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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-K

(Mark One)

Commission File Number 0-23081

FARO TECHNOLOGIES, INC.

(Exact name of Registrant as specified in its charter)

(Registrant’s Telephone Number, Including Area Code): (407) 333-9911

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

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

Common Stock, par value $.001

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  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definite proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).    Yes  ¨    No  x

As of March 11, 2003, there were outstanding 11,891,726 shares of Common Stock. The aggregate market value of the voting stock held by non-affiliates of the Registrant based on the last sale price reported on the NASDAQ National Market as of June 28, 2002 was $13,049,034.

DOCUMENTS INCORPORATED BY REFERENCE

PART I

CAUTIONARY STATEMENTS FOR FORWARD-LOOKING INFORMATION

FARO Technologies, Inc. (the Company) has made forward-looking statements (within the meaning of the Private Securities Litigation Reform Act of 1995) in this report that are subject to risks and uncertainties, such as statements about our plans, objectives, projections, expectations, assumptions, strategies, or future events. Other written or oral statements, which constitute forward-looking statements, also may be made from time to time by or on behalf of the Company. Words such as “may,” “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “will,” “should,” “could,” variations of such words, and similar expressions are intended to identify such forward-looking statements. Statements that are not historical facts or that describe the Company’s future plans, objectives, or goals also are forward-looking statements. These statements are not guarantees of future performance and are subject to a number of known and unknown risks, uncertainties, and other factors, including those discussed below and elsewhere in this report, that could cause actual results to differ materially from future results, performances, or achievements expressed or implied by such forward-looking statements. Consequently, undue reliance should not be placed on these forward-looking statements. The Company undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

Factors that could cause actual results to differ materially from what is expressed or forecasted in such forward-looking statements include, but are not limited to: (i) the potential loss of material customers; (ii) the failure to properly manage growth and successfully integrate acquired businesses such as SpatialMetriX(SMX) Corporation; (iii) inability of the Company’s products to attain broad market acceptance or increased length of the Company’s sales cycle; (iv) inability of the Company to maintain or reduce operating expenses; (v) the impact of competitive product and pricing; (vi) inability of the Company to ramp-up shipments of its new laser trackers and new generation portable measure arm products as a result of manufacturing delays; (vii) fluctuations in quarterly operating results as a result of the size, timing and recognition of revenue from significant orders, increases in operating expenses required for product development and marketing, the timing and market acceptance of new products and product enhancements; customer order deferrals in anticipation of new products and product enhancements; the Company’s success in expanding its sales and marketing programs, and general economic conditions; (viii) the financial condition of the Company’s clients; (ix) adverse consequences of exchange rate fluctuations; (x) inability to protect our intellectual property and other proprietary rights; (xi) dependence on Simon Raab and Gregory A. Fraser and other key personnel; and (xii) the cyclical nature of the industries of the Company’s customers.

ITEM 1.    BUSINESS

Industry Background

The Company believes that there are three principal forces driving the need for its products and services: 1) the widespread use by manufacturers of Computer-Aided Design (CAD) in product development which shortens product cycles; 2) the adoption by manufacturers of quality standards such as Six Sigma and ISO-9000 (and its offshoot QS-9000), which stress the measurement of every step in a manufacturing process to reduce or eliminate defects, and 3) the inability of traditional measurement devices to address many manufacturing problems, especially those related to large components for products such as automobiles, aircraft, and heavy duty construction equipment.

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CAD changes the manufacturing process.    The creation of physical products involves the processes of design, engineering, production and measurement and quality inspection. These basic processes have been profoundly affected by the computer hardware and software revolution that began in the 1980s. CAD software was developed to automate the design process, providing manufacturers with computerized 3-D design capability. Today, most manufacturers use some form of CAD software to create designs and engineering specifications for new products and to quantify and modify designs and specifications for existing products. Use of CAD can shorten the time between design changes. While manufacturers previously designed their products to be in production for longer periods of time, current manufacturing practices must accommodate more frequent product introductions and modifications, while satisfying more stringent quality and safety standards. Assembly fixtures and measurement tools must be figuratively linked to the CAD design to enable production to keep up with the rate of design change.

Quality standards dictate measurement to reduce defects.    QS-9000 is the name given to the Quality System Requirements of the automotive industry that were developed by Chrysler, Ford, General Motors and major truck manufacturers and issued in late 1994. Companies that become registered under QS-9000 are considered to have higher standards and better quality products. Six Sigma embodies the principles of total quality management that focus on measuring results and reducing product or service failure rates to 3.4 per million. All aspects of a Six Sigma company’s infrastructure must be analyzed, and if necessary, restructured to increase revenues and raise customer satisfaction levels. The all-encompassing nature of these and other quality standards has resulted in manufacturers measuring every aspect of their process, including stages of product assembly that may have never been measured before, in part because of the lack of suitable measurement equipment.

Traditional products don’t measure up.    A significant aspect of the manufacturing process, which traditionally has not benefited from computer-aided technology, is measurement and quality inspection. Historically, manufacturers have measured and inspected products using hand-measurement tools such as scales, calipers, micrometers and plumb lines for simple measuring tasks, test (or check) fixtures for certain large manufactured products and traditional coordinate measurement machines (“CMMs”) for objects that require higher precision measurement. However, the broader utility of each of these measurement methods is limited.

Although hand-measurement tools are often appropriate for simple geometric measurements, including hole diameters or length and width of a rectangular component, their use for complex part measurements, such as the fender of a car, is limited Also, these devices do not allow for the measurements to be directly compared to the CAD model of the part. Test fixtures (customized fixed tools used to make comparative measurements of complex production parts to “master parts”) are relatively expensive and must be reworked or discarded each time a dimensional change is made in the part being measured. In addition, these manual measuring devices do not permit the manufacturer to compare the dimensions of an object with its CAD model.

Conventional CMMs are generally large, fixed-base machines that provide very high levels of precision and provide a link to the CAD model of the object being measured. However, fixed-base CMM’s require the object being measured be brought to the CMM and the object fit within the CMM’s measurement grid. As manufactured subassemblies increase in size and become integrated into even larger assemblies, they become less transportable, thus diminishing the utility of a conventional CMM. Consequently, manufacturers must continue to use hand-measuring tools, or expensive customized

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test fixtures, in order to measure large or unconventionally shaped objects. Some parts or assemblies are not easily accessible and cannot be measured at all using traditional devices.

Escalating global competition has created a demand for higher quality products with shorter life cycles. Manufacturers require more rapid design, greater control of the manufacturing process, tools to compare components to their CAD specifications and the ability to precisely measure components that cannot be measured or inspected by conventional devices. Moreover, they increasingly require measurement capabilities to be integrated into the manufacturing process and to be available on the factory floor.

FARO’s Business

The Company designs, develops, markets and supports portable, software-driven, 3-D measurement systems that are used in a broad range of manufacturing and industrial applications. The Company’s principal products are the Faro-Arm Control Station and Control Station Pro (articulated measuring devices), the Faro Laser Tracker and Laser Control Station; and their companion Soft Check Tool and CAM2 software, respectively, which provide for CAD-based inspection and factory-level statistical process control. Together, these products integrate the measurement and quality inspection function with CAD software to improve productivity, enhance product quality and decrease rework and scrap in the manufacturing process. The Company uses the acronym “CAM2” for this process, which stands for Computer-aided manufacturing measurement. The Company’s products bring precision measurement, quality inspection and specification conformance capabilities, integrated with leading CAD software, to the factory floor. The Company is a pioneer in the development and marketing of 3-D measurement technology in manufacturing and industrial applications and currently holds 29 patents. The Company’s products have been purchased by approximately 2,900 customers worldwide, ranging from small machine shops to such large manufacturing and industrial companies as Audi, Bell Helicopter, Boeing, British Aerospace, Caterpillar, DaimlerChrysler, General Electric, General Motors, Honda, Johnson Controls, Komatsu Dresser, Lockheed Martin, Nissan, Siemens, Volkswagen among many others.

Acquisition of SMX

On January 16, 2002, the Company acquired SpatialMetriX Corporation (“SMX”), a leading manufacturer and supplier of laser trackers and targets, metrology software in exchange for 500,000 shares of FARO common stock (50,000 shares of which are being held in escrow) and the satisfaction by the Company of certain obligations of SMX. In connection therewith, the Company issued an additional 350,000 shares of FARO common stock and paid $2.0 million in cash to fully satisfy SMX’s obligations to its two lenders. The Company also assumed and/or satisfied other obligations of SMX, including approximately $2.9 million in financing provided by the Company to SMX prior to January 16, 2002.

The Company estimates that SMX had 35% of the installed laser tracker market. The Company exercised its contractual right to acquire SMX only after the successful design by SMX of a new generation laser tracker, which the Company sells at competitive prices compared to both the previous generation SMX tracker, and competitor’s current products. SMX’s previous generation laser tracker, which was introduced in 1996, was sold until September 2001. SMX halted production and sale of its earlier generation laser tracker in September 2001. The operations of the new laser product line are contributing favorably to the Company’s revenue growth and, beginning in the third quarter of 2002, to the results of operations. The Company has sold approximately $8.8 million in laser products in 2002 and expects to continue to ramp up sales of the laser tracker in 2003. The operating expenses of the new laser product line, beginning with the third quarter 2002, are consistent with the Company’s historic operating expense ratios.

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FARO Products

The FARO Arm Control Station.    The FARO Arm Control Station is a combination of a portable, six or seven-axis, instrumented articulated measurement arm, a touch screen computer, and software programs known as SoftCheck Tools.

The FARO Arm Control Station Pro.    In contrast to the basic FARO Arm Control Station, the Control Station Pro customers may write their own inspection programs using the Company’s CAM2 software. This product requires more sophisticated operators, and is often used to measure multiple parts in the same day, while the basic FARO Arm Control Station is often dedicated to the same part. The FARO Arm Control Station Pro is a combination of an articulated arm, standard computer (with keyboard), and one of the Company’s following CAM2 Software programs: CAM2 Design, CAM2 Measure or CAM2 Automotive.

The FARO Laser Tracker Control Station.    A combination of a portable, large volume laser measurement tool, a touch screen computer, and software programs known as SoftCheck Tools.

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CAM2 Software    CAM2 is the Company’s family of proprietary CAD-based measurement and statistical process control software. The CAM2 product line includes four software programs:

Specialty Products.    The Company licenses and supports certain specialty products based on its articulated arm technologies that are used in medical applications. License and support fees from these products do not represent a significant portion of the Company’s revenues. However, the Company is maintaining an active campaign to license its formerly developed medical intellectual property to manufacturers of computer assisted surgical products.

Customers

The Company’s products have been purchased by approximately 2,900 customers worldwide, ranging from small machine shops to large manufacturing and industrial companies. The Company’s ten largest customers by revenue represented an aggregate of 9.0% of the Company’s total revenues in 2002. No customer represented more than 1.5% of the Company’s sales in 2002.

Sales and Marketing

The Company directs its sales and marketing efforts from its headquarters in Lake Mary, Florida. At December 31, 2002, the Company employed 108 sales and marketing professionals who provide global representation, operating from both the Company’s headquarters in the United States, and regional sales offices located in Germany, United Kingdom, France, Spain, Italy and Japan. See Footnote 15 to the Notes to Consolidated Financial Statements, incorporated herein by reference to Item 8 hereof, for financial information about the Company’s foreign and domestic operations and export sales required by this Item.

The Company uses a process of integrated lead qualification and sales demonstration. Once a customer opportunity is identified, the Company employs a team-based sales approach involving inside and outside sales personnel who are supported by application engineers. The Company employs a variety of marketing techniques to promote brand awareness and customer identification.

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Research and Development

The Company believes that its future success depends on its ability to achieve technological leadership, which will require ongoing enhancements of its products and the development of new applications and products that provide 3-D measurement solutions. Accordingly, the Company intends to continue to make substantial investments in the development of new technologies, the commercialization of new products that build on the Company’s existing technological base and the enhancement and development of additional applications for its products.

The Company’s research and development efforts are directed primarily at enhancing the functional adaptability of its current products and developing new and innovative products that respond to specific requirements of the emerging market for 3-D measurement systems. The Company’s research and development efforts have been devoted primarily to mechanical hardware, electronics and software. The Company’s engineering development efforts will continue to focus on the FAROArm^®, the FARO Laser Tracker^®, and the family of CAM2 products. See Technology below.

At December 31, 2002, the Company employed 33 scientists and technicians in its research and development efforts. Research and development expenses were approximately $4.0 million in 2002 as compared to $3.4 million in 2001 and $3.5 million in 2000. Research and development activities, especially with respect to new products and technologies, are subject to significant risks, and there can be no assurance that any of the Company’s research and development activities will be completed successfully or on schedule, or, if so completed, will be commercially accepted.

Technology

The primary measurement function of both the articulated arm and the laser tracker is to provide orientation and position information with respect to the probe at the end of the arm (as with the FARO Arm) or target device with respect to the base unit (as with the FARO Laser Tracker). This information is processed by software and can be compared to the desired dimensions contained in the CAD data of a production part or assembly to determine whether the measured data conforms to such dimensional specifications.

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The Company’s products are the result of a successful integration of state-of-the-art developments in mechanical, optical and electronic hardware and applications software. The unique nature of the Company’s technical developments is evidenced by its numerous U.S. and international patents. The Company maintains low cost product design processes by retaining development responsibilities for all hardware, electronics and software.

Mechanical Hardware.

Electronics.    An on-board computer that is designed to handle complex analyses of data as well as communications with a variety of host computers processes the rotational information for each hardware device. The Company’s electronics are based on digital signal processing and surface mount technologies. The Company’s products meet all mandatory electronic safety requirements. Advanced circuit board development, surface mount production and automated testing methods are used to ensure low cost and high reliability.

Software.    CAM2 is a Windows-based family of programs written for the most recent PC-based technology. CAM2 has been entirely designed and programmed by the Company utilizing field input. CAM2 CADanalyser^® is a family member for viewing, analyzing and browsing CAD files. CAM2 Measure^® is a complete 3D measurement application written entirely on the ACIS CAD development platform. Family member CAM2 Automotive^® is also a complete 3D measurement software designed for very large CAD files and for specific Automotive applications and is written using a FARO’s proprietary graphics display engine. Family member CAM2 SPC Process^® is designed for plant wide dimensional data acquisition and presentation in classical SPC (Statistical Process Control) formats for plant-wide quality control. CAM2 Open Measure is a version of CAM2 Measure which can be adapted to any CAD platform. This permits CAD users to have a complete 3D measurement application operating on their native CAD platform.

All the CAM2 family members implement UNICODE standards for worldwide translation allowing the Company to create foreign language versions to enter international markets more effectively. The software is developed with the cooperation of diverse user sites and a well-developed system for tracking and implementing market demands. The Company’s software products are available in 8 languages worldwide.

Intellectual Property

The Company holds or has pending 29 patents in the United States. The Company also has 12 registered trademarks in the United States, 26 foreign registered trademarks, 6 trademark applications pending in the United States and 4 foreign trademark applications pending.

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The Company relies on a combination of contractual provisions and trade secret laws to protect its proprietary information. There can be no assurance that the steps taken by the Company to protect its trade secrets and proprietary information will be sufficient to prevent misappropriation of its proprietary information or to preclude third-party development of similar intellectual property.

Despite the Company’s efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of the Company’s products or to obtain and use information that the Company regards as proprietary. The Company intends to vigorously defend its proprietary rights against infringement by third parties. However, policing unauthorized use of the Company’s products is difficult, particularly overseas, and the Company is unable to determine the extent to which piracy of its software products exists. In addition, the laws of some foreign countries do not protect the Company’s proprietary rights to the same extent as the laws of the United States.

The Company does not believe that any of its products infringe on the proprietary rights of third parties. There can be no assurance, however, that third parties will not claim infringement by the Company with respect to current or future products. Any such claims, with or without merit, could be time-consuming, result in costly litigation, cause product shipment delays or require the Company to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to the Company or at all, which could have a material adverse effect upon the Company’s business, operating results and financial condition.

Manufacturing and Assembly

The Company manufactures its articulated arm products primarily at its headquarters in Lake Mary, Florida, with manufacture of its laser tracker products in Kennett Square, Pennsylvania. Some manufacturing also occurs in Europe. Manufacturing consists primarily of assembling components and subassemblies, purchased from suppliers, into finished products. The primary components, which include machined parts and electronic circuit boards, are produced by subcontractors according to the Company’s specifications. All products are assembled, calibrated and tested for accuracy and functionality before shipment. In limited circumstances, the Company performs in-house circuit board assembly and part machining.

“Quality” has rapidly emerged as a new emphasis in commerce and industry, and is a significant factor in international trade. The Company’s manufacturing, engineering and design headquarters have been registered to the ISO 9001 standard since July 1998. Semi-annual surveillance audits have documented continuous improvement to this multinational standard. The Company continues to examine its scope of registration as the business evolves and has chosen English as the standard business language for its operations. This decision is expected to significantly influence the Company’s operations and documentation globally. This has been done in concert with the ISO Standard Registrar, and is expected to increase customer confidence in the Company’s products and services worldwide.

The Company continues to achieve new levels of certification, achieving Accreditation to Guide 25 in May, 2000, and Registration to ISO/IEC 17025 in October, 2001. These global standards apply to the “Calibration and Certification of Measuring and Test Equipment”, and certify the organization’s level of training, procedures, and efficiency.

In July, 2002 the Company’s European Operations were registered to ISO 9001:2000. In addition the calibration and certification facilities in Europe were accredited to ISO 17025.

In October, 2002 the Company Headquarters completed the transition to the ISO 9001:2000 standard, and continued registration to ISO 17025 for Calibration and Certification Laboratories.

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Competition

The broad market for measurement devices, which include hand-measurement tools, test fixtures and conventional, fixed-base CMMs, and portable measurement systems such as the Company’s products, is highly competitive. Manufacturers of hand-measurement tools and traditional CMMs include a significant number of well-established companies that are substantially larger and possess substantially greater financial, technical and marketing resources than the Company. There can be no assurance that these entities or others will not succeed in developing products or technologies that will directly compete with those of the Company. The market for measurement software to retrofit traditional CMMs, and for statistical process control is also highly competitive. The Company will be required to make continued investments in technology and product development to maintain its technological advantage over its competition. There can be no assurance that the Company will have sufficient resources to make such investments or that the Company’s product development efforts will be sufficient to allow the Company to compete successfully as the industry evolves. The Company’s products compete on the basis of portability, accuracy, application features, ease-of-use, quality, price and technical support.

The Company’s significant direct competitors for its Control Station and related software are Romer SRL (France), Romer, Inc., a Cimcore Company (California), and Kosaka Laboratory Ltd. (Japan). In addition the Company is aware of a direct competitor in Germany, two direct competitors in Italy, and a direct competitor in the United Kingdom, each of which the Company believes currently has significantly less sales volume than the Company. However, there can be no assurance that these companies or other companies will not devote additional resources to the development and marketing of products that compete with those of the Company. With respect to the laser tracker market, Leica Geosystems (Switzerland) is the company’s only significant direct competitor. Leica Geosystems has the largest market share in the laser tracker market, is well established and is substantially larger and possesses substantially greater financial, technical, and marketing resources than the Company. As the market for portable coordinate measurement systems expands, additional competition may emerge and the Company’s existing and future competitors may commit more resources to the markets in which the Company participates.

The worldwide trend toward CAD-based factory floor metrology has resulted in the introduction of CAD-based inspection software and statistical process control for conventional CMMs by most of the large CMM manufacturers. Certain CMM manufacturers are miniaturizing, and in some cases increasing the mobility of, their conventional CMMs. Nonetheless, these CMMs still have small measurement volumes, lack the adaptability typical of portable, articulated arm measurement devices and lose accuracy outside the controlled environment of the metrology lab.

Backlog

At December 31, 2002, the Company had orders representing approximately $8.8 million in product sales outstanding. The majority of these specific orders were shipped by March 11, 2003, and, as of March 11, 2003, the Company had orders representing approximately $9.6 million in product sales outstanding. At December 31, 2001, the Company had orders representing approximately $706,000 in product sales outstanding.

The Company’s increased backlog is the result of the introduction of its new laser tracker and articulated arm product lines in 2002. The Company expects this backlog to decrease. The Company believes that substantially all of the outstanding sales orders as of March 11, 2003 will be billed during 2003.

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Employees

At December 31, 2002, the Company had 291 full-time employees, consisting of 108 sales and marketing professionals, 61 production staff, 33 research and development staff, 45 administrative staff, and 44 customer service/application engineering specialists. The Company is not a party to any collective bargaining agreements. The Company believes its employee relations are good. Management believes that its future growth and success will depend in part on its ability to retain and continue to attract highly skilled personnel. The Company anticipates that it will obtain the additional personnel required to satisfy its staffing requirements over the foreseeable future.

Management of the Registrant

The officers and key management personnel of the Company are as follows:

Simon Raab, Ph.D., a co-founder of the Company, has served as the Chairman of the Board, Chief Executive Officer and a director of the Company since its inception in 1982 and as President since 1986. Mr. Raab holds a Ph.D. in Mechanical Engineering from McGill University, Montreal, Canada, a Masters of Engineering Physics from Cornell University and a Bachelor of Science in Physics with a minor in Biophysics from the University of Waterloo, Canada.

Gregory A. Fraser, Ph.D., a co-founder of the Company, has served as Executive Vice President, Secretary, and Treasurer since August 1999. Prior to that Mr. Fraser served as Chief Financial Officer and Executive Vice President since May 1997 and as Secretary, Treasurer and a director of the Company since its inception in 1982. Mr. Fraser holds a Ph.D. in Mechanical Engineering from McGill University, Montreal, Canada, a Masters of Theoretical and Applied Mechanics from Northwestern University and a Bachelor of Science and Bachelor of Mechanical Engineering from Northwestern University.

Joanne M. Karimi., has served as Vice President of Human Resources of the Company since July 2001 and as Director of Human Resource Systems since October 1998. Prior to that, Ms. Karimi served as Director of Human resources of the Disney Vacation Club, a unit of The Walt Disney Company. Ms. Karimi holds a MBA and a Bachelor’s Degree in Business Management from the University of West Florida.

Allen Sajedi has served as Vice President and Chief Technical Officer since 2002 and as Chief Engineer of the Company since 1990. Mr. Sajedi holds a Bachelor’s Degree in Mechanical Engineering from McGill University, Montreal, Canada.

Wendelin K.J. Scharbach, a co-founder of CATS GmbH, a predecessor of FARO Europe, the Company’s principal subsidiary in Europe, has served as Co-managing Director of FARO Europe since May 1998. Prior to that Mr. Scharbach was Managing Director of CATS GmbH.

Siegfried K. Buss, a co-founder of CATS GmbH, a predecessor of FARO Europe, the Company’s principal subsidiary in Europe, has served as Co-managing Director of FARO Europe since May 1998. Prior to that Mr. Buss was Managing Director of CATS GmbH.

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ITEM 2.    PROPERTIES.

The Company’s headquarters are located in a leased building in Lake Mary, Florida containing approximately 35,000 square feet. This facility houses the Company’s U.S. sales and marketing, production, research and development, administrative staff, and customer service/application operations. Additionally, the Company has a leased facility consisting of 16,000 square feet located in Kennett Square, Pennsylvania. Such facility houses manufacturing operations of the laser tracker product lines.

The Company’s European headquarters are located in a leased building in Stuttgart, Germany containing approximately 19,500 square feet. The Company also has a combined sales and research and development facility that is located in a leased building in Aveiro, Portugal containing approximately 2,800 square feet. The Company believes that its current facilities will be adequate for its foreseeable needs and that it will be able to locate suitable space for additional regional offices or enhanced production needs as those needs develop.

The information required by the remainder of this Item is incorporated herein by reference to Exhibit 99.1 attached hereto.

ITEM 3.    LEGAL PROCEEDINGS.

On January 16, 2002, the Company acquired SpatialMetriX Corporation (“SMX”) in exchange for 500,000 shares of FARO common stock (50,000 shares of which are being held in escrow) and the satisfaction by the Company of certain obligations of SMX. In connection therewith, the Company issued an additional 350,000 shares of FARO common stock and paid $2.0 million in cash to fully satisfy SMX’s obligations to its two lenders. The Company also assumed and/or satisfied other obligations of SMX. The Company believes that SMX breached several of its representations and warranties to FARO in connection with the acquisition, and as a result, the Company has asserted indemnification and set-off claims against the former SMX shareholders, which include but are not limited to the shares being held in escrow. The representative for the former SMX shareholders has disclaimed any liability for these claims. There is no pending litigation for these claims. The Company does not believe that the results of such litigation, even if the outcome were unfavorable to the Company, would have a materially adverse effect on the Company’s business, financial condition or results of operations.

The Company is not involved in any pending legal proceedings other than routine litigation arising in the ordinary course of business.

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

No matters were submitted to a vote of security holders during the last quarter of calendar 2002.

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PART II

ITEM 5.    MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER                      MATTERS.

The Company’s Common Stock, par value $.001 per share, began trading on the NASDAQ Stock Market in September 1997 under the symbol FARO. Before that date, there was no established public trading market for the Common Stock. The following table sets forth the high and low sale price of the Company’s Common Stock for its two most recent fiscal years:

The Company has not paid any cash dividends on its Common Stock to date. The payment of dividends, if any in the future is within the discretion of the Board of Directors and will depend on the Company’s earnings, its capital requirements and financial condition, and may be restricted by future credit arrangements entered into by the Company. The Company expects to retain future earnings for use in operating and expanding its business and does not anticipate paying any cash dividends in the reasonably foreseeable future. As of March 11, 2003, the last sale price of the Company’s Common Stock was $2.56, and there were approximately 87 holders of record of Common Stock. The Company believes that there are approximately 1,300 beneficial owners of its Common Stock.

In 1998 the Board of Directors authorized the officers of the Company, without further approval of the Board, to purchase in the open market up to a maximum of one million shares of the Company’s Common Stock. In 1998, the Company purchased 40,000 shares of its Common Stock in the open market under such stock repurchase plan. During the three years in the period ended December 31, 2002 the Company did not purchase any shares of its Common Stock in the open market.

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ITEM 6.    SELECTED FINANCIAL DATA.

The operating results of SMX have been included in the consolidated statements effective January 16, 2002, the date of acquisition (See Acquisition of SMX above). The pro forma selected financial data is presented for informational purposes assuming that the Company had acquired SMX as of January 1, 2001. The pro forma selected financial data has been prepared for comparative purposes only and do not purport to be indicative of the results of operations and financial position which actually would have resulted had the acquisition occurred on the date indicated, or which may result in the future.

ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following information should be read in conjunction with the Consolidated Financial Statements of the Company, including the notes thereto, included elsewhere in this document.

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Overview

The Company designs, develops, markets and supports portable, software-driven, measurement systems that are used in a broad range of manufacturing and industrial applications. The Company’s principal products are the Control Station and the Control Station Pro measuring devices and their companion Soft Check Tool and CAM2 software, respectively, which provide for CAD-based inspection and factory-level statistical process control. Together, these products integrate the measurement and quality inspection function with CAD software to improve productivity, enhance product quality and decrease rework and scrap in the manufacturing process. The Company’s products bring precision measurement, quality inspection and specification conformance capabilities, integrated with leading CAD software, to the factory floor. The Company is a pioneer in the development and marketing of 3-D measurement technology in manufacturing and industrial applications and currently holds 29 patents. The Company’s products have been purchased by approximately 2,900 customers worldwide, ranging from small machine shops to such large manufacturing and industrial companies as Audi, Bell Helicopter, Boeing, British Aerospace, Caterpillar, DaimlerChrysler, General Electric, General Motors, Honda, Johnson Controls, Komatsu Dresser, Lockheed Martin, Siemens and Volkswagen among many others.

From its inception in 1982 through 1992, the Company focused on providing computerized, 3-D measurement devices to the orthopedic and neurosurgical markets. During this period, the company introduced a knee laxity measurement device, a diagnostic tool for measuring posture, scoliosis and back flexibility, and a surgical guidance device utilizing a six-axis articulated arm.

In 1992, in an effort to capitalize on a demand for 3-D portable measurement tools for the factory floor, the Company made a strategic decision to target its core measurement technology to the manufacturing and industrial markets. In order to focus on manufacturing and industrial applications of its technology, the Company phased out the direct sale of its medical products and entered into licensing agreements with two major neurosurgical companies for its medical technology. Since 1992, the Company has entered into additional licensing agreements for the use of its technology for medical applications.

Prior to 2002 the Company accounted for royalty revenues from these licensing agreements as “Other Income”. In 2002, the Company reclassified Royalty Revenues from “Other Income” to “Sales” on the basis that the licensing of technology is consistent with the Company’s main business of 3D measurement.

In 1995, the Company made a strategic decision to target international markets. The Company established sales offices in France and Germany in 1996, Great Britain in 1997, Japan and Spain in 2000 and Italy in 2001. International sales represented 57.0%, 59.1%, and 50.0% of sales in 2002, 2001, and 2000, respectively.

The Company derives revenues primarily from the sale of its measurement equipment, and its related multi-faceted Soft Check Tool and CAM2 software. Revenue related to these products is recognized upon shipment. Going forward, the Company expects to generate an increasing percentage of its revenue from the sale of its laser tracker product.

Historically, the Company’s sales growth has resulted from increased unit sales due to an expanded sales effort that included the addition of sales personnel and expanded promotional efforts. In 2000, the Company introduced The Control Station with SoftCheck Tools, new accessory items such as the FARO Rail, the FARO Powerhouse and new versions of all the members of the CAM2 software

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family. In January 2002, the Company acquired SpatialMetrix Corporation (“SMX”), a leading manufacturer and supplier of laser trackers and metrology software. The new generation laser tracker is a high-accuracy, portable 3-dimensional measurement technology.

In addition to providing a one-year basic warranty without additional charge, the Company offers its customers one and three-year extended maintenance contracts, which include on-line help services, software upgrades and hardware warranties. In addition, the Company sells training and technology consulting services relating to its products. The Company recognizes the revenue from extended maintenance contracts proportionately, in the same manner as costs are incurred for such revenues.

Cost of sales consists primarily of material, production overhead and labor. Selling expenses consist primarily of salaries and commissions to sales and marketing personnel, and promotion, advertising, travel and telecommunications.

General and administrative expenses consist primarily of salaries for administrative personnel, rent, utilities and professional and legal expenses. Research and development expenses represent salaries, equipment and third-party services.

Accounting for wholly owned foreign subsidiaries is maintained in the currency of the respective foreign jurisdiction and, therefore, fluctuations in exchange rates may have an impact on intercompany accounts reflected in the Company’s consolidated financial statements. In the normal course of business, the Company from time to time employs off-balance sheet financial instruments to hedge its exposure to foreign currency exchange rates, including cross-currency swaps, forward contracts, and foreign currency options (see Foreign Exchange Exposure below).

During fiscal years 2002 and 2001, the Company’s sales growth has been adversely affected by the economic slowdown currently affecting the United States and Europe. This effect, however, was partially offset by sales growth resulting from the acquisition of SMX in January 2002. In 2001 the Company adopted a cost reduction plan, which continued into 2002. This plan included reducing discretionary spending, canceling certain non-strategic product developments, and a reduction of the company’s existing U.S. workforce, primarily in administration, research and development, and manufacturing.

New Products

The Company commenced shipments of its new generation laser tracker product line late in the third quarter of 2002. The Company also released a new generation of its FAROArm production under the names Platinum and Titanium. The arms replace previous generation arms that were released in 1998. The Company expects the new generation arms to allow the Company to maintain its market leadership in this segment of the portable measure market. Manufacture of both the new generation laser trackers and the new generation portable measurement arms involve both new and distinct manufacturing designs as well as innovative production processes when compared to the Company’s previous product offering.

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Results of Operations

The following table sets forth for the periods presented, the percentage of sales represented by certain items in the Company’s consolidated statements of operations:

2002 Compared to 2001

Sales.    Sales increased by $10.1 million or 28.0%, from $36.1 million for the year ended December 31, 2001 to $46.2 million for year ended December 31, 2002. The increase resulted primarily from sales of the new laser product line in 2002. Geographically sales increased in all regions primarily due to sales of the new laser product line (United States increased $5.1 million or 34.5%, Europe increased $2.2 million or 15.4%, Japan increased $1.9 million or 111.8%, other foreign sales increased $900,000 or 16.4%). (See note 15 to the Financial Statements where “Other Foreign” includes approximately $800,000 of European Sales). Royalty income included in sales decreased by $20,000 from $1,010,000 for the year ended December 31, 2001 to $990,000 for the year ended December 31, 2002.

Gross profit.    Gross profit increased by $3.3 million or 15.1%, from $21.8 million for the year ended December 31, 2001 to $ 25.1 million for the year ended December 31, 2002. Gross margin decreased from 60.4% for the year ended December 31, 2001 to 54.4% for the year ended December 31, 2002. The decrease in gross margin was primarily a result of a one-time inventory write-down ($729,000) recorded in the second quarter of 2002 related to the new laser product line (see Acquisition of SMX above), the impact of the new laser product line acquired in January 2002 and, to a lesser extent, the new generation arm products introduced in the third quarter of 2002 (see New Products above). Gross margins on sales are expected to ultimately meet or exceed the Company’s historic levels once both production facilities are at full production levels. Plant capacity utilization is expected to increase with additional manufacturing efficiencies expected in 2003.

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Selling expenses.    Selling expenses increased by $456,000 or 3.4%, from $13.4 million for the year ended December 31, 2001 to $13.9 million for the year ended December 31, 2002. This increase was a result of higher sales commissions on higher sales in the U.S. ($1.0 million) and higher expenses in Japan ($382,000) offset largely by cost reduction measures implemented in the United States ($742,000) and Europe ($184,000). While an increase in total expenses was experienced in 2002 compared to 2001, this amount represents a decrease in the percentage of sales from 37.2% in 2001 to 30.0% in 2002.

General and administrative expenses.    General and administrative expenses increased by $2.1 million or 36.2% from $5.8 million for the year ended December 31, 2001 to $7.9 million for the year ended December 31, 2002. The increase was due to administrative expenses resulting from the integration of the former SMX in 2002 ($915,000), professional fees unrelated to SMX ($352,000), a provision for doubtful accounts receivable ($245,000) recorded in the second quarter of 2002 related to the recently acquired laser product line, and a shifting of personnel from Research and Development to Administrative positions ($549,000).

Depreciation and amortization expenses.    Depreciation and amortization expenses decreased by $292,000, or 11.2%, from $2.6 million for the year ended December 31, 2001 to $2.3 million in 2002. Depreciation and amortization expenses in 2002 reflect the effect (approximately $740,000) of the adoption, effective January 1, 2002, of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (SFAS No. 142) partly offset by an increase in depreciation resulting from newly acquired assets in late 2002. See note 6 consolidated financial statement.

Research and development expenses.    Research and development expenses increased by $663,000, or 19.5%, from $3.4 million for the year ended December 31, 2001 to $4.0 million for the year ended December 31, 2002 principally as a result of research and development expenses of the new laser tracker product line ($1.6 million) offset in part by lower expenses for the new generation arm development in the US ($388,000) and shifting of personnel to administrative positions costs in Europe ($549,000—see General and Administrative expenses above).

Interest income.    Interest income decreased by $339,000, or 37.7%, from $900,000 for the year ended December 31, 2001 to $561,000 for the year ended December 31, 2002. The decrease was primarily attributable to lower interest bearing cash balances (see Liquidity and Capital Resources below) and lower interest rates prevailing in 2002.

Other income(loss).    Other income increased by $644,000, from $43,000 loss for the year ended December 31, 2001 to $601,000 in income for the year ended December 31, 2002 primarily due to foreign currency gains during the current year.

Income tax expense.    Income tax expense decreased by $131,000 from $342,000 for the year ended December 31, 2001 to $211,000 for the year ended December 31, 2002.

Net loss.    Net loss decreased by $800,000 from $2.8 million for the year ended December 31, 2001 to $2.0 million for the year ended December 31, 2002 primarily due to higher gross profit from increased sales and cost savings measures implemented in the US and Europe, partially offset by integration expenses of the Laser Division and reduced income tax expense.

2001 Compared to 2000

Sales.    Sales decreased $4.8 million, or 11.7%, from $40.9 million in 2000 to $36.1 million in 2001. The decrease resulted from lower sales in the U.S. ($5.7 million, or 27.9%, from $20.5 million to

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$14.8 million) and Germany ($1.7 million, or 19.8%, from $8.6 million to $6.9 million), partially offset by increased sales in the remainder of the world (an increase of $2.5 million, or 21.0%, from $11.9 million to $14.4 million). The decrease in the U.S. primarily resulted from lower product unit sales resulting mainly from the slowing U.S. economy throughout 2001. The decrease in Germany reflects the adverse translation effect (approximately $700,000) of the stronger U.S. dollar in 2001. Royalty income included in Sales increased by $550,000 from $460,000 for the year ended December 31, 2000 to $1,010,000 for the year ended December 31, 2001.

Gross profit.    Gross profit decreased by $4.4 million, or 16.8%, from $26.2 million in 2000 to $21.8 million in 2001. Gross margin decreased to 60.4% in 2001 from 64.0% in 2000. The decrease in gross margin resulted primarily from downward pressure on unit prices in the U.S. and Europe and the translation effect of the stronger U.S. dollar on international sales.

Selling expenses.    Selling expenses decreased $598,000, or 4.3%, from $14.0 million in 2000 to $13.4 million in 2001. This decrease was primarily a result of lower selling expenses in the United States ($1.3 million) resulting from cost reduction efforts in the second half of 2001 and lower sales commissions on lower U.S. sales, the translation effect of the stronger U.S. dollar in 2001 (approximately $250,000), offset in part by higher expenses in Europe ($670,000) and Japan ($282,000), principally as a result of higher compensation and marketing expenses.

General and administrative expenses.    General and administrative expenses increased by $50,000, or 1.0%, from $5.8 million in 2000 to $5.8 million in 2001. The increase was due to new operations in Japan ($188,000), offset in part by lower expenses in the U.S. ($53,000) and Europe ($15,000) and the effect of the stronger U.S. dollar in 2001 (approximately $70,000).

Depreciation and amortization expenses.    Depreciation and amortization expenses decreased by $372,000, or 12.8%, from $2.9 million in 2000 to $2.5 million in 2001 primarily as a result of assets becoming fully amortized in 2001.

Research and development expenses.    Research and development expenses decreased by $179,000, or 5.0%, from $3.5 million in 2000 to $3.4 million in 2001. The decrease was due to decline across many expense categories in Europe ($286,000) and the translation effect of the stronger U.S. dollar in 2001 ($50,000) on the European R&D expenses, offset in part by increase across many expense categories in the United States ($157,000).

Interest income.    Interest income increased by $40,000, from $860,000 in 2000 to $900,000 in 2001 primarily as a result of higher average principal amounts invested in 2001, including loans to SMX (see Liquidity and Capital Resources below).

Other income, net.    Net expenses decreased by $114,000 from $157,000 in 2000 to $43,000 in 2001. The decrease resulted principally from lower foreign exchange losses in Europe in 2001.

Income tax expense.    Income tax expense decreased by $83,000, from $425,000 in 2000 to $342,000 in 2001. The net tax expense resulted from an increase in the valuation allowance for the Company’s US deferred income tax assets offset by benefits realized by the utilization of German net operating loss carryforwards which were previously reserved. At December 31, 2001 the Company has deferred income tax assets of approximately $7.7 million (including $1.4 million related to the U.S. operations and $6.3 million related to foreign operations) which are offset by a valuation allowance of

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approximately $7.6 million. These deferred income tax assets are primarily attributable to net operating loss carryforwards and intangible assets for which future income tax benefits may be realized.

Net income (loss).    The Company’s net income (loss) decreased by $2.9 million, from net income of $40,000 in 2000 to a loss of $2.8 million in 2001 to due to the factors mentioned above.

Acquisition of SMX

On January 16, 2002, the Company acquired SpatialMetriX Corporation (“SMX”), a leading manufacturer and supplier of laser trackers and targets, metrology software and contract inspection services, in exchange for 500,000 shares of FARO common stock (50,000 shares of which are being held in escrow) and the satisfaction by the Company of certain obligations of SMX. In connection therewith, the Company issued an additional 350,000 shares of FARO common stock and paid $2.0 million in cash to fully satisfy SMX’s obligations to its two lenders. The Company also assumed and/or satisfied other obligations of SMX, including approximately $2.9 million in financing provided by the Company to SMX prior to January 16, 2002.

The Company estimates that SMX had 35% of the installed laser tracker market. The Company exercised its contractual right to acquire SMX only after the successful design by SMX of a new generation laser tracker, which the Company sells at competitive prices compared to both the previous generation SMX tracker, and competitor’s current products. SMX’s previous generation laser tracker, which was introduced in 1996, was sold until September 2001. SMX halted production and sale of its earlier generation laser tracker in September 2001. The operations of the new laser product line are contributing favorably to the Company’s revenue growth and, beginning in the third quarter of 2002, results of operations. The Company sold approximately $8.8 million in laser products and services in 2002 and expects to continue to ramp up sales of the laser tracker in 2003. The operating expenses of the new laser product line are, beginning in the third quarter of 2002, consistent with the Company’s historic operating expense ratios.

Liquidity and Capital Resources

Since 1997, the Company has financed its operations primarily from cash provided by operating activities and from the proceeds of its 1997 initial public offering of Common Stock (approximately $31.7 million). Total marketable securities (cash and cash equivalents, short-term investments and investments) at December 31, 2002 were $5.9 million, compared to $14.1 million at December 31, 2001. This significant ($8.2 million) reduction is primarily due to the acquisition of SMX in January 2002 and the related operating expenses for the year ending December 31, 2002.

We believe that our working capital, together with anticipated cash flow from our operations, will be sufficient to fund our long-term liquidity requirements. Our liquidity is not dependant upon the use of off-balance sheet financing arrangements, such as scrutinization of receivables or obtaining access to assets through special purpose entities.

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For the year ended December 31, 2002, net cash used in operating activities was $5.0 million compared to $842,000 in 2001. Net cash used in operating activities was from increases in accounts receivable and inventories ($5.9 million) and a decrease in accounts payable ($1.8 million) offset by net profit before depreciation ($252,000) and provisions for expenses ($1.2 million) and other items ($1.2 million). Net cash used by investing activities for the year ended December 31, 2002 was $118,000 compared to net cash provided of $267,000 in 2001. The change in investing activities was due primarily to the acquisition of SMX. Net cash provided by financing activities for the year ended December 31, 2002 was $1.4 million compared to $9,000 in 2001. In 2002 a line of credit was utilized in the amount of $1.5 million. The Company invests excess balances in short-term investment-grade securities, such as money market investments, obligations of the U.S. government and its agencies, and obligations of state and local governmental agencies.

On January 16, 2002, in connection with its acquisition of SMX, the Company issued 500,000 shares of FARO common stock and satisfied certain obligations of SMX. Additionally, the Company issued an additional 350,000 shares of FARO common stock and paid $2.0 million in cash to fully satisfy SMX’s obligations to its two lenders (see Acquisition of SMX above). The Company also assumed and/or settled other obligations of SMX, including approximately $2.9 million in financing provided by the Company to SMX prior to January 16, 2002.

The Company recently commenced shipments of its new generation laser tracker product line and released a new generation Platinum and Titanium advanced portable measure arm products (see New Products above). Manufacture of both the new generation laser trackers and the new generation portable measure arms involve new and distinct manufacturing designs, and production processes, when compared to the Company’s previous product offering. Plant capacity utilization is expected to increase with additional manufacturing efficiencies expected in the fourth quarter.

The Company’s principal commitments at December 31, 2002 consisted of leases on its headquarters and regional offices (see Contractual Obligations and Commercial Commitments below). There were no material commitments for capital expenditures at that date. The Company believes that its cash, investments and cash flows from operations will be sufficient to satisfy its working capital and capital expenditure needs at least through 2003.

Contractual Obligations and Commercial Commitments

The Company was a party to a term loan that expires in 2003, capital leases for automotive and other equipment with an initial term of 36 to 60 months and non-cancelable operating leases, including leases with related parties (see Note 8 of Notes to Consolidated Financial Statements) that expire on or before 2007.

Commitments under these agreements are as follows at December 31, 2002:

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Critical Accounting Policies

In response to the SEC’S financial reporting release, FR-60, Cautionary Advice Regarding Disclosure About Critical Accounting Policies, we have selected our most subjective accounting estimation processes for purposes of explaining the methodology used in calculating the estimate in addition to any inherent uncertainties pertaining to the estimate and the possible effects on the Company’s financial condition. The two accounting estimation processes discussed below are the Company’s process of recognizing research and development expenditures, and determining the allowances for both obsolete and slow-moving inventory and doubtful accounts receivable. These estimation processes affect current assets and operating results and are therefore critical in assessing the financial and operating status of the Company. These estimates involve certain assumptions that if incorrect could create an adverse impact on the Company’s operations and financial position.

Research and development costs incurred in the discovery of new knowledge and the resulting translation of this new knowledge into plans and designs for new products, prior to the attainment of the related products’ technological feasibility, are recorded as expenses in the period incurred. Product design costs incurred in the development of products after technological feasibility is attained are capitalized and amortized using the straight-line method over the estimated economic lives of the related products, not to exceed 3 years. The Company considers technological feasibility to be established when the Company has completed all planning, designing, coding and testing activities that are necessary to establish design specifications including function, features and technical performance requirements. Capitalization of product design costs ceases and amortization of such costs begins when the product is available for general release to customers. The Company periodically assesses the value of capitalized product design costs and records a write-down for impairment when, in the circumstances (including the discontinuance or probable discontinuance of the related products from the market), it deems the asset to be obsolete or impaired.

The reserve for obsolete and slow-moving inventory was $90,000, $298,000 and $418,000 at December 31, 2002, 2001 and 2000, respectively. The reserve for obsolete and slow-moving inventory is used to state the Company’s inventories at the lower of average cost or net realizable value. Since the amount of inventorial cost that the Company will truly recoup through sales cannot be known with exact certainty, the Company relies on past sales experience and future sales forecasts. Inventory is considered as obsolete if the Company has withdrawn it from the market or if the Company has had no sales of the product for the past 12 months nor sales forecasted for the next 12 months, therefore an allowance in an amount equal to 100% of the average cost of such inventory is recorded. The Company classifies as slow-moving inventory with quantities of on hand greater than the amounts we have sold in the past 12 months or have forecasted to sell in the next 12 months, and reserve such amount as is adequate to reduce the carrying value to net realizable value.

The Company performs ongoing evaluations of its customers and adjusts their credit ratings accordingly. The Company continuously monitors collections and payments from its customers and maintains a provision for un-collectable amounts based on its historical experience and any other issues it has identified. While such credit losses have historically been within its expectations, the Company cannot guarantee this will continue in the future. The allowances recorded for 2002, 2001 and 2000 were approximately, $582,000, $311,000 and $30,000 respectively.

Transactions with Related and Other Parties

The Company leases its headquarters from Xenon Research, Inc. (“Xenon”), all of the issued and outstanding capital stock of which is owned by Simon Raab, the Company’s President and Chief

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Executive Officer, and Diana Raab, his spouse. The term of the lease expires on February 28, 2006, and the Company has two five-year renewal options. Base rent under the lease was $397,000 for 2002. Base rent during renewal periods will reflect changes in the U.S. Bureau of Labor statistics consumer Price Index for all Urban Consumers.

In June 2000, the Company and each of the former CATS shareholders entered into an Amended and Restated Loan Agreement pursuant to which the Company granted loans to the former shareholders of CATS gmbh in the aggregate amount of $1.1 million (“the Loans”). The loans were made to fund the tax obligations incurred by the former CATS shareholders in connection with the Company’s acquisition of CATS gmbh in 1998. The Company agreed to the terms of the loans are part of the acquisition agreement for CATS gmbh. The Loans are for a term of three years, at an interest rate of approximately 4.7%, and grant the borrowers an option to extend the term for an additional three years. As collateral for the Loans, the former CATS shareholders pledged to the Company 177,074 shares of the Company’s Common Stock. The Loans are a non-recourse obligation of the former CATS shareholders.

The company engaged Cole & Partners, a mergers and acquisition and corporate finance advisory service firm, to serve as the company’s financial advisor in connection with the company’s acquisition in January, 2002 of SpatialMetriX, Inc. Stephen R. Cole, one of the Company’s directors and member of the Audit Committee, is the founding Partner and President of Cole & Partners. The Company paid to Cole & Partners total fees of approximately $450,000 for its services, of which $302,000 was paid in 2002.

Foreign Exchange Exposure

The Company conducts a significant portion of its business outside the United States. At present, the majority of the Company’s revenues are invoiced, and a significant portion of its operating expenses paid, in foreign currencies. Fluctuations in exchange rates between the U.S. dollar and such foreign currencies may have a material adverse effect on the Company’s business, results of operations and financial condition, and could specifically result in foreign exchange gains and losses. The impact of future exchange rate fluctuations on the results of the Company’s operations cannot be accurately predicted. To the extent that the percentage of the Company’s non-U.S. dollar revenues derived from international sales increases in the future, the Company’s exposure to risks associated with fluctuations in foreign exchange rates will increase further. See additional discussion under Impact of Recently Issued Accounting Standards below.

Inflation

The Company believes that inflation has not had a material impact on its results of operations in recent years and does not expect inflation to have a material impact on its operations in 2003.

Conversion to the Euro

On January 1, 2002, certain member countries of the European Union adopted the Euro as their national currency. The transition period for the introduction of the Euro ended June 30, 2002. The adoption of the Euro did not have a material effect on the Company’s financial condition or results of operations.

Impact of Recently Issued Accounting Standards

In October 2001, the Financial Accounting Standards Board (“FASB”) issued Statement No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (SFAS No. 144) which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS No. 144 supersedes Statement of Financial Accounting Standards No. 121, “Accounting for the Impairment of

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Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,” (SFAS No. 121) but retains many of the fundamental provisions of SFAS No. 121. SFAS No. 144 also supersedes 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.” SFAS No. 144 retains the requirement in Opinion 30 to report separately discontinued operations and extends this reporting requirement to a component of an entity that either has been disposed of or is classified as held for sale. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001, and interim periods within those fiscal years. Early application is permitted. The Company does not expect the adoption of SFAS No. 144 to have a material impact on its financial statements or results of operations.

In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (SFAS No. 142). SFAS No. 142 requires that goodwill no longer be amortized to earnings, but instead be reviewed for impairment. The Company adopted this new Statement effective January 1, 2002.

In January 2001, the Company adopted FASB Statement No. 133 (SFAS No. 133), Accounting for Derivative Instruments and Hedging Activities, as amended. SFAS 133 requires companies to recognize all their derivative instruments as either assets or liabilities at fair value in the statement of position. In September 2002, the Company entered into a foreign exchange rate swap allowing the Company the right to purchase up to $1.8 million at a base rate of 1.0444 Euros per $1.00. Under the agreement, the Company and the bank are to compensate one another based on the exchange rate agreement differential at specified measurement dates. This foreign exchange rate agreement does not qualify for special hedge accounting treatment, as it does not meet the specified criteria under SFAS 133. Therefore the changes in fair value are included in the determination of earnings.

In June 2001, Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“Statement 142”), was issued stating that indefinite-life identifiable intangible assets and goodwill are not amortized. The Company periodically reviews its identifiable assets and goodwill, considering factors such as projected cash flows and revenue and earnings multiples, to determine whether the value of the assets are impaired and the amortization periods are appropriate. If an asset is impaired, the difference between the value of the asset reflected on the financial statements and its current fair value is recognized as an expense in the period in which the impairment occurs. Goodwill is impaired when the carrying amount of the reporting unit exceeds the implied fair value of the reporting unit. The Company adopted this accounting standard on January 2, 2002.

In June 2001, the FASB issued Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations (SFAS No. 143) which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The standard applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development, and (or) normal use of the asset. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002. The Company believes that the adoption of SFAS No. 143 will not have a material effect in its financial position or results of operations.

In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146 (SFAS 146), Accounting for Costs Associated with Exit or Disposal Activities. SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullified Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination

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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 a liability is incurred rather than when an exit or disposal plan is approved. We are required to adopt the provisions of SFAS 146 for any exit or disposal activities initiated after December 31, 2002. The effect  of adoption of SFAS 146 will be a change on a prospective basis of the timing of when restructuring charges are recorded from a commitment date approach to when a liability is recorded. The Company does not expect the adoption of SFAS 146 to have a material impact on its financial statements or results of operations.

In November 2002, the FASB issued FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. This interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The disclosure requirements of this interpretation are effective for interim and annual periods after December 15, 2002. The initial recognition and initial measurement requirements of this interpretation are effective prospectively for guarantees issued or modified after December 31, 2002. The interpretation’s expanded disclosures will not have a material impact on the Company’s financial position or results of operations.

In November 2002, the EITF reached a consensus on Issue 00-21, “Multiple-Deliverable Revenue Arrangements” (“EITF 00-21”). EITF 00-21 addresses how to account for arrangements that may involve the delivery or performance of multiple products, services, and/or rights to use assets. The consensus mandates how to identify whether goods or services or both that are to be delivered separately in a bundled sales arrangement should be accounted for separately because they are “separate units of accounting.” The guidance can affect the timing of revenue recognition for such arrangements, even though it does not change rules governing the timing or pattern of revenue recognition of individual items accounted for separately. The final consensus will be applicable to agreements entered into in fiscal years beginning after June 15, 2003 with early adoption permitted. Additionally, companies will be permitted to apply the consensus guidance to all existing arrangements as the cumulative effect of a change in accounting principle in accordance with APB Opinion No. 20, Accounting Changes. The Company is assessing, but at this point does not believe the adoption of EITF 00-21 will have a material impact on our financial position, cash flows or results of operations.

In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148 (SFAS 148), Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of FASB Statement No. 123, SFAS 148 amends SFAS 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The transition guidance and annual disclosure provisions of SFAS 148 are effective for financial statements issued for fiscal years ending after December 15, 2002, and are included in Note 1 to the consolidated financial statements. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002. The Company does not believe the adoption of this statement will have a material impact on its financial position or results of operations.

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ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

The information required by this item is incorporated by reference herein from the section of this Report in Part II, Item 7, under the captions “Foreign Exchange Exposure”, “Inflation” and “Conversion to the Euro Currency” above.

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ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

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INDEPENDENT CERTIFIED PUBLIC ACCOUNTANT’S REPORT

To the Board of Directors and Shareholders of FARO Technologies, Inc.:

We have audited the accompanying consolidated balance sheets of FARO Technologies, Inc. and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2002. 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 auditing standards generally accepted in the 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes 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 consolidated financial position of FARO Technologies, Inc. and subsidiaries at December 31, 2002 and 2001 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States.

As described in Note 6 to the financial statements, the Company adopted Statement of Financial Accounting Standards No. 142 “Goodwill and Other Intangible Assets”, effective January 1, 2002.

/s/ ERNST & YOUNG LLP

Orlando, Florida

March 19, 2003

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FARO TECHNOLOGIES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to condensed consolidated financial statements.

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FARO TECHNOLOGIES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes to condensed consolidated financial statements.

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FARO TECHNOLOGIES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY