquisition on or after January 1, 2009 and is currently evaluating the impact this new standard will have on the Company’s future results of operations and financial condition.

3. Accounts Receivable

The Company maintains an allowance for uncollectible accounts receivable based on management’s assessment of the collectability of its customer accounts by reviewing customer payment patterns and other relevant factors. The Company reviews the adequacy of the allowance for uncollectible accounts on a quarterly basis and adjusts the balance as determined necessary.

		2008				2007				2006
Balance, beginning of period		$	235,337			$	333,281			$	461,282
Provision for doubtful accounts			28,436				(50,000	)			(70,000	)
Write-offs			(17,311	)			(47,944	)			(58,001	)
Balance, end of period		$	246,462			$	235,337			$	333,281

4. Accrued Expenses

Accrued expenses consist of the following:

		December 31,
		2008				2007				2006
Accrued payroll and employee benefits		$	618,494			$	578,075			$	740,544
Accrued income taxes			—				16,925				—
Other accrued expenses			650,430				356,242				125,031
		$	1,268,924			$	951,242			$	865,575

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS

5. Income Taxes

The income tax provision consists of the following:

		2008				2007				2006
Current -
Federal		$	1,549,593			$	2,418,988			$	2,402,763
State			424,062				717,789				371,683
			1,973,655				3,136,777				2,774,446
Deferred -
Federal			56,819				(55,514	)			156,395
State			15,580				(9,263	)			24,159
			72,399				(64,777	)			180,554
		$	2,046,054			$	3,072,000			$	2,955,000

A reconciliation of the effective rate with the federal statutory rate is as follows:

		2008				2007				2006
Federal statutory rate			34.0	%			34.0	%			34.0	%
State income taxes, net of federal benefit			5.8				6.4				3.3
Permanent differences			1.0				0.3				0.3
Effective tax rate			40.8	%			40.7	%			37.6	%

The components of the net deferred tax assets included in the accompanying balance sheets are as follows at December 31:

		2008				2007
Deferred tax assets:
Deferred revenue		$	61,158			$	96,406
Stock-based compensation			151,446				121,075
Allowance for doubtful accounts			121,079				93,384
Excess of book over tax depreciation and amortization			139,021				231,346
Accrued expenses			91,765				124,524
Other			40,093				32,628
			604,562				699,363
Deferred tax liabilities:
Prepaid expenses			16,143				38,545
		$	588,419			$	660,818

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109. FIN 48 contains a two-step approach to recognizing and measuring uncertain tax positions (tax contingencies) accounted for in accordance with SFAS No. 109. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on an audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. The Company considers many factors when evaluating and estimating the Company’s tax positions and tax benefits, which may require periodic adjustments and which may not accurately forecast actual outcomes.

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS

5. Income Taxes (Continued)

The Company adopted the provisions of FIN 48, effective January 1, 2007, without material effect in the financial statements. The Company’s evaluation was performed for the tax years ended December 31, 2003, 2004, 2005 and 2006, the tax years which remained subject to examination by major tax jurisdictions as of January 1, 2007 and 2008.

The Company operates within multiple taxing jurisdictions and could be subject to audit in these jurisdictions. These audits may involve complex issues, which may require an extended period of time to resolve. The Company has provided for its estimated taxes payable in the accompanying financial statements. Interest and penalties related to income tax matters are recognized as a general and administrative expense. The Company did not have any unrecognized tax benefits and did not have any interest or penalties accrued as of December 31, 2008 and 2007. The Company does not expect the unrecognized tax benefits to change significantly over the next twelve months.

6. Preferred Stock

The Board of Directors has the authority to designate authorized preferred shares in one or more series and to fix the relative rights and preferences without vote or action by the stockholders. The Board of Directors has no present plans to designate or issue any shares of preferred stock.

7. Stock-Based Awards

On March 22, 2006, the Company adopted a new stock-based plan (the “2006 Equity Incentive Plan”) for officers, directors, employees and consultants. The 2006 Equity Incentive Plan provides for grants of options with terms of up to ten years, grants of restricted stock, issuances of stock bonuses or grants other stock-based awards, covering up to 250,000 shares of common stock. As of December 31, 2008, 158,100 shares remained available for future grant under the 2006 Equity Incentive Plan.

The Company granted 26,700 SUAs to certain members of management and its directors on May 11, 2006. The fair value of the SUAs was $16.70 per share, which was the closing price of the Company’s stock on May 11, 2006. The SUAs vest over a period of two to four years and are convertible into an equivalent number of shares of the Company’s common stock provided that the awardee remains continuously employed throughout the vesting periods. Of these 26,700 units, 2,000 were cancelled upon employee termination, 1,950 units vested and were issued on April 30, 2007 and 5,200 units vested and were issued, net of tax withholdings, on May 11, 2007. On May 11, 2008, an additional 7,150 units vested and were issued, net of tax withholdings.

The Company granted 34,000 SUA’s to certain members of management and its directors on May 10, 2007. The fair value of the SUAs was $18.41 per share, which was the closing price of the Company’s stock on May 10, 2007. The SUAs vest over a period of two to four years and are convertible into an equivalent number of shares of the Company’s common stock provided that the awardee remains continuously employed throughout the vesting periods. Of these 34,000 units, 10,000 units vested and were issued, net of tax withholdings, on May 10, 2008.

In 2008, the Company granted 32,600 SUAs on May 15, 1,000 SUAs on October 14, and 800 SUAs on November 3. The fair values of the SUAs were $16.50, $10.67 and $9.30 per share, respectively, which was the closing price of the Company’s stock on those dates. The SUAs vest over a period of two to four years and are convertible into an equivalent number of shares of the Company’s common stock provided that the awardee remains continuously employed throughout the vesting period. Of these 34,400 units, 1,200 were cancelled upon termination of an employee.

The Company also has stock option plans that have expired or have been terminated, but shares can be issued upon exercise of outstanding options that were granted prior to such expiration or termination. No additional grants of options or other stock-based awards may be made under such expired or terminated plans. Activity for these plans is included in this footnote. Options granted under the plans consisted of both non-qualified and incentive stock options and were granted in each case at a price that was not less than the fair market value of the common stock at the date of grant. These options generally have lives of ten years and vest either immediately or over periods up to four years.

A summary of stock option activity for the Company’s expired stock option plans is as follows:

						Weighted				Weighted
						Average				Average				Aggregate
		Number				Exercise Price				Remaining				Intrinsic Value
		of Shares				Per Share				Contractual Life				(1)
Outstanding, December 31, 2005			556,946				16.09
Granted			—				—
Exercised			(5,150	)			11.67
Terminated			(23,938	)			23.47
Outstanding, December 31, 2006			527,858			$	15.79
Granted			—				—
Exercised			(50,479	)			13.79
Terminated			(27,345	)			20.65
Outstanding, December 31, 2007			450,034			$	15.63
Granted			—				—
Exercised*			(18,139	)			13.93
Terminated			(39,785	)			20.51
Outstanding, December 31, 2008			392,110			$	15.22			4.4 years				$	65,060
Exercisable, December 31, 2008			392,110			$	15.22			4.4 years				$	65,060
Available for grant, December 31, 2008			—

A summary of activity for SUAs under the Company’s 2006 Equity Incentive Plan is as follows:

						Aggregate
		Number				Intrinsic Value
		of Shares				(2)
Outstanding, December 31, 2005			—
Granted			26,700
Vested			—
Terminated			—
Outstanding, December 31, 2006			26,700
Granted			34,000
Converted to common stock			(7,150	)
Terminated			(2,000	)
Outstanding, December 31, 2007			51,550
Granted*			34,400
Converted to common stock			(17,150	)
Terminated			(1,200	)
Outstanding, December 31, 2008			67,600			$	436,696
Available for grant, December 31, 2008			158,100

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS

7. Stock-Based Awards (Continued)

As of December 31, 2008, a total of 617,810 shares of common stock were reserved for issuance under the various stock option and stock-based plans. As of December 31, 2008, the unamortized fair value of awards relating to SUAs was $882,658 to be amortized over a weighted average period of 1.9 years.

8. Employee Benefit Plan

The Psychemedics Corporation 401(k) Savings and Retirement Plan (the 401(k) Plan) is a qualified defined contribution plan in accordance with Section 401(k) of the Internal Revenue Code. All employees over the age of 21 are eligible to make pre-tax contributions up to a specified percentage of their compensation. Under the 401(k) Plan, the Company may, but is not obligated to, match a portion of the employees’ contributions up to a defined maximum. Matching contributions of $127,080, $118,141 and $118,101 were made in the years ended December 31, 2008, 2007 and 2006, respectively.

9. Royalty Agreements

The Company has a royalty-free license from its founder, which was received in a fair market value exchange in connection with the formation of the Company, for the proprietary rights to certain patented hair analysis technology used by the Company in its drug testing services. The Company has two agreements to sublicense its technology, which have not generated significant royalties to date.

10. Commitments and Contingencies

Commitments

The Company leases certain of its facilities and equipment under operating lease agreements expiring on various dates through December 2012. Total minimum lease payments, including scheduled increases, are charged to operations on the straight-line basis over the life of the respective lease. Rent expense was approximately $516,000, $501,000 and $506,000 in 2008, 2007 and 2006, respectively.

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS

10. Commitments and Contingencies (Continued)

At December 31, 2008, minimum commitments remaining under lease agreements were approximately as follows:

Years Ending December 31:		Amount
2009			543,000
2010			467,000
2011			325,000
2012			301,000
		$	1,636,000

Purchase Commitment

The Company has a supply agreement with a vendor which requires the Company to purchase isotopes used in its drug testing procedures from this sole supplier in exchange for variable annual payments based upon prior year purchases. Purchases amounted to $606,484 in 2008, $587,964 in 2007 and $543,832 in 2006. The Company expects to purchase approximately $587,000 in 2009. In exchange for exclusivity, the supplier has provided the Company with the right to purchase the isotope technology at fair market value under certain conditions, including the failure to meet the Company’s purchase commitments. This agreement does not include a fixed termination date; however, it is cancelable upon mutual agreement by the parties or six months after termination notice by the Company of its intent to use a different technology in connection with its drug testing procedures.

Contingencies

The Company is subject to legal proceedings and claims, which arise in the ordinary course of its business. The Company believes that although there can be no assurance as to the disposition of these proceedings, based upon information available to the Company at this time, the expected outcome of these matters would not have a material impact on the Company’s results of operations or financial condition.

11. Selected Quarterly Financial Data (Unaudited)

The following are selected quarterly financial data for the years ended December 31, 2008 and 2007:

		Quarter Ended (000’s except per share amounts)
		March 31,				June 30,				September 30,				December 31,
		2008				2008				2008				2008
Revenues		$	5,709			$	6,211			$	6,205			$	4,824
Gross profit			3,322				3,776				3,653				2,600
Income from operations			1,383				1,659				1,369				297
Net income			890				1,033				874				173
Basic net income per share			0.17				0.20				0.17				0.03
Diluted net income per share			0.17				0.20				0.17				0.03