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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

[X]	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

[   ]

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

I-Flow Corporation

(949) 206-2700

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. [X]  Yes    [   ]  No

As of October 31, 2002 there were 15,452,638 shares outstanding of common stock.

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I-FLOW CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2002

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				Page
Part I: Financial Information
	Item 1. Financial Statements (Unaudited)
		Condensed Consolidated Balance Sheets as of September 30, 2002 and and December 31, 2001			1
		Condensed Consolidated Statements of Operations and Comprehensive Operations for the three and nine-month periods ended September 30, 2002 and 2001			2
		Condensed Consolidated Statements of Cash Flows for the nine-month periods ended September 30, 2002 and 2001			3
		Notes to Condensed Consolidated Financial Statements (Unaudited)			4
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations				9
	Item 3. Quantitative and Qualitative Disclosures About Market Risk				16
	Item 4. Controls and Procedures				16
Part II: Other Information
	Item 1. Legal Proceedings				17
	Item 5. Other Information				17
	Item 6. Exhibits and Reports on Form 8-K				17
Signatures					20

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I-FLOW CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)

					September 30,				December 31,
					2002				2001
ASSETS
	CURRENT ASSETS:
		Cash and cash equivalents			$	2,106,000			$	2,033,000
		Accounts receivable, net				9,987,000				10,010,000
		Inventories, net				6,932,000				6,984,000
		Prepaid expenses and other				555,000				353,000
		Deferred taxes				2,294,000				2,294,000
			Total current assets			21,874,000				21,674,000
		Property, net				5,333,000				4,805,000
		Goodwill, net				2,639,000				6,115,000
		Other long-term assets				1,228,000				1,068,000
		Deferred taxes				2,042,000				2,042,000
TOTAL					$	33,116,000			$	35,704,000
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
		Accounts payable			$	3,367,000			$	3,115,000
		Accrued payroll and related expenses				1,644,000				1,875,000
		Income taxes payable				760,000				576,000
		Current portion of long-term debt				110,000				221,000
		Other liabilities				38,000				65,000
			Total current liabilities			5,919,000				5,852,000
LONG-TERM DEBT, less current portion						9,000				83,000
STOCKHOLDERS’ EQUITY:
		Preferred stock — $0.001 par value; 5,000,000 shares authorized; no shares issued and outstanding at September 30, 2002 (unaudited) and December 31, 2001, respectively				—				—
		Common stock — $0.001 par value; 40,000,000 shares authorized; 15,441,931 and 15,344,550 shares issued and outstanding at September 30, 2002 (unaudited) and December 31, 2001, respectively				42,898,000				42,274,000
		Accumulated other comprehensive income (loss)				(80,000	)			1,000
		Accumulated deficit				(15,630,000	)			(12,506,000	)
			Net stockholders’ equity			27,188,000				29,769,000
TOTAL					$	33,116,000			$	35,704,000

See accompanying notes to unaudited condensed consolidated financial statements.

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I-FLOW CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE OPERATIONS
(Unaudited)

					Three Months Ended								Nine Months Ended
					September 30,								September 30,
					2002				2001				2002				2001
Net revenues					$	9,639,000			$	7,991,000			$	27,694,000			$	24,462,000
Costs and expenses:
	Cost of sales					3,711,000				3,303,000				10,959,000				10,118,000
	Selling and marketing					3,103,000				1,199,000				8,409,000				3,860,000
	General and administrative					2,106,000				2,236,000				6,116,000				6,817,000
	Product development					542,000				493,000				1,633,000				1,575,000
		Total costs and expenses				9,462,000				7,231,000				27,117,000				22,370,000
Operating income						177,000				760,000				577,000				2,092,000
Interest expense (income), net						—				(28,000	)			(5,000	)			49,000
Income tax provision						70,000				377,000				233,000				917,000
Net income before effect of a change in accounting principle						107,000				411,000				349,000				1,126,000
Effect of a change in accounting principle:
	Goodwill impairment					—				—				(3,474,000	)			—
Net income (loss)					$	107,000			$	411,000			$	(3,125,000	)		$	1,126,000
Net income per share, before effect of change in accounting principle
			Basic		$	0.01			$	0.03			$	0.02			$	0.07
			Diluted		$	0.01			$	0.03			$	0.02			$	0.07
Loss per share from goodwill impairment
			Basic		$	—			$	—			$	(0.22	)		$	—
			Diluted		$	—			$	—			$	(0.22	)		$	—
Net income (loss) per share
			Basic		$	0.01			$	0.03			$	(0.20	)		$	0.07
			Diluted		$	0.01			$	0.03			$	(0.20	)		$	0.07
Comprehensive Operations:
			Net income (loss)		$	107,000			$	411,000			$	(3,125,000	)		$	1,126,000
			Foreign currency translation gain (loss)			(18,000	)			(26,000	)			(81,000	)			(62,000	)
			Comprehensive income (loss)		$	89,000			$	385,000			$	(3,206,000	)		$	1,064,000

See accompanying notes to unaudited condensed consolidated financial statements.

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I-FLOW CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

				Nine Months Ended
				September 30,
				2002				2001
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)				$	(3,125,000	)		$	1,126,000
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
	Depreciation and amortization				1,515,000				2,010,000
	Goodwill impairment				3,474,000				—
	Compensation expense related to stock option grants				577,000				465,000
	Change in allowance for doubtful accounts				(407,000	)			77,000
	Changes in operating assets and liabilities (net of acquisition assets and liabilities):
		Accounts receivable			431,000				3,416,000
		Inventories			53,000				(2,541,000	)
		Prepaid expenses and other current assets			(121,000	)			(93,000	)
		Accounts payable, accrued payroll and related expenses			(30,000	)			86,000
		Income taxes payable			184,000				612,000
		Other liabilities			(21,000	)			(72,000	)
Net cash provided by operating activities					2,530,000				5,086,000
CASH FLOWS FROM INVESTING ACTIVITIES:
	Property acquisitions				(1,865,000	)			(1,360,000	)
	Cash paid for acquisition				—				(165,000	)
	Change in other assets				(350,000	)			(347,000	)
Net cash used in investing activities					(2,215,000	)			(1,872,000	)
CASH FLOWS FROM FINANCING ACTIVITIES:
	Net proceeds (repayments) from line of credit				—				(500,000	)
	Principal payments on notes payable				(186,000	)			(1,906,000	)
	Proceeds from exercise of stock options and warrants				48,000				99,000
Net cash used in financing activities					(138,000	)			(2,307,000	)
Effect of exchange rates on cash					(104,000	)			(66,000	)
NET INCREASE IN CASH AND CASH EQUIVALENTS					73,000				841,000
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD					2,033,000				1,184,000
CASH AND CASH EQUIVALENTS AT END OF PERIOD				$	2,106,000			$	2,025,000
SUPPLEMENTAL CASH FLOW INFORMATION:
Interest paid				$	11,000			$	92,000
Income tax payments				$	49,000			$	321,000
Liabilities issued and assumed in connection with acquisition:
	Fair value of assets acquired (including intangibles)			$	—			$	165,000
	Cash outflows for business acquisition				—				(165,000	)
	Common stock issued				—				—
Liabilities issued and assumed				$	—			$	—

See accompanying notes to unaudited condensed consolidated financial statements.

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I-FLOW CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.		Basis of Presentation
		The accompanying unaudited consolidated financial statements contain all adjustments (consisting only of normal recurring adjustments, and a goodwill impairment charge related to a change in accounting principle) that, in the opinion of management, are necessary to present fairly the financial position of I-Flow Corporation and its subsidiaries (the “Company”) at September 30, 2002 and the results of its operations and its cash flows for the three and nine-month periods ended September 30, 2002 and 2001. Certain information and footnote disclosures normally included in financial statements have been condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission although the Company believes that the disclosures in the financial statements are adequate to make the information presented not misleading.
		The financial statements included herein should be read in conjunction with the financial statements of the Company included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001 filed with the Securities and Exchange Commission on April 1, 2002.
		Certain amounts previously reported have been reclassified to conform with the presentation at September 30, 2002.
2.		Inventories
		Inventories consisted of the following:

3.		Earnings (Loss) Per Share
		Basic net income (loss) per share is computed using the weighted average number of common shares outstanding during the periods presented, excluding unvested restricted stock which the Company has a right to repurchase in the event of early termination of employment.
		Diluted net income (loss) per share is computed using the weighted average number of common and common equivalent shares outstanding during the periods utilizing the treasury stock method for stock options and unvested restricted stock.

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The following is a reconciliation between the number of shares used in the basic and diluted net income per share calculations:

		Potential common shares of 4,571,000 and 4,317,000 have been excluded from diluted weighted average common shares for the three and nine-month periods ended September 30, 2002, respectively, as the effect would be anti-dilutive.
		Potential common shares of 3,574,000 and 3,739,000 have been excluded from diluted weighted average common shares for the three and nine-month periods ended September 30, 2001, respectively, as the effect would be anti-dilutive.
4.		Business Segments
		The Company operates in two business segments: manufacturing and marketing of medical infusion products, and rentals of medical infusion pumps.
		Business segment information is as follows for the three and nine-month periods ended September 30, 2002 and 2001:

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5.		New Accounting Pronouncements; Goodwill Impairment
		In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations (“SFAS 141”) and SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). FASB also issued SFAS No. 143, Accounting for Obligations Associated with the Retirement of Long-Lived Assets (“SFAS 143”), SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”), and SFAS 146, Accounting for Costs Associated with Exit or Disposal Activities (“SFAS 146”) in August 2001, October 2001 and July 2002, respectively.
		SFAS 141 requires that all business combinations initiated after June 30, 2001 be accounted for under the purchase method. SFAS 141 superseded APB Opinion No. 16, Business Combinations, and Statement of Financial Accounting Standards No. 38, Accounting for Preacquisition Contingencies of Purchased Enterprises. The Company’s adoption of the provisions of SFAS 141 has not had a material impact on the Company’s consolidated results of operations and financial position.
		SFAS 142 addresses the financial accounting and reporting requirements for acquired goodwill and other intangible assets. The Company adopted the provisions of SFAS 142 in January 2002. Under SFAS 142, the Company is no longer required to amortize goodwill and other intangible assets with indefinite lives. Instead, SFAS 142 requires that goodwill and intangible assets deemed to have an indefinite useful life be reviewed for impairment upon adoption of SFAS 142 and annually thereafter. The Company will perform its annual impairment review during the first quarter of each year, commencing in the first quarter of 2003 or more frequently when an event occurs or circumstances change to indicate that an impairment of goodwill has likely occurred.
		Under SFAS 142, goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value. The Company’s reporting units are generally consistent with the operating segments underlying the segments identified in Note 4. Business Segments. This methodology differs from the Company’s previous policy, as permitted under accounting standards existing at that time, of using undiscounted cash flows on an enterprise-wide basis to determine if goodwill is recoverable.
		In accordance with SFAS 142, the Company completed a test for impairment in June 2002 and concluded that consolidated goodwill in the amount of $3,474,000 was impaired. The Company recorded a non-cash charge of approximately $3,474,000 to reduce the carrying value of its goodwill. Such charge is non-operational in nature and is reflected as a cumulative effect of an accounting change, effective January 1, 2002, in the accompanying Condensed Consolidated Statements of Operations and Comprehensive Operations.
		The total impairment amount of $3,474,000 is attributable to the Company’s manufacturing and marketing business segment, and represents the previously unamortized goodwill resulting from the Company’s purchase of substantially all of the assets of Block Medical, Inc. on July 22, 1996, and the Company’s acquisition of all of the outstanding stock of Spinal Specialties, Inc. on January 14, 2000. In calculating the impairment charge, the fair value of the impaired reporting unit comprising the operating segment was estimated using a market multiple methodology. The impairment of the goodwill associated with the manufacturing and marketing segment resulted from the low profitability of the business segment.
		As of September 30, 2002, the goodwill of $2,639,000 deemed unimpaired is attributable to the Company’s rentals business segment. A reconciliation of net income is shown below for all periods presented to conform to the requirements of SFAS 142.

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Had the impairment loss been recorded upon initial adoption of SFAS No. 142 during the first quarter of 2002, the net income and per share data for the three months ended March 31, 2002 would have been restated as follows:

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Amortizable intangible assets included in other long-term assets in the accompanying condensed consolidated balance sheets are as follows:

		Amortization expense for the three and nine-month periods ended September 30, 2002 was $63,000 and $184,000, respectively, compared to $58,000 and $154,000 for the same periods in the prior year. Amortization expense of intangible assets is expected to be approximately $230,000 in each of the next five fiscal years. During the three and nine-month periods ended September 30, 2002, the Company acquired patents with an aggregate cost of $126,000 and $223,000, respectively. The Company amortizes patents over a period of 7 years.
		SFAS 143 establishes accounting standards for the recognition and measurement of an asset retirement obligation and its associated asset retirement cost. It also provides accounting guidance for legal obligations associated with the retirement of tangible long-lived assets. SFAS 143 is effective for fiscal years beginning after June 15, 2002, with early adoption permitted. The Company is currently evaluating the provisions of SFAS 143 but expects that the provisions of SFAS 143 will not have a material impact on its consolidated results of operations and financial position upon adoption.
		SFAS 144 establishes a single accounting model for the impairment or disposal of long-lived assets and new standards for reporting discontinued operations. SFAS 144 supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, and APB Opinion No. 30, Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. The provisions of SFAS 144 are effective in fiscal years beginning after December 15, 2001 and, in general, are to be applied prospectively. The adoption of SFAS 144 did not have a material impact on the Company’s consolidated results of operations and financial position.
		SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities. SFAS 146 supersedes Emerging Issues Task Force (EITF) Issue 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring).” SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under Issue 94-3, a liability for an exit cost, as defined in EITF 94-3, was recognized at the date of an entity’s commitment to an exit plan. SFAS 146 also establishes that the liability should initially be measured and recorded at fair value. The Company will adopt the provisions of SFAS 146 for exit or disposal activities that are initiated after December 31, 2002.

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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Certain disclosures made by the Company in this report and in other reports and statements released by the Company are and will be forward-looking in nature, such as comments that express the Company’s opinions about trends and factors that may impact future operating results. Disclosures that use words such as “believes,” “anticipates,” or “expects” or use similar expressions are intended to identify forward-looking statements. Forward-looking statements are subject to certain risks and uncertainties, which could cause actual results to differ significantly from those expected, and readers are cautioned not to place undue reliance on these forward-looking statements. The Company undertakes no obligation to republish revised forward-looking statements to reflect the occurrence of unanticipated events. Readers are also urged to carefully review and consider the various disclosures made by the Company in this report that seek to advise interested parties of the risks and other factors that affect the Company’s business, as well as in the Company’s reports on Forms 10-K, 10-Q and 8-K that are periodically filed with the Securities and Exchange Commission. The risks affecting the Company’s business include reliance on the success of the home health care industry, the Company’s success in pursuing its direct sales strategy, the reimbursement system currently in place and future changes to that system, competition in the industry, economic and political conditions in foreign countries, inadequacy of booked reserves, technological changes and product availability. All forward-looking statements, whether made in this report or elsewhere, should be considered in context with the various disclosures made by the Company about its business.

Significant Accounting Policies

		The Company prepares its consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. As such, the Company is required to make estimates, judgments and assumptions that the Company believes are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. The significant accounting policies that the Company believes are the most critical to aid in fully understanding and evaluating our reported financial results are:
		Revenue Recognition
		The Company recognizes revenue from product sales at the time of shipment and passage of title. The Company also offers the right of return for defective products, and continuously monitors and tracks such product returns. Also, the Company records a provision for the estimated amount of future returns based on historical experience and notification of pending returns. While returns have historically been insignificant, the Company cannot guarantee that it will continue to experience the same return rates as in the past. Any significant increase in product returns could have a material adverse impact on the Company’s operating results for the period or periods in which the returns occur.
		The Company recognizes rental revenues from medical pumps over the term of the related agreement, generally on a month-to-month basis. Pump rentals are billed at the Company’s established rates, which generally differ substantially from contractually allowable rates provided by third party payors such as Medicare, Medicaid and commercial insurance carriers. The Company records net rental revenues at the estimated realizable amounts from patients and third party payors. The Company experiences significant delays between the time of billing and the time of payment from many of these third party payors; however, it continuously monitors reimbursement rates from third party payors and timing of payments. Because of the delays in collection, the portion of the Company’s accounts receivable attributable to pump rentals is disproportionately larger than that segment’s relative revenue. Any significant change in reimbursement or collection rates could have a material impact on the Company’s operating results for the period or periods in which the change occurs.

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		Accounts Receivable
		The Company performs ongoing credit evaluations of its customers and adjusts credit limits based upon payment history, expected purchases, and the customer’s current credit worthiness, as determined by the Company’s review. Receivables from customers are generally unsecured. The Company continuously monitors its customer account balances and actively pursues collections on past due balances. The Company maintains an allowance for doubtful accounts which is comprised of a general reserve based on historical collections performance plus a specific reserve for certain known customer collections issues. If actual bad debts are greater than the reserves calculated based on historical trends and known customer issues, the Company may be required to book additional bad debt expense which could have a material adverse impact on the Company’s operating results for the period or periods in which such additional expense occurs.
		In addition, for the Company’s rentals business segment, the Company maintains a contractual allowance representing the estimated portion of gross billings that will be ultimately uncollectible due to the substantial difference between the Company’s established pump rental rates and the contractually allowable rates provided by third party payors such as Medicare, Medicaid and commercial insurance carriers. If actual collections are less than previously estimated, this may indicate that net revenues and accounts receivable have been overstated, and the Company may be required to record an adjustment to revenue and the contractual allowance which could have a material adverse impact on the Company’s operating results for the period or periods in which such adjustment occurs.
		Inventories
		The Company values inventory at the lower of the actual cost to purchase or manufacture the inventory or the current estimated market value of the inventory. The Company regularly reviews inventory quantities on hand and records a provision for excess and obsolete inventory based primarily on the estimated forecast of product demand and production requirements for the next two years. A significant increase in the demand for the Company’s products could result in a short-term increase in the cost of inventory purchases while a significant decrease in demand could result in an increase in the amount of excess inventory quantities on hand. Additionally, the Company’s estimates of future product demand may prove to be inaccurate, in which case the Company may have understated or overstated the provision required for excess and obsolete inventory. In the future, if inventory is determined to be overvalued, the Company would be required to recognize such costs in cost of goods sold at the time of such determination. Likewise, if inventory is determined to be undervalued, the Company may have over-reported cost of goods sold in previous periods and would be required to recognize such additional operating income at the time of sale. Therefore, although the Company seeks to ensure the accuracy of its forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of its inventory and reported operating results.
		Deferred Taxes
		The Company recognizes deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. The Company regularly reviews its deferred tax assets for recoverability and establishes a valuation allowance based on historical taxable income, projected future taxable income and the expected timing of the reversals of existing temporary differences. If the Company continues to operate at a profit in the future and generates sufficient future taxable income, it could be required to reverse the current valuation allowance against the deferred tax assets which would result in a substantial decrease in the Company’s effective tax rate. Conversely, if the Company is unable to operate at a profit and unable to generate sufficient future taxable income, it could be required to establish an additional valuation allowance against all or a significant portion of its deferred tax assets resulting in a substantial increase in its effective tax rate and a material adverse impact on its operating results.

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		Goodwill and Other Intangibles
		The Company performs a review for impairment of the carrying value of goodwill on an annual basis and more frequently when an event occurs or circumstances change that would more likely than not reduce the fair value of goodwill below its carrying amount. In determining the fair value of the entire Company, the Company considers the market price of the Company’s common stock and various other factors. If the fair value of a reporting unit of the Company is less than the net book value of the reporting unit, the Company may potentially be required to record an impairment loss for goodwill that could have a material adverse impact on the Company’s operating results for the period in which such impairment loss was recorded.

Results of Operations

		Net revenues during the three and nine-month periods ended September 30, 2002 were $9,639,000 and $27,694,000 compared to $7,991,000 and $24,462,000 for the same periods in the prior year, representing increases of 21% and 13%, respectively. The net increases in revenues of $1,648,000 and $3,232,000 for the three and nine-month periods ended September 30, 2002 compared to the same periods in the prior year were primarily due to increases in regional anesthesia product revenues of $1,160,000 and $2,714,000, respectively. The revenue increase over the prior year included substantially higher average selling prices for the Company’s ON-Q® Post-Operative Pain Relief System as a result of the change in distribution method from a third party distributor to a direct sales force selling to hospitals and other end users.
		The Company incurred cost of sales of $3,711,000 and $10,959,000 during the three and nine-month periods ended September 30, 2002 compared to $3,303,000 and $10,118,000 for the same periods in the prior year. This represents an increase of 12% and 8%, respectively. However, during the three and nine-month periods ended September 30, 2002, cost of sales as a percentage of net revenues decreased from the comparable prior year periods by approximately 3% and 2%, respectively, primarily due to the increased average selling prices on the Company’s ON-Q Post-Operative Pain Relief System as a result of the change in distribution method from a third party distributor to a direct sales force.
		Selling and marketing expenses for the three and nine-month periods ended September 30, 2002 increased over the same periods in the prior year by $1,904,000 or 159% and $4,549,000 or 118%, respectively. These increases were primarily due to the additional costs associated with the Company’s new direct sales force and related marketing expenses and infrastructure necessary to support the ON-Q Post-Operative Pain Relief System. The Company assumed exclusive distribution rights for the ON-Q product from Ethicon-Endo Surgery, Inc., effective January 1, 2002.
		General and administrative expenses for the three-month period ended September 30, 2002 decreased by $130,000, or 6% compared to the same period in the prior year, while such expenses for the nine-month period ended September 30, 2002 decreased by $701,000, or 10%. As a percentage of net revenues, general and administrative expenses decreased by 6% for both the three and nine-month periods ended September 30, 2002. The decreases for the three and nine-month periods ended September 30, 2002 were primarily due to decreases in goodwill amortization of $187,000 and $680,000, respectively, and reduced compensation expense.
		Product development expenses for the three and nine-month periods ended September 30, 2002 increased over the same periods in the prior year by $49,000 or 10% and $58,000 or 4%, respectively. These increases were primarily due to increased consulting expenses and other outside services. The Company will continue to incur product development expenses as it continues its efforts to introduce new and improved technology and cost-efficient products into the market.
		During the three and nine-month periods ended September 30, 2002, the Company recorded income tax expense of $70,000 and $233,000, respectively, compared to income tax expense of $377,000 and $917,000 for the same periods in the prior year. The Company’s effective tax rate decreased to 39.5% during the quarter ended September 30, 2002 from 47.8% in the quarter ended September 30, 2001, which included a $23,000 year-to-date adjustment of the estimated provision for federal income taxes. For the

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nine months ended September 30, 2002, the effective tax rate was 40.0% compared to 44.9% for the nine months ended September 30, 2001.

Liquidity and Capital Resources

		During the nine-month period ended September 30, 2002, cash of $2,530,000 was provided by operating activities consisting of a net loss of $3,125,000 plus non-cash expenses of $5,159,000 and net changes in operating assets and liabilities of $496,000.
		The Company used cash in investing activities during the nine-month period ended September 30, 2002 aggregating $2,215,000, compared to $1,872,000 for the same period in the prior year. The expenditures in the nine months ended September 30, 2002 consisted of $1,865,000 used to acquire computer equipment, purchased software, leasehold improvements, furniture, fixtures, tooling and equipment for use in the Company’s operations along with a net outflow related to other assets, primarily patents, of $350,000. The Company currently expects expenditures for fixed assets to be relatively consistent for the remainder of the year.
		During the nine-month period ended September 30, 2002, cash of $138,000 was used in financing activities consisting of $186,000 of payments on notes payable, partially offset by $48,000 in proceeds from the exercise of stock options.
		As of September 30, 2002, the Company had cash and cash equivalents of $2,106,000 and net accounts receivable of $9,987,000. Management believes the Company’s funds are sufficient to provide for its projected needs for operation during the next 12 months. However, the Company may decide to sell additional equity or increase its borrowings in order to fund increased product development or for other purposes.

New Accounting Pronouncements

		In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations (“SFAS 141”) and SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). FASB also issued SFAS No. 143, Accounting for Obligations Associated with the Retirement of Long-Lived Assets (“SFAS 143”), SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”), and SFAS 146, Accounting for Costs Associated with Exit or Disposal Activities (“SFAS 146”) in August 2001, October 2001 and July 2002, respectively.
		SFAS 141 requires that all business combinations initiated after June 30, 2001 be accounted for under the purchase method. SFAS 141 superseded APB Opinion No. 16, Business Combinations, and Statement of Financial Accounting Standards No. 38, Accounting for Preacquisition Contingencies of Purchased Enterprises. The Company’s adoption of the provisions of SFAS 141 has not had a material impact on the Company’s consolidated results of operations and financial position.
		SFAS 142 addresses the financial accounting and reporting requirements for acquired goodwill and other intangible assets. The Company adopted the provisions of SFAS 142 in January 2002. Under SFAS 142, the Company is no longer required to amortize goodwill and other intangible assets with indefinite lives. Instead, SFAS 142 requires that goodwill and intangible assets deemed to have an indefinite useful life be reviewed for impairment upon adoption of SFAS 142 and annually thereafter. The Company will perform its annual impairment review during the first quarter of each year, commencing in the first quarter of 2003 or more frequently when an event occurs or circumstances change to indicate that an impairment of goodwill has likely occurred.
		Under SFAS 142, goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value. The Company’s reporting units are generally consistent with the operating segments underlying the segments identified in Note 4. Business Segments. This methodology differs from the Company’s previous policy, as permitted under accounting standards existing at that time, of using undiscounted cash flows on an enterprise-wide basis to determine if goodwill is recoverable.

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		In accordance with SFAS 142, the Company completed a test for impairment in June 2002 and concluded that consolidated goodwill in the amount of $3,474,000 was impaired. The Company recorded a non-cash charge of approximately $3,474,000 to reduce the carrying value of its goodwill. Such charge is non-operational in nature and is reflected as a cumulative effect of an accounting change, effective January 1, 2002, in the accompanying Condensed Consolidated Statements of Operations and Comprehensive Operations.
		The total impairment amount of $3,474,000 is attributable to the Company’s manufacturing and marketing business segment, and represents the previously unamortized goodwill resulting from the Company’s purchase of substantially all of the assets of Block Medical, Inc. on July 22, 1996, and the Company’s acquisition of all of the outstanding stock of Spinal Specialties, Inc. on January 14, 2000. In calculating the impairment charge, the fair value of the impaired reporting unit comprising the operating segment was estimated using a market multiple methodology. The impairment of the goodwill associated with the manufacturing and marketing segment resulted from the low profitability of the business segment.
		As of September 30, 2002, the goodwill of $2,639,000 deemed unimpaired is attributable to the Company’s rentals business segment. A reconciliation of net income is shown below for all periods presented to conform to the requirements of SFAS 142.