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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

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

INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
(Exact Name of Registrant as Specified in Its Charter)

Registrant’s Telephone Number: (818) 709-1244

     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 [   ]

     The registrant had 10,841,657 shares of common stock outstanding as of October 21, 2002.

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INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.

INDEX TO FORM 10-Q

Three and Nine Months Ended September 30, 2002

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PART I
FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS

Assets

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INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)

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INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)

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INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

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INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited)

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INTERNATIONAL REMOTE IMAGING SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Formation and Business of the Company.

     International Remote Imaging Systems, Inc., (collectively “IRIS” or the “Company”) was incorporated in California in 1979 and reincorporated during 1987 in Delaware. International Remote Imaging Systems, Inc. and its subsidiaries design, develop, manufacture and market in vitro diagnostic (“IVD”) equipment, including IVD imaging systems based on patented and proprietary automated intelligent microscopy (“AIM”) technology, as well as special purpose centrifuges and other small instruments for automating microscopic procedures performed in clinical laboratories.

2. Summary of Significant Accounting Policies.

Basis of Presentation of Unaudited Interim Financial Statements:

     In the opinion of management, the accompanying unaudited consolidated financial statements contain all normal recurring adjustments necessary to present fairly the financial position of the Company as of September 30, 2002 and 2001 and the results of its operations for the three and nine month periods then ended. These financial statements should be read in conjunction with the financial statements and notes included in the Company’s latest annual report on Form 10-K. Interim results are not necessarily indicative of results for a full year.

Use of Estimates:

     The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting periods. The significant estimates in the preparation of the consolidated financial statements relate to the assessment of the carrying value of accounts receivables, inventories, purchased intangibles, estimated provisions for warranty costs and deferred tax assets. Actual results could materially differ from those estimates.

Principles of Consolidation:

     The consolidated financial statements include the accounts of International Remote Imaging Systems, Inc. and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in the consolidated financial statements.

     Recent Accounting Pronouncements:

     In August 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Statements (SFAS) No. 143, Accounting for Asset Retirement Obligations. This Statement is effective for fiscal years beginning after June 15, 2002. SFAS No. 143 provides accounting requirements for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. Under the Statement, the asset retirement obligation is recorded at fair value in the period in which it is incurred by increasing the carrying amount of the related long-lived asset. The liability is accreted to its present value in each subsequent period and the capitalized cost is depreciated over the useful life of the related asset. International Remote Imaging Systems, Inc. is currently evaluating the impact of SFAS No. 143 on its consolidated financial statements.

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. This statement eliminates the current requirement that gains and losses on debt extinguishment must be classified as extraordinary items in the income statement. Instead, such gains and losses will be classified as extraordinary items only if they are deemed to be unusual and infrequent, in accordance with the current GAAP criteria for extraordinary classification. In addition, SFAS 145 eliminates an inconsistency in lease accounting by requiring that modifications of capital leases that result in reclassification as operating leases be accounted for consistent with sale-leaseback accounting rules. The statement also contains other nonsubstantive corrections to authoritative accounting literature. The changes related to debt extinguishment will be effective for fiscal years beginning after May 15, 2002, and the changes related to lease accounting will be effective for transactions occurring after May 15, 2002. Adoption of this standard will not have any immediate effect on International Remote Imaging Systems, Inc.s consolidated financial

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statements. International Remote Imaging Systems, Inc. will apply this guidance prospectively.

     In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses accounting for restructuring and similar costs. SFAS No. 146 supersedes previous accounting guidance, principally Emerging Issues Task Force (EITF) Issue No. 94-3. International Remote Imaging Systems, Inc. will adopt the provisions of SFAS No. 146 for restructuring activities initiated after December 31, 2002. SFAS No. 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF No. 94-3, a liability for an exit cost was recognized at the date of a companys commitment to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. Accordingly, SFAS No. 146 may affect the timing of recognizing future restructuring costs as well as the amount recognized.

Reclassifications:

     Certain reclassifications have been made to the 2001 financial statements to conform to the 2002 presentation.

3. Comprehensive Income.

     The Company’s components of comprehensive income are net income and unrealized losses on investments. Income tax effects allocated to the unrealized losses on available for sale securities for the three and nine months ended September 30, 2002 were benefits of $149,526 and $109,445, respectively.

     The following is a reconciliation of accumulated other comprehensive income balance for the three and nine months ended September 30, 2002:

4. Inventories.

     Inventories are carried at the lower of cost or market on a first-in first-out basis and consist of the following:

5. Related Party Transaction

     In April 2002, the Company made a $125,000 loan to Dr. John A. O’Malley, the Chairman, CEO and President of the Company, in accordance with his current employment agreement. The loan bears interest at the rate of five percent per annum and has a term of five years. It is secured by 120,000 shares of the Company’s stock owned by Dr. O’Malley. The loan will be repaid firstly, from the proceeds of any future sale of common shares of the Company by Dr. O’Malley and, secondly, at Dr. O’Malley’s discretion. At the end of the term of the loan, any remaining unpaid balance will be settled by the forfeiture by Dr. O’Malley of the remaining shares held by the Company as security. Pursuant to the agreement, Dr. O’Malley paid $1,392 of interest in the third quarter of 2002.

6. Purchased Intangibles

The Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” effective January 1, 2002. Under SFAS No. 142, goodwill and indefinite life intangible assets are no longer amortized but are subject to periodic impairment tests. Other intangible assets with finite lives

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continue to be amortized over their useful lives. In accordance with SFAS No. 142, the Company completed the transitional intangible asset test upon adoption of SFAS No. 142 and the transitional impairment test during the six months ended June 30, 2002. The transitional intangible asset test did not result in a change in the useful lives of the Company’s definite life intangible assets or an impairment of the Company’s definite life intangible assets (“patents”.) The transitional impairment test did not result in an impairment of our indefinite life intangibles.

In connection with the adoption of SFAS No. 142, prior period amounts were not restated. A reconciliation of the previously reported net income and earnings per share for the nine months ended September 30, 2001 to the amounts adjusted for the elimination of amortization expense recorded on indefinite life intangible assets prior to the adoption of SFAS No. 142, net of income taxes, is as follows:

The net carrying value of intangible assets as of September 30, 2002 is comprised of indefinite life assets of $188,911 related to its small instruments segment, and patents of $276,067 and $97,991 respectively related to its urinalysis and small instruments segments.

The change in the net carrying amount of indefinite life intangible assets and patents during the nine months ended September 30, 2002 is due to increases to, and amortization of, patents.

The net amount of the patents of $374,058 included in other assets on the accompanying September 30, 2002 balance sheet, subject to amortization, comprise a gross carrying amount of $1,538,400, net of accumulated amortization of $1,164,342.

Amortization expense for the patents was $82,000 for the nine months ended September 30, 2002. Annual estimated amortization expense for each of the five succeeding fiscal years is expected to approximate $110,000 per year.

7. Short-Term Borrowings and Notes Payable.

     In February 2002, the Company refinanced its existing credit facility and replaced it with a new $8.0 million credit facility with California Bank and Trust. The new facility consists of a $500,000 term loan, a $1.0 million term loan and a $6.5 million revolving line of credit. The $500,000 term loan is payable in 60 equal monthly installments. The $1.0 million term loan shall carry interest only for the first 12 months, followed by 48 months of equal principal payments plus interest. The $6.5 million credit line matures in June 2004. Borrowings under the line of credit are limited to a percentage of eligible receivables and inventory. The entire credit facility bears interest at the lender’s prime rate (4.75% at September 30, 2002), or LIBOR rate plus 2.0%. The Company is subject to certain financial covenants under the debt agreements with California Bank and Trust. As of September 30, 2002, the Company was in compliance with the covenants under the debt agreements.

     At September 30, 2002, the outstanding amounts under the Company’s credit facility consist of $433,000 under the first term loan, $1.0 million under the second term loan and $1.0 million under the revolving line of credit. An additional $2.9 million was available under the line of credit at that date.

     At September 30, 2002, the outstanding principal balance on the unsecured Subordinated Note Payable was $2.2 million. The note is payable in monthly installments of approximately $97,000 plus interest on the unpaid balance. The note bears interest at the prime rate (4.75% on September 30, 2002) plus 2.0% and matures on July 31, 2004.

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8. Capital Stock.

     Conversion of Preferred Stock:

     On August 3, 2002, the Company’s Series B Preferred Stock automatically converted into common stock at the ratio of 1.21 shares of common stock for each share of preferred stock, a total of 248,050 common shares. The conversion ratio represents the ratio of the liquidation value of each preferred share ($3.00 per share) divided by the average daily closing price of the common stock for the five trading days ending three trading days prior to the August 3, 2002 conversion date ($2.47 per share).

Stock Issuances:

     During the nine months ended September 30, 2002, the Company (i) issued 267,150 shares of common stock from the exercise of warrants, (ii) issued options to purchase 514,030 shares of common stock under the Company’s stock option plans and (iii) cancelled options to purchase 76,192 shares of common stock. Options for 47,650 shares of common stock were exercised during the period. At September 30, 2002, options to purchase 2,718,535 shares of common stock were issued and outstanding under the Company’s stock options plans. The outstanding options expire by the end of 2012. The exercise price for these options ranges from $0.69 to $4.38 per share. At September 30, 2002, there were 123,742 shares of common stock available for the granting of future options under the Company’s stock option plans.

Warrants:

     As of September 30, 2002, the following warrants to purchase common stock were outstanding and exercisable:

9. Income Taxes.

     The income tax provision for the nine-month period ended September 30, 2002 was $509,959 as compared to $677,071 for the comparable period last year. The income tax provision differs from the federal statutory rate due primarily to state income taxes and permanent differences between income reported for financial statement and income tax purposes.

     Realization of deferred tax assets associated with Net Operating Losses (NOL) and tax credit carryforwards is dependent upon generating sufficient taxable income prior to their expiration. Management believes that there is a risk that certain of these NOL and credit carryforwards may expire unused and accordingly, has established a valuation reserve against them. Although realization is not assured for the remaining deferred tax assets, management believes it is more likely than not that they will be realized through future taxable income or alternative tax strategies. However, the net deferred tax assets could be reduced in the near term if management’s estimates of taxable income during the carryforward period are significantly reduced or alternative tax strategies are not available. The Company will continue to review its valuation allowances and make adjustments, if necessary. Should the Company undergo an ownership change as defined in Section 382 of the Internal Revenue Code, the Company’s NOL generated prior to the ownership change would be subject to an annual limitation. If this occurred, a further adjustment of the valuation allowance would be necessary.

10. Earnings Per Share (EPS).

     The computation of per share amounts for the three and nine months ended September 30, 2002 and 2001 is based on the average number of common shares outstanding for the period. Options and warrants to purchase 628,830 and 185,670 shares of common stock outstanding during the three months ended September 30, 2002 and 2001, respectively, were not considered in the computation of diluted EPS because their inclusion would have been antidilutive. Options and warrants to purchase 430,830 and 239,270 shares of common stock outstanding

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during the nine months ended September 30, 2002 and nine months ended September 30, 2001, respectively, were not considered in the computation of diluted EPS because their inclusion would have been antidilutive.

     The following is a reconciliation of shares used in computing basic and diluted earnings per share amounts.

11. Segment and Geographic Information.

     The Company’s operations are organized on the basis of products and related services and under SFAS No.131 operates in two segments: (1) urinalysis and (2) small instruments.

     The urinalysis segment designs, develops, manufactures and markets IVD imaging systems based on patented and proprietary AIM technology for automating microscopic procedures for urinalysis. The segment also provides ongoing sales of supplies and service necessary for the operation of installed urinalysis workstations. In the United States, these products are sold through our direct sales force; internationally, these products are sold through distributors.

     The small instruments segment designs, develops, manufactures and markets a variety of benchtop centrifuges, small instruments and supplies. These products are used primarily for manual specimen preparation and dedicated applications in coagulation, cytology, hematology and urinalysis. These products are sold worldwide through distributors.

     The accounting policies of the segments are the same as those described in the “Summary of Significant Accounting Policies” included in the Company’s report on Form 10-K for the year ended December 31, 2001. The Company evaluates the performance of its segments and allocates resources to them based on earnings before income taxes, excluding corporate charges (“Segment Profit”).

     The tables below present information about reported segments for the three and nine month periods ended September 30, 2002 and 2001:

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     Three Months Ended September 30, 2002:

     Three Months Ended September 30, 2001:

     Nine Months Ended September 30, 2002:

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     Nine Months Ended September 30, 2001:

     Long-lived assets were all located in the United States and totaled $5,119,037 at September 30, 2002, and $3,620,018 at December 31, 2001.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

     We generate revenues primarily from sales of our urinalysis workstation, an in vitro diagnostic, or IVD, imaging system based on our patented and proprietary AIM technology, and the related supplies and service required to operate this workstation. We also earn revenues from sales of ancillary lines of small instruments and supplies.

     The nature of our business requires that we make significant investments in research and development for new products and enhancements to existing products. We fund our research and development primarily from internal sources, but, through our subsidiary, Advanced Digital Imaging Research, LLC (“ADIR”), we also receive partial funding from time to time under grants from the National Institutes of Health and joint development projects with third parties.

     The following table summarizes total product technology expenditures for the periods indicated:

Results of Operations

     Comparison of Quarter Ended September 30, 2002 to Quarter Ended September 30, 2001

     Net revenues for the quarter ended September 30, 2002 increased to $7.1 million from $6.9 million last year, an increase of 2%. Sales of IVD imaging systems increased $209,000 to $1.5 million from $1.3 million in the same period last year. This represented the sale of 2 more workstations than in the prior period. IVD imaging system sales consist of sales of our urinalysis workstations. We plan to introduce a significantly upgraded model in November, 2002, based on a new operating platform. This model, named the iQ200, received clearance from the Food and Drug Administration on October 21, 2002. However, revenues from the sale of this product are not

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anticipated until the end of the first quarter of 2003. The failure to make a successful and timely transition to this upgraded model would have a material and adverse affect on IVD imaging system sales. This is an inherent risk in any major upgrade to products in our industry.

     Sales of IVD imaging system supplies and services increased to $3.9 million from $3.7 million, an increase of $223,000 or 6% over the same period last year, primarily due to the larger installed base of urinalysis work stations. Sales of small instruments and supplies decreased $293,000 to $1.5 million, a decrease of 17%. The decline is due primarily to decreased sales to OEM customers. Royalties and licensing revenues increased to $148,000 from $127,000 in the comparable period from the prior year.

     Revenues from the urinalysis segment totaled $5.6 million in the current period as compared to $5.2 million in the comparable period last year, an increase of $453,000 or 9%. This increase is due to both higher systems sales and higher supplies and services sales, as explained in the preceding paragraphs. Revenues from the small instruments segment decreased $293,000 from the comparable period last year to $1.5 million. This decline is due primarily to decreased sales of small instruments and supplies to OEM customers.

     Cost of goods for IVD imaging systems as a percentage of sales of IVD imaging systems totaled 67% in the current period as compared to 60% in the comparable period from last year. This increase is due primarily to a change in product mix, with a greater proportion of the current period’s sales comprised of lower margin instruments than in the year ago period. Cost of goods for IVD imaging system supplies and services as a percentage of sales of such products were 40% for the current period as compared to 39% in the same period last year. Cost of goods for small instruments and supplies as a percentage of sales of such products totaled 49% for the current period, as compared to 46% in the third quarter of last year. This increase is due primarily to increased costs resulting from smaller production runs in the current period. The aggregate gross margin totaled 53% for the quarter ended September 30, 2002 as compared to 56% in the comparable period of the prior year.

     Cost of goods sold as a percentage of revenues from the urinalysis segment totaled 46%, as compared to 43% in the third quarter of last year. Cost of goods for small instruments as a percentage of revenues totaled 49% in the current period, as compared to 46% in the third quarter of the prior year.

     Marketing and selling expenses totaled $1.1 million, compared to $874,000 for the comparable prior year period, an increase of $189,000, or 22%. This increase is due primarily to the addition of a senior sales management person as well as increased marketing efforts for our products. Marketing and selling expenses as a percentage of net revenues were 15% in the quarter ended September 30, 2002, as compared to 13% in the same period last year.

     General and administrative expenses were $1.3 million, compared to $1.1 million in the comparable period in the prior year, an increase of $161,000 or 15%. The increase is due primarily to the addition of senior management in 2002. General and administrative expenses for the period as a percentage of net revenue were 18% as compared to 16% in the same period in the prior year.

     Net research and development expenses were $1.1 million for the quarter ended September 30, 2002, down slightly from the level of the third quarter of last year. Net research and development expenses as a percentage of revenues were 16% in the quarter ended September 30, 2002, as compared to 17% in the same period in the prior year. Total product technology expenditures, including capitalized software development costs and reimbursed costs under research and development grants and contracts, were down $173,000 from the prior year to $1.5 million. This decline was due primarily to a reduction in the amount of work done under research and development grants and contracts at our ADIR subsidiary. The continued high level of total product technology expenditures is due primarily to the iQ200 project begun in 1999 to improve our urinalysis workstation product line, and for which we recently received clearance from the Food and Drug Administration We believe that this project is important to maintaining our competitive position in the urinalysis market. We expect our net research and development expenses to continue at current levels for the remainder of 2002.

     Amortization of intangible assets is lower in the current quarter than in the year ago comparable period. This is due to the fact that the balance in the current quarter includes only the amortization of patents, whereas the year ago amounts also included the amortization of acquired intangible assets. The Company ceased amortization of acquired intangible assets in 2002 in accordance with SFAS 142.

     Operating income for the quarter ended September 30, 2002 decreased to $244,000 as compared to $664,000 in the comparable quarter of the prior year, primarily as a result of higher marketing and selling expenses and higher general and administrative expenses in the current period.

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     Interest expense decreased to $121,000 in the quarter ended September 30, 2002 from $218,000 in the comparable quarter of the prior year as a result of significantly lower interest rates on the revised credit facility associated with the change in bankers, and reduced indebtedness.

     For the quarter ended September 30, 2002, urinalysis segment profits decreased to $506,000 from $648,000 in the comparable quarter of the prior year. This decrease is attributable to higher marketing and selling expenses in the current quarter. Segment profits for the small instruments segment totaled $396,000, as compared to $578,000 in the comparable quarter of the prior year. The decrease results from lower sales volume in that segment. Unallocated corporate expenses totaled $730,000 in the current period as compared to $760,000 in the same period last year.

     The income tax provision for the quarter ended September 30, 2002 totaled $69,000, as compared to $186,000 in the quarter ended September 30, 2001. The decrease is a function of the taxable income.

     Net income decreased to $104,000, or $0.01 per diluted share, for the quarter ended September 30, 2002, as compared to $280,000, or $0.02 per diluted share, for the same period of the prior year.

Comparison of Nine Months Ended September 30, 2002 to Nine Months Ended September 30, 2001

     Net revenues for the nine months ended September 30, 2002 decreased to $20.8 million from $21.2 million, a decrease of $390,000 or 2% from the same period last year. Sales of IVD imaging systems decreased to $4.0 million from $4.2 million, a decrease of $280,000 or 7% from the same period last year. The decrease is due to lower instrument sales primarily to international distributors, but also domestically, as the Company positions itself for transition to its next generation operating platform. Sales of IVD imaging systems supplies and services increased to $12.2 million from $11.6 million, an increase of $532,000 or 5% over the same period last year, primarily due to the larger installed base of urinalysis workstations. Sales of small instruments and supplies decreased $796,000 to $4.3 million, a decrease of 16%. The decline is due primarily to lower sales of small instruments to OEM customers. Royalties and licensing revenues increased $155,000 from the year ago period, due primarily to a new $100,000 royalty earned by our StatSpin subsidiary during the current period.

     Revenues from the urinalysis segment totaled $16.4 million in the current period as compared to $16.1 million in the same period last year, a slight increase which resulted from lower instrument sales being more than offset by higher levels of supplies and services revenue, as discussed in the previous paragraph. Revenues from the small instruments segment decreased $696,000 from the comparable period last year to $4.4 million. This decline is due primarily to lower sales, partially offset by the $100,000 royalty.

     Cost of goods sold for IVD imaging systems as a percentage of sales of those systems totaled 60% in the current period as compared to 59% in the same period last year. Cost of goods sold for IVD imaging system supplies and services as a percentage of sales of such products was 39% which was the same as for the first nine months of 2001. Cost of goods sold for small instruments and supplies as a percentage of sales of small instruments and supplies totaled 49% for the current period as compared to 48% in the year ago period. The aggregate gross margin totaled 56% for the first nine months of 2002 which was the same as in the comparable period of last year.

     Cost of goods sold as a percentage of revenues from the urinalysis segment totaled 43% as compared to 44% in the first nine months of 2002. Cost of goods for small instruments as a percentage of revenues totaled 48% in the current period which was the same as in the year ago period.

     Marketing and selling expenses totaled $3.1 million in the current period as compared to $2.7 million for the comparable period last year, an increase of $359,000 or 13%. This increase was primarily due to the addition of a senior sales management person as well as increased marketing efforts. Marketing and selling expenses as a percentage of net revenues were 15% in the current period as compared to 13% last year.

     General and administrative expenses were $3.6 million, an increase of $373,000 or 12% from the comparable period in the prior year. This increase is due primarily to the addition of senior management. General and administrative expenses for the period as a percentage of net revenues were 17% as compared to 15% in the same period of the prior year.

     Net research and development expenses decreased to $3.3 million for the first nine months of 2002 as compared to $3.5 million in the same period of 2001, a decrease of $212,000 or 6%. Net research and

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development expenses as a percentage of revenues was 16% in the current period, the same as in the comparable period of the prior year. Total product technology expenditures, including capitalized software development costs and reimbursed costs under research and development grants and contracts at our ADIR facility was down $277,000 in the current period as compared to the year ago period, which was consistent with the aforementioned decrease in net research and development expenses. Still, total product technology expenditures continued at a high level due primarily to the iQ200 project begun in 1999 to improve our urinalysis workstation product line. We believe that this project is important to maintaining our competitive position in the urinalysis market. We expect our net research and development expenses to continue at current levels during 2002.

     Amortization of intangible assets is lower in the current period than in the same period last year. This is due to the fact that the balance in the current period includes only the amortization of patents, whereas the year ago amounts also included the amortization of acquired intangible assets. The Company ceased amortization of acquired intangible assets in 2002 in accordance with SFAS 142.

     Operating income for the first nine months of 2002 decreased to $1.6 million as compared to $2.2 million in the first nine months of 2001, principally as a result of higher marketing and selling and general and administrative expenses in 2002.

     Interest expense decreased to $429,000 in the current period from $655,000 in the prior year as a result of lower interest rates on the revised credit facility associated with the change in bankers, and reduced indebtedness.

     For the first nine months of 2002, urinalysis segment profits decreased to $2.3 million from $2.6 million in the comparable period of 2001. This decrease is attributable to higher marketing and selling expenses in the current period. Segment profits for the small instruments segment totaled $1.2 million as compared to $1.4 million in the comparable period last year. This decrease resulted from lower sales volume in that segment. Unallocated corporate expenses totaled $2.2 million in the current period as compared to $2.4 million in the same period last year. The decrease was primarily due to reduced charges incurred for legal services in the current period.

     The income tax provision for the first nine months of 2002 totaled $510,000 as compared to $677,000 in the first nine months of 2001. The decrease reflects the decreased taxable income experienced by the Company in 2002.

     Net income decreased to $765,000 or $0.07 per diluted share for the first nine months of 2002 as compared to $1.0 million or $0.09 per diluted share for the same period of the prior year.

Liquidity and Capital Resources

     Cash and cash equivalents decreased to $1.8 million at September 30, 2002 from $2.3 million at December 31, 2001. Cash flow provided by operations for the nine months ended September 30, 2002 increased to $1.8 million from $411,000 for the comparable period last year. This increase is due primarily to payments of lower accrued bonuses in the current year than in the prior year and decreases in inventories in the current year. Our primary source of liquidity is cash from operations, which depends heavily on sales of our urinalysis workstations. We plan to introduce the iQ200 model, built on a new operating platform, in late November 2002. We received clearance from the Food and Drug Administration on October 21, 2002. However revenues from the sale of this product are not anticipated until the end of the first quarter of 2003. The failure to make a successful and timely transition to this upgraded model would have a material and adverse affect on workstation sales, and, consequently, our liquidity. This is an inherent risk in any major upgrade to products in our industry.

     Cash used by investing activities totaled $2.0 million for the nine months ended September 30, 2002, as compared to $1.0 million in the same period last year. The increase is due primarily to the increase in expenditures for property and equipment as part of our efforts to expand and upgrade our facilities, as well as increased software development costs under our research and development program.

     Net cash used by financing activities totaled $328,000 and consisted primarily of principal payments made on the subordinated note, and net principal payments made on the term loans and revolving line of credit under our credit facility, partially offset by funds received from the exercise of stock options and warrants. As of September 30, 2002, we owed $1.4 million on the term loans and $1.0 million on the revolving line of credit and were eligible to borrow an additional $2.9 million under the revolving credit line.

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     In February 2002, we refinanced our existing credit facility and replaced it with a new $8.0 million credit facility with California Bank and Trust. The new facility consists of a $500,000 term loan, a $1.0 million term loan and a $6.5 million revolving line of credit. The $500,000 term loan is payable in 60 equal monthly installments. The $1.0 million term loan carries interest only for the first 12 months, followed by 48 months of equal principal payments plus interest. The $6.5 million credit line matures in June 2004. Borrowings under the line of credit are limited to a percentage of eligible receivables and inventory. The entire credit facility bears interest at the lender’s prime rate, or LIBOR rate plus 2.0%. At September 30, 2002, the Company was in compliance with all its covenants signed with the Bank.

     We expect to continue to incur high levels of research and development expenditures for the balance of the year. We plan to continue to fund this project with cash generated from operations.

     We reduced our outstanding debt by more than $700,000 in the first nine months of 2002 and, after considering the effect of the refinancing discussed above, our scheduled principal payments total $1.4 million during the next twelve months. We believe that our current cash on hand, together with cash generated from operations and cash available under the credit facility will be sufficient to fund normal operations and pay principal and interest on outstanding debt for at least a year.

Shareholder Rights Plan

     We have a shareholder rights plan. The rights are not presently exercisable. They become exercisable only if a person or group acquires 20% or more of our common stock, or announces a tender offer for 20% or more of our common stock, without board approval. If the rights are triggered, all common stockholders (except the hostile party) will be entitled to purchase shares of common stock at a price based on a substantial discount from the market price of the common stock. The Board of Directors may terminate the plan at any time or redeem the rights prior to their becoming exercisable. The rights expire on December 22, 2009.

Critical Accounting Policies and Estimates

     Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to our valuation of inventory and our allowance for uncollectible accounts receivable. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

	•		Inventory is evaluated on a continual basis and reserve adjustments are made based on management’s estimate of future sales value, if any, of specific inventory items. Reserve adjustments are made for the difference between the cost of the inventory and the estimated market value and charged to operations in the period in which the facts that give rise to the adjustments become known.
	•		Accounts receivable balances are evaluated on a continual basis and allowances are provided for potentially uncollectible accounts based on management’s estimate of the collectability of customer accounts. If the financial condition of a customer were to deteriorate, resulting in an impairment of their ability to make payments, an additional allowance may be required. Allowance adjustments are charged to operations in the period in which the facts that give rise to the adjustments become known.

     Net deferred tax assets are evaluated on a continual basis. The carrying value of the Company’s net deferred tax assets assumes that the Company will be able to generate sufficient future taxable income in certain tax jurisdictions, based on estimates and assumptions. If these estimates and related assumptions change in the future, the Company may be required to record additional valuation allowances against its deferred tax assets resulting in additional income tax expense in the Company’s consolidated statement of operations. Management evaluates the realizability of the deferred tax assets quarterly and assesses the need for additional valuation allowances quarterly.

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Recent Issued Accounting Standards

     In August 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Statements (SFAS) No. 143, Accounting for Asset Retirement Obligations. This Statement is effective for fiscal years beginning after June 15, 2002. SFAS No. 143 provides accounting requirements for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. Under the Statement, the asset retirement obligation is recorded at fair value in the period in which it is incurred by increasing the carrying amount of the related long-lived asset. The liability is accreted to its present value in each subsequent period and the capitalized cost is depreciated over the useful life of the related asset. International Remote Imaging Systems, Inc. is currently evaluating the impact of SFAS No. 143 on its consolidated financial statements.

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. This statement eliminates the current requirement that gains and losses on debt extinguishment must be classified as extraordinary items in the income statement. Instead, such gains and losses will be classified as extraordinary items only if they are deemed to be unusual and infrequent, in accordance with the current GAAP criteria for extraordinary classification. In addition, SFAS 145 eliminates an inconsistency in lease accounting by requiring that modifications of capital leases that result in reclassification as operating leases be accounted for consistent with sale-leaseback accounting rules. The statement also contains other nonsubstantive corrections to authoritative accounting literature. The changes related to debt extinguishment will be effective for fiscal years beginning after May 15, 2002, and the changes related to lease accounting will be effective for transactions occurring after May 15, 2002. Adoption of this standard will not have any immediate effect on International Remote Imaging Systems, Inc.s consolidated financial statements. International Remote Imaging Systems, Inc. will apply this guidance prospectively.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses accounting for restructuring and similar costs. SFAS No. 146 supersedes previous accounting guidance, principally Emerging Issues Task Force (EITF) Issue No. 94-3. International Remote Imaging Systems, Inc. will adopt the provisions of SFAS No. 146 for restructuring activities initiated after December 31, 2002. SFAS No. 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF No. 94-3, a liability for an exit cost was recognized at the date of a companys commitment to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. Accordingly, SFAS No. 146 may affect the timing of recognizing future restructuring costs as well as the amount recognized.

Inflation

     We do not foresee any material impact on our operations from inflation.

Healthcare Reform Policies