Critical Accounting Policies and Estimates

General. Our discussion and analysis of our financial condition and results of operations are based upon our financial statements. These financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ materially from those estimates. We believe that the estimates, assumptions, and judgments involved in the accounting policies described below have the greatest potential impact on our financial statements and, therefore, consider these to be critical accounting policies. See "Notes to Condensed Financial Statements, Note 1: Summary of Significant Accounting Policies," included elsewhere in this report for more information about these critical accounting policies, as well as descriptions of other significant accounting p olicies.

We account for cost-reimbursement contracts by charging actual labor, materials, and other direct costs, plus estimated indirect costs of operations as incurred (incurred costs). Indirect costs include overhead, research and development, and general and administrative expenses. General and administrative costs are not applied to certain subcontract costs associated with our cost-reimbursement contracts. These subcontracts must be in excess of $250,000 and must meet certain other predetermined criteria. We recognize contract revenues and profits on cost-reimbursement contracts by applying an estimated fee rate to all incurred costs on an individual contract basis. Fee calculations are based on either negotiated fee amounts or management’s assessment of the fee amounts that are likely to be earned.

Our policy for recognizing interim fees on our cost-plus-award-fee contracts is based on management’s assessment as to the likelihood that the award fee or an incremental portion of the award fee will be earned, on a contract-by-contract basis. Management’s assessments are based on numerous factors including: contract terms, nature of the work to be performed, our relationship and history with the customer, our history with similar types of projects, and our current and anticipated performance on the specific contract. No award fee is recognized until management determines that it is probable that an award fee or a portion thereof will be earned. Historically, management’s estimates have generally been consistent with actual fees awarded. However, changes could arise within an award fee period causing management to either lower or raise the award fee estimate in the period in which it occurs.

Our engineering services contracts are typically performed on a level-of-effort basis. Revenue is recognized in accordance with our policy regarding cost-reimbursement contracts.

We account for fixed-price contracts by using the percentage-of-completion method of accounting. Under this method, labor, materials, and other direct costs, plus estimated indirect costs of operations are charged as incurred (incurred costs). A portion of the contract revenue, based on estimated profits and the degree of completion of the contract as measured by a comparison of the actual and estimated costs, is recognized as revenue each period.

For those contracts in which all of the terms have not yet been finalized, revenue does not include an estimated fee rate on cost.

Management reviews contract performance, costs incurred, and estimated completion costs regularly. Revenues and profits are adjusted on all contracts in the period in which changes, including anticipated losses, become determinable. Unexpected increases in the cost to develop or manufacture a product, whether due to inaccurate estimates in the bidding process, unanticipated increases in material costs, inefficiencies, or other factors, are borne by us on fixed-price contracts, and could have a materially adverse effect on results of operations and financial condition. Unexpected cost increases in cost-reimbursement contracts may be borne by us for purposes of maintaining customer relationships. Historically, the effect on operating results and financial condition from cost-reimbursement losses has been minimal.

Our accounting policy for recording the indirect rate variance is based on management’s belief that variances accumulated during interim reporting periods will be absorbed by expected contract activities during the remainder of the year. We consider the rate variance to be unfavorable when our actual indirect rates are greater than our annual targeted rates. In contrast, a favorable rate variance occurs when our actual indirect rates are lower than our annual targeted rates. During interim reporting periods, unfavorable rate variances are recorded as reductions to operating expenses and increases to work in process inventory. Favorable rate variances are recorded as increases to operating expenses and decreases to work in process inventory.

If we anticipate that actual contract activities will be different than planned levels, there are alternatives we can utilize to reduce the variance: we can adjust some of our planned indirect spending during the year, modify our billing rates to our customers, or record adjustments to expense based on estimates of future contract activities. At July 30, 2004, the favorable inventoried indirect rate variance was approximately $1,034,000. At August 1, 2003, the favorable inventoried rate variance was approximately $1,185,000. Management determined that a portion of this favorable indirect rate variance at August 1, 2003 would remain unabsorbed by the end of fiscal year 2003, resulting in higher operating income. Consequently, at the end of the third quarter of fiscal year 2003, a $350,000 adjustment was recorded to increase operating income and reduce the favorable inventoried rate variance to approximately $835,000.

If our rate variance is unfavorable, the modification of our billing rates will likely increase revenue and operating expenses, and decrease inventory. Fee percentages on fixed-price and cost-reimbursement contracts will generally decline as a result of any increase to indirect costs. If our rate variance is favorable, the modification of our billing rates will decrease revenue and operating expenses, and increase inventory. In this event, fee percentages on fixed-price contracts will generally increase. Fee percentages on cost-reimbursable contracts will generally be unaffected as a result of any reduction to indirect costs, due to the fact that programs will typically expend all of the funds available. Any impact on operating income, however, depends on a number of other factors, including mix of contract types, contract terms, and anticipated performance on specific contracts, and anticipated changes in inventory.

We expect to absorb the current positive indirect rate variance through certain contract activities. However, if these activities do not absorb the positive indirect rate variance, we may have to modify our billing rates at the end of fiscal year 2004. In the event that our rates decline, our revenues and contract costs could decline, creating a marginal increase in fees overall. This is due to the fact that we believe our largest portion of revenues will be from cost-reimbursement contracts, whose fee percentages will be unaffected, since these programs will likely expend the total funds available. However, we also believe that we will experience a marginal increase in operating income due to the increased profitability on our fixed-price contracts.

Price redetermination. As a government contractor, we are subject to price redetermination on certain fixed-price contracts if it is determined that we did not price our products and services consistent with the requirements of the Federal Acquisition Regulations. During the first nine months of fiscal years 2004 and 2003, we did not incur any price redeterminations on any of our contracts.

As of July 30, 2004, we continue to believe that there is a renewed interest in signal intelligence by the U.S. government to respond to the threat of terrorist activities and the war against terrorism. We also believe that our company is well positioned to benefit from the spending that might result.

A significant portion of our revenue is generated by cost-reimbursable contracts. These contracts tend to be developmental in nature, and require highly specialized, technical skill sets. We believe that this trend will continue through the end of fiscal year 2004.

We currently anticipate that the mix of contract types for fiscal year 2004 will be similar to that experienced in fiscal year 2003.

Our single largest contract represented 19% and 21% of revenues for the third quarter and first nine months of fiscal year 2004, respectively. For the third quarter and first nine months of fiscal year 2003, our single largest contract represented 17% and 19% of revenues, respectively. In addition, another significant program represented approximately 9% of revenues for the third quarter and first nine months of fiscal year 2004. This program did not recognize any revenues during the same periods of fiscal year 2003, since it did not begin until the fourth quarter of fiscal year 2003.

Contract costs. Contract costs consist of direct costs incurred in the performance of the contract, including labor, materials, and estimated overhead costs. Contract costs were approximately $24,629,000, or 64.4% of revenues, for the third quarter of fiscal year 2004 compared to approximately $17,538,000, or 67.5%, of revenues for the same period of fiscal year 2003. Contract costs were lower as a percentage of revenue during the third quarter of fiscal year 2004 compared to the same period of 2003 primarily due to the additional contract costs recorded during the third quarter of fiscal year 2003 of approximately $606,000 as a result of scrapping obsolete inventory. During the first nine months of fiscal year 2004, we incurred contract costs of approximately $67,075,000, or 64.9% of revenues, compared to contract costs incurred during the first nine months of fiscal year 2003 of approximately $42,950,000, or 64.8% of revenues. As a percentage of revenues, contract costs were n ot significantly different between the first nine months of fiscal year 2004 and the same period of fiscal year 2003, and were within historical levels.

Research and development (R&D). Company-directed investment in research and development consists of expenditures recoverable from customers through our billing rates and expenditures funded from earnings. For interim reporting periods, R&D expenses include labor, materials, and estimated overhead costs. R&D expenses were approximately $4,413,000, or 11.5% of revenues, for the third quarter of fiscal year 2004 compared to approximately $2,281,000, or 8.8% of revenues, for the same period of fiscal year 2003. During the first nine months of fiscal year 2004, R&D expenses were approximately $9,969,000, or 9.6% of revenues, compared to approximately $5,882,000, or 8.9% of revenues, incurred during the first nine months of fiscal year 2003. R&D expenses grew in absolute dollars based on management’s decision to try to maintain R&D spending as a percentage of projected revenues at levels comparable to historical levels.

General and administrative. General and administrative expenses include administrative salaries, costs related to marketing and proposal activities, costs associated with product warranties, and other administrative costs. We record general and administrative expenses based on annual targeted indirect rates applied to the quarterly revenue base, for interim reporting periods. General and administrative expenses were approximately $3,631,000, or 9.5% of revenues, for the third quarter of fiscal year 2004 compared to approximately $4,268,000, or 16.4% of revenues, for the same period of fiscal year 2003. During the third quarter of fiscal year 2003, general and administrative expenses were higher in absolute dollars due to the adjustment of the indirect rate variance. As a percentage of revenues, general and administrative expenses decreased during the third quarter of fiscal year 2004 due to the significant growth in revenues recognized during the third quarter of fiscal y ear 2004. General and administrative expenses incurred during the first nine months of fiscal year 2004 were approximately $12,846,000, or 12.4% of revenues, compared to approximately $10,994,000, or 16.6% of revenues, incurred during the first nine months of fiscal year 2003. General and administrative expenses were higher in absolute dollars during the first nine months of fiscal year 2004 primarily due to our annual targeted indirect rate applied to a higher revenue base. General and administrative expenses were lower as a percentage of revenue due to our ability to significantly grow revenues without having to proportionately increase our general and administrative expenditures. However, we believe that our rapid growth in revenue could cause additional general and administrative expenditures during the remaining three months of fiscal year 2004.

Interest income (expense), net. Net interest income for the third quarter of fiscal year 2004 was approximately $121,000 compared to net interest income of approximately $120,000 for the third quarter of fiscal year 2003. Net interest income recognized during the first nine months of fiscal year 2004 was approximately $399,000 compared to approximately $320,000 recognized during the same period of fiscal year 2003. Interest income increased during the third quarter and first nine months of fiscal year 2004 as a result of higher cash and investment balances at the beginning of fiscal year 2004 when compared to the beginning of fiscal year 2003.

Provision for income taxes. Our provision for income taxes for the third quarter and first nine months of fiscal year 2004 was approximately $2,264,000 and $4,337,000, respectively. Our operating income increased during the third quarter of fiscal year 2004, which increased our effective tax rate to 39.6% and 31.2% for the third quarter and first nine months of fiscal year 2004, respectively. In addition, our fiscal year 2004 income tax expense included a reduction of approximately $803,000 associated with the reversal of our valuation allowance on our deferred tax assets. The reduction was recorded during the second quarter of fiscal year 2004. We estimate that our annual effective tax rate could be in the range of 34% to 35%, which will result in a tax rate of approximately 40% or greater for the fourth quarter of fiscal year 2004. Our provision for income taxes for the first nine months of fiscal year 2003 was approximately $1,013,000, representing an effective tax rate of 1 5%. Our estimated annual effective tax rate at August 1, 2003 differed from the statutory rate primarily due to anticipated benefits from the utilization of deferred tax assets.

Our primary sources of liquidity during the first nine months of fiscal year 2004 were cash flows generated from operations and the issuance of common stock through our employee stock option plans and purchase plan.

The October 31, 2002 balance sheet was changed in our Annual Report on Form 10-K for our fiscal year ended October 31, 2003 in order to correct a misclassification between cash equivalents and short-term investments. The misclassification had no impact on our statement of operations for any period. The statement of cash flows for the first nine months of fiscal year 2003 has been changed in this report to reflect the correct beginning cash balance for fiscal year 2003.

Net cash from operating activities. Net cash provided by operating activities has varied significantly from quarter to quarter. These quarter-to-quarter variances are primarily the result of changes in net income and operating assets and liabilities. Operating activities provided approximately $6,654,000 and $8,584,000 during the first nine months of fiscal years 2004 and 2003, respectively. Net income for the first nine months of fiscal year 2004 was approximately $9,552,000 compared to a net income of approximately $5,742,000 for the comparable period of fiscal year 2003. This increase in net income is due in part to our growth in revenues and, in part, to an increase in program profitability generated from the sale of certain products.

Accounts receivable balances increased during the first nine months of fiscal years 2004 and 2003 by approximately $9,393,000, and $1,460,000, respectively. Accounts receivable balances increased during the first nine months of fiscal year 2004 due to the significant revenue generated during this period. We received a significant amount of cash during the first nine months of fiscal year 2003, primarily as a result of an improved payment process of one of our significant customers.

Cash used to support inventory, prepaid expenses, and other assets was approximately $716,000 and $936,000 during the first nine months of fiscal years 2004 and 2003, respectively. The fluctuation in cash used between the first nine months of fiscal year 2004 and the first nine months of fiscal year 2003 is primarily due to the difference in the rate variance between those two periods.In the first nine months of fiscal year 2004, the favorable rate variance decreased inventory balances by approximately $1,034,00. During the same period of fiscal year 2003, the favorable rate variance decreased inventory balances by approximately $835,000.

If we are unable to comply with complex government regulations governing security and contracting practices, we could be disqualified as a supplier to the United States Government. As a supplier to United States Government defense and intelligence agencies, we must comply with numerous regulations, including those governing security and contracting practices. Failure to comply with these procurement regulations and practices could result in fines being imposed against us or our suspension for a period of time from eligibility for bidding on, or for award of, new government contracts. If we are disqualified as a supplier to government agencies, we will lose most, if not all, of our customers, revenues from sales of our products would decline significantly, and our ability to continue operations would be seriously jeopardized. Among the causes for disqualification are violations of various statutes, including those related to procurement integrity, export control, U. S. government security regulations, employment practices, protection of the environment, accuracy of records in the recording of costs, and foreign corruption. The government may investigate and make inquiries of our business practices and conduct audits of contract performance and cost accounting. Depending on the results of these audits and investigations, the government may make claims against us, and if they prevail, certain incurred costs would not be recoverable.

Continued competition in our markets may lead to a reduction in our revenues and market share. The signal intelligence market is highly competitive and we expect that competition will increase in the future. Our current competitors have significantly greater technical, manufacturing, financial, and marketing resources than we do. We expect that more companies will enter the market for signal intelligence. We may not be able to compete successfully against either current or future competitors. Increased competition could result in reduced revenue, lower margins, or loss of market share, any of which could significantly harm our business. Our competitors may introduce improved products with lower prices, and we will have to do the same to remain competitive.

If we are unable to recruit, train, and retain key personnel with required security clearances, our ability to develop, introduce, and sell our products may be adversely impacted. Our ability to execute our business plan is contingent upon successfully attracting and retaining qualified employees who obtain, or are able to obtain, necessary government security clearances. If we fail to attract and retain qualified employees who can obtain the necessary security clearances, our business could be significantly harmed. The loss of the services of any of our qualified employees, the inability to attract or retain qualified personnel in the future, or delays in hiring required personnel could negatively impact our ability to develop, introduce, and sell our products. In addition, employees may leave us and subsequently compete against us.

Many of the personnel we hire will need U.S. government security clearances in order to perform tasks we require on our government contracts. We have found that there is a shortage of qualified personnel possessing the necessary clearances, and new security clearances are taking longer to be granted. If we are not able to obtain security clearances for our personnel where required, they will be unable to perform tasks requiring clearances, and we may be unable to satisfy the terms of our contracts, resulting in customer dissatisfaction and possible loss of current or future contracts.