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SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission File No. 0-30821

TELECOMMUNICATION SYSTEMS, INC.

(410) 263-7616

      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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act): Yes [  ]     No [ X ]

      Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

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INDEX

TELECOMMUNICATION SYSTEMS, INC.

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TeleCommunication Systems, Inc.

See accompanying Notes to Consolidated Financial Statements

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TeleCommunication Systems, Inc.

See accompanying Notes to Consolidated Financial Statements

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TeleCommunication Systems, Inc.

See accompanying Notes to Consolidated Financial Statements

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TeleCommunication Systems, Inc.

1.     Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three- and six- month periods ended June 30, 2003 are not necessarily indicative of the results that may be expected for the year ended December 31, 2003. These consolidated financial statements should be read in conjunction with our audited financial statements and related notes included in our 2002 Annual Report on Form 10-K.

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 and related disclosures. Actual results could differ from those estimates.

We use estimates to determine tax liabilities to state and local governments and estimate these liabilities based on our knowledge of applicable laws and regulations. Based on a review of such laws, we revised our estimate of these liabilities and recorded a reduction of the related expense of $260 and $560 for the three and six months ended June 30, 2003, respectively.

2.     Loss Per Common Share

Basic loss per common share is based upon the average number of shares of common stock outstanding during the period. Because we incurred a net loss in all periods presented, potentially dilutive securities were excluded from the computation because the result would be anti-dilutive. These potentially dilutive securities consist of stock options, restricted stock grants, and warrants.

3.     Supplemental Disclosure of Cash Flow Information

Property and equipment acquired under capital leases totaled $179 and $157 in the three months ended June 30, 2003 and 2002, respectively, and $179 and $174 during the six months ended June 30, 2003 and 2002, respectively.

Interest paid totaled $204 and $224 for the three months ended June 30, 2003 and 2002, respectively, and $492 and $501 for the six months ended June 30, 2003 and 2002, respectively.

4.     Segment Information

During the fourth quarter of 2002, management began evaluating our performance within three operating segments: network software, service bureau and network solutions. Management also began evaluating our performance based on gross profit. Gross profit is defined as revenue less direct cost of revenue, excluding the amortization of software development costs, which under accounting principles generally accepted in the United States, is considered in determining gross profit from software license revenues. We have restated prior period segment information for comparative purposes.

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Notes to Consolidated Financial Statements — (Continued)

A reconciliation of gross profit to net loss is as follows:

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Notes to Consolidated Financial Statements — (Continued)

5.     Intangible Assets

Intangible assets consisted of the following as of:

We routinely update our estimates of the future value of the software products that have been capitalized. As of June 30, 2003, it was determined that the expected margins from selling developed versions of key software products over their remaining useful lives was less than their remaining book value plus costs to complete. Therefore, we recorded additional amortization of $7,000 for the quarter ended June 30, 2003. This change in estimate gave consideration to the low level of license revenues earned during the second quarter of 2003 and revised estimates of future revenues net of costs to complete.

6.     Concentrations of Credit Risk and Major Customers

Financial instruments that potentially subject us to significant concentrations of credit risk consist primarily of accounts receivable and unbilled receivables. Accounts receivable are generally due within thirty days and no collateral is required. We maintain reserves for potential credit losses and historically such losses have been insignificant and within our expectations.

7.     Stock-Based Compensation

We have two stock-based employee compensation plans, our Third Amended and Restated 1997 Stock Incentive Plan (the “Stock Incentive Plan”) and our Employee Stock Purchase Plan. We record

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Notes to Consolidated Financial Statements — (Continued)

compensation expense for all stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB No. 25) and related Interpretations. Under APB 25, compensation expense is recorded over the vesting period to the extent that the fair value of the underlying stock on the date of grant exceeds the exercise or acquisition price of the stock or stock-based award. The following table illustrates the effect on net loss attributable to common stockholders and loss per common share if we had applied the fair value recognition provisions of Financial Accounting Standards Board Statement No. 123, Accounting for Stock-Based Compensation (Statement No. 123), to stock-based employee compensation.

In calculating the fair value of our stock options using Black-Scholes, we assumed that the expected life was 5 years, that the risk free interest rate was 3%, and that there was no dividend yield. We also assumed that the expected volatility of our stock was 120% for restricted stock and for options granted in 2003 and 130% for options granted prior to 2003. In valuing these options at June 30, 2002, we assumed volatilities of 139% for options granted in 2002, 164% for options granted in 2001, and 60% for options granted in 2000.

Prior to our initial public offering in 2000, we granted incentive stock options to employees and directors to purchase 885,983 shares of Class A Common Stock. The options were granted at an exercise price less than the estimated market value of Class A Common Stock at the date of grant. Net loss attributable to common stockholders, as reported, includes $222 and $443 of non-cash stock compensation expense related to these grants for the three months ended June 30, 2003 and 2002, respectively, and $595 and $867 of expense for the six months then ended. We expect to record future stock compensation expense of $1,504 as a result of option grants that will be recognized over the remaining vesting period of three years.

In the second quarter of 2003, we issued restricted stock to directors and certain key executives. The restrictions expire at the end of one year for directors and in annual increments over three years for executives and are based on continued employment. Net loss attributable to common stockholders for the three and six months ended June 30, 2003, as reported, includes $167 of non-cash stock compensation expense related to such stock grants. We expect to record future stock compensation

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Notes to Consolidated Financial Statements — (Continued)

expense of $1,720 as a result of these restricted stock grants that will be recognized over the remaining vesting period for directors and executives.

8.     Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board issued Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46). FIN 46 clarifies the requirements for consolidating certain entities in which equity investors do not have a controlling financial interest. We adopted FIN 46 during the second quarter of 2003. Since we are not affiliated with any variable interest entities, the adoption did not have an impact in the preparation of our consolidated financial statements.

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      The following discussion and analysis of the financial condition and results of operations should be read in conjunction with the consolidated financial statements, related notes, and other detailed information included elsewhere in this Quarterly Report on Form 10-Q. This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are statements other than historical information or statements of current condition. Some forward-looking statements may be identified by the use of such terms as “believes”, “anticipates”, “intends”, or “expects”. For example, the statement regarding our belief as to the sufficiency of our capital resources to meet our anticipated working capital and capital expenditures for at least the next twelve months is a forward-looking statement. These forward-looking statements relate to our plans, objectives and expectations for future operations. In light of the risks and uncertainties inherent in all such projected operational matters, the inclusion of forward-looking statements in this report should not be regarded as a representation by us or any other person that our objectives or plans will be achieved or that any of our operating expectations will be realized. Our actual financial results realized could differ materially from the statements made herein, depending in particular upon the risks and uncertainties described in our filings with the Securities and Exchange Commission. These include without limitation risks and uncertainties relating to our financial results and our ability to (i) reach profitability as early as anticipated or at all, (ii) continue to rely on our customers and other third parties to provide additional products and services that create a demand for our products and services, (iii) conduct our business in foreign countries, (iv) adapt and integrate new technologies into our products, (v) develop software without any errors or defects, (vi) protect our intellectual property rights, (vii) implement our business strategy (viii) realize backlog, and (vix) achieve continued revenue growth in the foreseeable future for our E9-1-1 business. These factors should not be considered exhaustive; we undertake no obligation to release publicly the results of any future revisions we may make to forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. We caution you not to put undue reliance on these forward-looking statements.

Critical Accounting Policies and Estimates

      Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to intangible assets and contingencies and litigation. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value 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 identified our most critical accounting policies to be those related to revenue recognition for our software contracts with multiple elements, contracts accounted for using the percentage of completion method, capitalized software, intangible assets and evaluation of impairment. We describe these accounting policies in relevant sections of this discussion and analysis. This discussion and analysis should be read in conjunction with our consolidated financial statements and related notes included in our 2002 Annual Report on Form 10-K.

Overview

      We manage our business in three segments: network software, service bureau and network solutions. Our network software segment develops, licenses, and maintains software products. Our service bureau segment provides our E9-1-1 service and hosts software application offerings. Our

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      Gross profit is defined as revenue less direct cost of revenue, excluding the amortization of software development costs, which under accounting principles generally accepted in the United States, is considered in determining gross profit from software license revenues. A reconciliation of segment gross profit to net loss is as follows (in thousands):