UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

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

For the Quarter Ended September 30, 2004

Commission File Number 1-13408

DIGITAL RECORDERS, INC.

5949 Sherry Lane, Suite 1050
Dallas, Texas 75225
(Address of principal executive offices, Zip Code)

Registrant’s telephone number, including area code: (214) 378-8992
Securities registered pursuant to Section 12(b) of the Act: None

Securities Registered Pursuant to Section 12(g) of the Exchange Act:

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 Exchange Act Rule 12b-2): Yes () No (x )

Indicate the number of shares outstanding of each of the Registrant’s classes of common stock as of November 1, 2004:

DIGITAL RECORDERS, INC. AND SUBSIDIARIES

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PART I - FINANCIAL INFORMATION

Item I. FINANCIAL STATEMENTS

DIGITAL RECORDERS, INC. AND SUBSIDIARIES

See accompanying notes to unaudited consolidated financial statements.

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DIGITAL RECORDERS, INC. AND SUBSIDIARIES

See accompanying notes to unaudited consolidated financial statements.

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     DIGITAL RECORDERS, INC. AND SUBSIDIARIES

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DIGITAL RECORDERS, INC. AND SUBSIDIARIES

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(1)BASIS OF PRESENTATION AND DISCLOSURE

The unaudited interim consolidated financial statements and related notes of Digital Recorders, Inc. and Subsidiaries (the “Company” or “DRI”) have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, certain information and footnote disclosures normally included in the financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to such rules and regulations. However, in the opinion of management, the accompanying unaudited financial statements contain all adjustments and information (consisting only of normal recurring accruals) considered necessary to present fairly the results for the interim periods presented.

The accompanying consolidated financial statements and related notes should be read in conjunction with the Company’s audited financial statements included in its Annual Report on Form 10-K/A (Amendment No. 2) for the year ended December 31, 2003. The results of operations for the three and nine months ended September 30, 2004, are not necessarily indicative of the results to be expected for the full calendar year.

Certain amounts in prior periods have been reclassified to conform with the current period presentation.

Revenue Recognition

Revenue from product sales is recognized upon shipment to customers based upon the defined shipping terms. Even though the Company receives customer sales orders that may require schedule product deliveries over several months, sales revenues are only recognized upon physical shipment of the product to the customer. Service revenues are recognized upon completing the service. Service revenues include product repair not under a warranty agreement, city route mapping, product installation, training, consulting services and funded research and development projects.

Software licensing fee revenue results from a multi-year licensing agreement consisting of a perpetual license for a jointly developed product and royalties based upon per unit installation by the licensee. Such revenues are recognized on the basis of, “per unit installed.” Management has evaluated Statement of Position 97-2 “Software Revenue Recognition” and determined that it is appropriate to recognize the revenues associated with this arrangement as the Company has no future obligation to provide future software, upgrades, post contract customer support or other services related thereto subsequent to the invoice date. For the nine months ended September 30, 2004 and 2003, software license fee revenues represented 3.3 percent and 1.0 percent, respectively, of Company revenues.

Stock-Based Compensation

Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” prescribes accounting and reporting standards for all stock-based compensation plans, including employee stock option plans. As allowed by SFAS No. 123, the Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board No. 25, “Accounting for Stock Issued To Employees,” and related interpretations, which does not require compensation to be recorded if the consideration to be received is at least equal to the fair value of the common stock to be received at the measurement date. Under the requirements of SFAS No. 123, non-employee stock-based transactions require comp ensation to be recorded based on the fair value of the securities issued or the services received, whichever is more reliably measurable.

Had compensation expense for the stock option plans been determined consistent with Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” the pro forma basic and diluted net income (loss) per common share would have been as follows:

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(2)

MANAGEMENT’S PLANS

The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.

The Company initiated plans and strategies in 2002 and 2003 to improve the operating results and to reduce the pressure on liquidity. The primary elements of the Company’s strategies, objectives, plans and actions were:

1.		Restructure Debt. The Company has historically raised significant amounts of cash through secured and subordinated debt financing.
		On November 6, 2003, the Company replaced its asset-based lending agreement formerly with Guaranty Business Credit Corporation with a three year agreement (the “Credit Agreement”) with LaSalle Business Credit LLC. The Credit Agreement provides up to $10.0 million in borrowing to be used for acquisitions, working capital and general corporate purposes. The borrowing is inclusive of $2.0 million for Letters of Credit and $0.5 million for term loans. The interest rate on loans under this agreement is the published prime lending rate (4.75 percent at September 30, 2004) plus 1.75 percent. There is a fee equal to 2.50 percent on the aggregate undrawn face amount of all Letters of Credit outstanding.
		On April 23, 2004, subordinated convertible debt holders holding aggregate common equivalent shares of 2,075,000, converted 100 percent of such debt into shares of common stock. As a result of this conversion, $4,150,000 has been recorded as additional equity on the balance sheet and the annual cash interest expense will decrease by approximately $332,000.
		The Company presently does not anticipate the need to secure additional debt financing or negotiate additional debt restructurings in order to meet the needs of current operations.
2.		Reduce Operating Costs and Improve Efficiency. In the normal course of business, the Company has aggressively sought opportunities to reduce the cost structure and increase overall efficiency and responsiveness to its customers. In 2003, the Company initiated “tracked and monitored” profit improvement initiatives designed to further leverage the economy of scale that was developing in its operations. The Company intends to continue developing its manufacturing and assembly infrastructure and organization to meet expected production requirements. The Company will continue manufacturing in-house certain key components of its products such as cable harnesses and assemblies, electronic destination sign systems, digital audio filter equipment and sub-system electronics. The Company believes this will enable it to: (1) produce highly reliable, quality products; (2) protect the proprietary nature of its technology and processes; (3) properly control its manufacturing and assembly processes and operations; and (4) achieve significant cost reductions. The cost reductions encompass all major elements of cost and operating expenses.

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3.		Increase Ownership Equity. During the three months ended March 31, 2004, the Company issued in private placements an additional 67 shares of Series E Stock. The net proceeds to the Company of such transactions were approximately $290,079.
		Between April 22, 2004 and June 4, 2004, warrant holders exercised their rights to acquire common stock. The Company received total cash in the amount of $1,291,603 for issuing 473,812 shares under the warrant agreements.
		Between April 22, 2004 and May 12, 2004, stock holders of Series AAA preferred stock converted 108 preferred shares at an aggregate value of $540,000 to 67,500 common shares. As a result of this conversion, the Company reclassified $540,000 from Series AAA preferred stock to common stock which will reduce annual preferred stock dividends by $54,000.
		On April 23, 2004, the holders of $4,150,000 of the Company’s subordinated convertible debt converted such debt into 2,075,000 common shares. As a result of this conversion, $4,150,000 has been recorded as equity on the balance sheet and the annual cash interest expense will decrease by approximately $332,000.
		On April 24, 2004, the Company sold 625,000 shares of common stock to institutional investors for $8.00 per share. The total proceeds to the Company, net of issuance expenses, were $4,575,000. The Company has also granted the investors a warrant valued at $674,840 to acquire 125,000 shares of common stock at an exercise price of $8.80 per share, exercisable for a period of five years.
		Between April 26, 2004 and July 21, 2004, stock option holders exercised their rights to acquire common stock. The Company received total cash in the amount of $66,792 for issuing 34,429 shares under the stock option plan.
		On April 27, 2004, the holder of the Series F convertible preferred stock converted all 304 preferred shares to 760,232 shares of common stock. As a result of this conversion, $1,520,414 of Series F convertible preferred stock has been reclassified as common stock which will reduce the annual preferred stock dividend expense by $45,612. Such dividends are “payment-in-kind” and do not represent an actual cash expense.
		Between July 1, 2004 and September 30, 2004, holders of Series E convertible preferred stock converted 191 preferred shares at an aggregate value of $955,000 to 318,327 common shares. As result of this conversion, the Company reclassified $955,000 from Series E preferred stock to common stock during the third quarter which will reduce annual preferred stock dividends by $66,850.
		On October 6, 2004, the Company sold 1,207,729 shares of Common Stock to an institutional investor for $4.14 per share. The proceeds to the Company, net of issuance expenses, were $4,536,500. The Company has also granted the investor a warrant to acquire 241,546 shares of Common Stock at an exercise price of $6.00, exercisable for a period of five years valued at $966,902. Additionally, the Company granted its placement agent warrants to acquire 120,773 shares of common stock at an exercise price of $5.28, exercisable for a period of five years valued at $491,528. These warrants are not exercisable for a period of six months from the date of placement above. In connection with the above transactions, the Company executed a Registration Rights Agreement for both the common shares and warrants.
4.		Maintain Our Focus on Technical Excellence and Innovation. The Company is continuing to maintain its leadership in the transportation and law enforcement and surveillance markets served. In order to expand and protect its technology, the Company will continue to seek patent protection for its products and licenses of key technology owned by others. The Company introduced improved and new technologies in 2003 and 2004 including the DR600 vehicle logic unit (“VLU”) that is the integration communication platform for transit vehicle systems including fare collection, automatic passenger counting, automatic vehicle announcement systems, engine monitoring, vehicle location and monitoring (for fleet management and security purposes) and other applications. The Company had previously introduced full color electronic

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		destination sign systems, and with its global presence, is leveraging its purchasing power to realize decreased cost of materials. Our subsidiary, Digital Audio Corporation, continues to develop new products for the law enforcement and surveillance markets in support of the initiatives in U.S. Homeland Security.
		The Company considers any increase in government funding related to national security, intelligence, and law enforcement initiatives as having the potential to influence positively the opportunity to sell our audio processing solutions and surface transit security enhancement products. As a result of increased attention to the potential for terrorists’ threats to transit vehicles and infrastructure, the Company has the potential to leverage on the vehicle locating and monitoring aspect of its Transportation Segment; an essential element of security is knowing, on a real time basis, the precise location of critical assets.
5.		Pursue Strategic Partnerships, Alliances and Acquisitions. In September 2003, a division of the Company and GE Transportation Systems Global Signaling, LLC (GETSGS), through General Electric’s (“GE”) Advanced Communications division based in Hingham, Mass, signed a three-year Teaming Agreement. Through this agreement, the Company and GETSGS are working together to deliver advanced technology systems integration projects. Our division focuses on vehicle location and passenger information processing and delivery systems while GETSGS focuses on communications technology, project management, and system integration. Through this agreement with GE, an organization that is uniquely capable of integrating our products with much larger systems in ways that exceed our independent technological and financial capabilities, the Company believes the agreement will significantly extend our transit market reach. The Company further believes the GPS-based vehicle location products, including the security aspects of such as noted above, may represent one of the Company’s more significant internal growth opportunities in coming years.
6.		Increase working capital through better asset management. The Company recognizes that the working capital assets of trade accounts receivable and inventories represent significant opportunities if properly and aggressively managed. Customer account balances are continually monitored and evaluated by reviewing payment history and patterns of heavy shipments that could limit credit line borrowings with the Company’s asset-based lender. As inventories increased in recent years, due to requirements of the markets served and changes in technology, the Company has developed initiatives to promote retrofit sales programs and incentives to utilize existing versions of technology.

The Company believes the balance sheet equity raised through Series E, Series F, and common stock placements to date, together with the borrowing availability under its existing credit facilities are sufficient to fund existing operations for the subsequent 12 month period when aggregated with other Company action plans and strategies to alleviate liquidity pressures.

(3)

SUBSEQUENT EVENT — PRO FORMA CONDENSED BALANCE SHEET AND SUPPLEMENTAL DATA

The following pro forma condensed balance sheet as of September 30, 2004 and supplemental data consider a transaction occurring after the balance sheet date, on October 6, 2004, that will have a significant effect on the information included in the Company’s balance sheets for future periods. This transaction involved the issuance by the Company of shares of its common stock, par value $.10 per share (“Common Stock”), in a private placement to an institutional investor. The pro forma condensed balance sheet and supplemental data give effect to this transaction as if it had occurred on September 30, 2004.

Supplemental information is also provided showing the effect of this transaction, on the same pro forma basis, on the Company’s outstanding balances under its lines of credit and the shares of Common Stock outstanding assuming all cash proceeds were used to pay down line of credit borrowings.

The following adjustment presents the description and related amounts with the transaction completed on October 6, 2004.

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On October 6, 2004, the Company sold 1,207,729 shares of Common Stock to an institutional investor for $4.14 per share. The proceeds to the Company, net of issuance expenses, were $4,536,500. The Company has also granted the investor a warrant to acquire 241,546 shares of Common Stock at an exercise price of $6.00, exercisable for a period of five years valued at $966,902. Additionally, the Company granted its placement agent warrants to acquire 120,773 shares of common stock at an exercise price of $5.28, exercisable for a period of five years valued at $491,528. These warrants are not exercisable for a period of six months from the date of placement above. In connection with the above transactions, the Company executed a Registration Rights Agreement for both the common shares and warrants.

(4)

GOODWILL AND OTHER INTANGIBLE ASSETS

The Company previously recorded goodwill in connection with its acquisitions of Digital Audio Corporation and Mobitec AB. The carrying values of these reporting units are determined by allocating all applicable assets (including goodwill) and liabilities based upon the unit in which the assets are employed and to which the liabilities relate, and considering the net cash flows to determine the fair value of the reporting units.

The Company completed its annual goodwill and indefinite life intangible asset impairment evaluation as of December 31, 2003, and concluded that no impairment existed. Therefore, as a result of this impairment evaluation, no impairment charges were recorded during the year ended December 31, 2003.

In the Company’s opinion, no significant changes have occurred related to the operations or in the carrying amount of goodwill for either of the Company’s operating segments or in the composition of the Company’s acquired intangible assets and the associated accumulated amortization since December 31, 2003. Therefore, an interim impairment evaluation has not been performed by the Company as of September 30, 2004.

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(5)

INVENTORIES

Inventories consist of the following:

(6)

PROPERTY AND EQUIPMENT

Property and equipment consists of the following:

(7)

LINES OF CREDIT AND LONG-TERM DEBT

a)

Lines of Credit

The Company has a three year asset-based lending agreement (the “Credit Agreement”) with LaSalle Business Credit LLC (“LBC”). Borrowings under the Credit Agreement are classified as current liabilities in accordance with EITF 95-22, Balance Sheet Classification of Borrowings Outstanding under Revolving Credit Agreements That Include Both a Subjective Acceleration Clause and a Lock-Box Arrangement. However, it is management’s intention to manage the Credit Agreement as long-term debt with a final maturity date of November 15, 2006, as provided for in the Credit Agreement.

At September 30, 2004, the Credit Agreement, as amended, provides up to $10.0 million in borrowings to be used for acquisitions, working capital and general corporate purposes. The borrowing is inclusive of $2.0 million for Letters of Credit and $0.5 million for term loans. The interest rate on loans under this agreement is

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		the published prime lending rate (4.75 percent at September 30, 2004) plus 1.75 percent. There is an annual fee equal to 2.50 percent on the aggregate undrawn face amount of all Letters of Credit outstanding.
		The Credit Agreement, as amended, includes customary covenants and conditions relating to the conduct and operation of the Company’s business. Specifically, the Credit Agreement subjects the Company to an escalating fixed charge coverage ratio from 1.0 to 1.5 and an escalating Minimum Tangible Net Worth (as defined) covenant from $1.5 million to $2.7 million over the term of the agreement calculated on a quarterly and rolling 12 month basis; limits annual capital expenditures to $1.5 million and limits credit by providing for a reserve of $600,000 until certain financial covenants have been met. At September 30, 2004, available collateral based on the value of eligible trade accounts receivable and inventory was $5,528,169. This, given the outstanding debt balance under this agreement of $4,096,869, would have resulted in additional borrowing availability of $1,431,300. However, the required reserve reduced additional borrowing availability by $600,000 to $831,300. The outstanding debt under the Credit Agreement is secured by substantially all U.S.-based assets of the Company.

		On April 14, 2004, the Company and LBC agreed to amendments to the escalating tangible net worth and escalating fixed charge coverage ratio loan covenants. The amendment took into effect the Company’s results of operations for the three months ended December 31, 2003 that affected the initial covenant computations. These covenants were revised after considering the results of operations for the three months ended December 31, 2003 and the Company’s projected operating plan for the year ending December 31, 2004.
		The escalating Minimum Tangible Net Worth covenant was reduced by $1,000,000 and reset to $1,500,000 from $2,500,000 for the period of December 31, 2003 through December 30, 2004 and increases $600,000 per year thereafter for the remaining life of the loan. The time periods required to maintain the escalating fixed charge coverage ratio were also reduced to exclude the three months ended December 31, 2003; and are 1.15:1.00 for the nine and twelve months ended September 30, 2004 and December 31, 2004. Additionally, the interest rate on borrowings increased from prime plus 1.00 to prime plus 1.75 effective April 14, 2004 and forward. The impact on the 2004 financial statements based on the outstanding balance of this loan as of September 30, 2004 would be approximately $30,524. Also, the reserve on borrowings was increased to $600,000 from $500,000 until receipt of the certified 2004 financial statements reflecting an EBITDA to fixed charge coverage ratio of at least 1.15:1.00.
		At September 30, 2004, the Company was not in compliance with the fixed charge coverage ratio within the Credit Agreement, as amended, but is working with the lender to obtain a waiver. All amounts due under the Credit Agreement are classified as a current liability. Although no assurance can be given, the Company does not expect a material negative impact stemming from the covenant violation. The amount outstanding at September 30, 2004, was $4,096,869.
		Mobitec AB, the Company’s wholly owned Swedish subsidiary, has an agreement with its bank in Sweden from which it may currently borrow up to a maximum of 10,000,000 krona or $1,361,000 U.S. based on the September 30, 2004 exchange rate of 0.1361. At September 30, 2004, 5,524,632 krona, or $751,904 was outstanding, resulting in additional borrowing availability of 4,475,368 krona, or $609,098. The maximum borrowing in the amount of 10,000,000 krona is secured by cash on deposit with the bank in the amount of 2,200,000 krona, or $299,420. The terms of this agreement require payment of an unused credit line fee equal to 0.50 percent of the unused portion and an average interest rate of 4.10 percent of the outstanding balance. This agreement is secured by certain assets of Mobitec AB. The line of credit agreement has an expiration date of December 31, 2004. On or before expiration, the Company expects to renew this credit agreement with an agreement substantially similar in terms and conditions.
		Mobitec AB also has an agreement with the same bank from which it may borrow up to 6,000,000 krona, or $816,600 based on the September 30, 2004 exchange rate of 0.1361. At September 30, 2004, 999,547 krona, or $136,038 was outstanding, resulting in additional borrowing availability of 5,000,453 krona, or $680,562. The line of credit bears an average interest rate of 5.29 percent and is collateralized by accounts receivable of Mobitec AB. The agreement has an expiration date of December 31, 2004. On or before expiration, the

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		Company expects to renew this credit agreement with an agreement substantially similar in terms and conditions.
		Transit Media-Mobitec GmbH, the Company’s wholly owned German subsidiary, has an agreement with its bank in Germany from which it may currently borrow up to a maximum of 512,000 Euro or $631,347 U.S. based on the September 30, 2004 exchange rate of 1.2331. At September 30, 2004, 455,201 Euro, or $561,308 was outstanding, resulting in additional borrowing availability of 56,799 Euro, or $70,039. The line of credit bears an average interest rate of 4.53 percent and is collateralized by accounts receivable and inventories of Transit Media-Mobitec GmbH. This agreement has an open ended term.
		Lines of credit at September 30, 2004 and December 31, 2003 consist of the following:

		b) Long-Term Debt
		Long-term debt consists of the following notes and obligations, the proceeds of which were used to finance the Mobitec acquisition and for working capital requirements.
		An unsecured note in the amount of $1,765,235 is payable to the estate of the seller of Mobitec AB. The note, as amended, requires three incrementally increasing quarterly payments due at the end of each successive quarter beginning with the third quarter of 2004 in the amounts of $50,000, $75,000, and $100,000 with the remaining balance in the amount of $1,540,235 due June 30, 2005. The quarterly payment in the amount of $50,000 was paid subsequent to the balance sheet date. The unsecured note had an annual interest rate of 9.0 percent paid annually which increased to 10.0 percent on July 1, 2004. A second unsecured obligation due to the shareholder in the amount of $225,000 was paid in full on July 30, 2004.
		A term loan from a Swedish bank dated June 28, 2001, having a balance of 8,800,000 krona, or $1,197,679 (based on the September 30, 2004 exchange rate of 0.1361), is payable in eight (8) remaining quarterly payments of 1,100,000 krona, or $149,710 at an annual interest rate of 5.35 percent and is secured by stock of DRI’s Swedish holding company subsidiary, DRI-Europa AB, and its consolidated subsidiary, Mobitec AB. Two (2) of the eight (8) remaining quarterly payments are due December 31, 2004.

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		Two convertible debentures dated June 27, 2001, and two convertible debentures dated July 31, 2002, having carrying amounts on December 31, 2003 of $2,838,000 and $1,150,000, respectively, were converted into an aggregate of 2,075,000 common shares on April 23, 2004.
		A convertible subordinated debenture in the amount of $250,000 dated August 26, 2002, is payable to a shareholder and member of the Board of Directors, and is due in full August 26, 2009, if not sooner redeemed or converted, with annual interest at 8.0 percent paid monthly. It also provides for monthly principal redemption installments commencing August 26, 2005, each of such installments to be in the dollar amount of ten dollars ($10) per thousand dollars ($1,000) of the then remaining principal amount. The loan agreement under which the convertible debenture was issued subjects the Company to a 1:1 ratio of Earnings Before Interest, Depreciation and Amortization (EBITDA) to interest to be calculated quarterly on a rolling four quarter basis and a 1.3:1 current ratio to be calculated at each quarter end. Both ratios were waived by the debt holder for calendar year 2004.
		Long-term debt at September 30, 2004 and December 31, 2003 consists of the following:

Net interest expense was $154,837 and $243,556 for the three months ended September 30, 2004 and 2003, respectively; and $729,126 and $832,998 for the nine months ended September 30, 2004 and 2003, respectively. Net interest expense for the nine months ended September 30, 2004 included $153,000 in amortized debt discount related to the conversion of the convertible debentures dated June 22, 2001.

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(8)		PER SHARE AMOUNTS
		The basic net income per common share has been computed based upon the weighted average shares of common stock outstanding. Diluted net income per common share has been computed based upon the weighted average shares of common stock outstanding and shares that would have been outstanding assuming the issuance of common stock for all potentially dilutive equities outstanding. The Company’s convertible preferred stock, convertible debt, options and warrants represent the only potentially dilutive equities outstanding.

		No recognition was given to potentially dilutive securities aggregating 1,718,433 shares in the three and nine months ended September 30, 2004, since, due to the net loss in those periods, such securities would have been anti-dilutive.
(9)		TRANSLATION OF FOREIGN CURRENCY
		The local currency of each of the countries of the operating foreign subsidiaries is considered to be the functional currency. Assets and liabilities of these foreign subsidiaries are translated into U.S. dollars using the exchange rates in effect at the balance sheet date. Results of operations are translated using the average exchange rate prevailing throughout the period. The effects of unrealized exchange rate fluctuations on translating foreign currency assets and liabilities into U.S. dollars are accumulated as the cumulative translation adjustment included in accumulated comprehensive income (loss) in shareholders’ equity. Realized gains and losses on foreign currency transactions are included in operations for the period.

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(10)		COMPREHENSIVE INCOME (LOSS)
		Comprehensive income (loss) for the three and nine months ended September 30, 2004 and 2003 consists of the following:

(11)		SEGMENT INFORMATION
		The Company has two principal business segments, which are based upon differences in products and technology: (1) transportation communications segment; and (2) law enforcement and surveillance segment. The transportation communications segment produces automated announcement and passenger information systems and electronic destination sign products for municipalities, regional transportation districts, and departments of transportation and bus vehicle manufacturers. The law enforcement and surveillance segment produces digital signal processing products for law enforcement agencies and organizations.
		Operating income (loss) for each segment is total sales less cost of sales and operating expenses applicable to the segment. Certain corporate overhead expenses including executive salaries and benefits, public company administrative expenses, legal and audit fees, and interest expense are not included in segment operating income (loss). Instead, such costs are included in the table below in a separate line labeled “parent entities.” Segment identifiable assets include accounts receivable, inventories, net property and equipment, net intangible assets and net goodwill. Sales, operating income (loss), identifiable assets, capital expenditures, long-lived assets, depreciation and amortization, and geographic information for the operating segments are as follows:

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(12)		TAXES
		As a result of its net operating loss carryforwards, the Company has significant deferred tax assets. SFAS No. 109, “Accounting for Income Taxes” (“FAS 109”), requires a valuation allowance be established when it is more likely than not that all or a portion of deferred tax assets will not be realized. Accordingly, the Company recorded a full valuation allowance, representing a non-cash charge of $787,431, against the deferred tax assets during the third quarter 2004. In addition, the Company expects to provide a full valuation allowance on future tax benefits until the Company can sustain a level of profitability that demonstrates its ability to utilize the deferred tax assets.
		As a result of its recent equity transactions, the Company has determined its ability to use its net operating loss carryforwards and related tax benefits in any single year are limited under the Internal Revenue Code. Because of the recency of the latest equity transaction, the exact annual limitation has not been determined. However, the Company does not believe such limitation will adversely impact its ability ultimately to use the net deferred tax asset.
		The Company’s effective tax benefit rate, excluding the deferred tax asset valuation allowance adjustment of $787,431, of 17 percent for the nine months ended September 30, 2004, was different than the statutory tax expense rate of 35 percent primarily due to the utilization of net operating loss carry forwards in an international jurisdiction in which the Company generated taxable earnings for the nine months ended September 30, 2004. As of December 31, 2003, the Company had established a valuation allowance against its deferred tax asset relative to the net operating losses due to the then uncertainty of the ability of the Company to use the loss carry forwards. The Company has assumed the reduction or reversal of the valuation allowance and recognized tax benefits and expense for the three and nine months ended September 30, 2004 as detailed in the table below. In addition, the Company has recognized an expense to increase the deferred tax asset valuation allowance in the amount of $787,431 in the U.S. companies for the three and nine months ended September 30, 2004. As a result of the tax items above, the total net reported tax expense for the three and nine months ended September 30, 2004, was $673,161 and $717,259, respectively.

(13)		LEGAL PROCEEDINGS
		The Company, in the normal course of its operations, is involved in legal actions incidental to its business. In management’s opinion, the ultimate resolution of these matters will not have a material adverse effect upon the current financial position of the Company or future results of operations.

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

THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS AND THE RELATED NOTES THAT ARE IN ITEM 1 OF THIS DOCUMENT.

Business — General

We directly or through contractors, design, manufacture, sell, and service information technology and audio surveillance technology products through two business segments. These two business segments are: (1) the transportation communications segment; and (2) the law enforcement and surveillance segment. While service is a significant aspect of our marketing strategy, it is not yet a material generator of revenue.

Our transportation communications segment produces products sold worldwide within the passenger and operating system information communication industry and market. This includes information systems for users and operators of transportation systems both on-board and off-board the vehicle. Additionally, Automatic Vehicle Locating and Automatic Vehicle Monitoring capabilities are addressed for fleet management, passenger information, and scheduling as well as for enhancement of security of transportation systems and vehicles. We sell to transportation vehicle equipment customers generally in two broad categories, (1) end customers, including municipalities; regional transportation districts; federal, state, and local departments of transportation; transit agencies; public, private, or commercial operators of vehicles; and rental car agencies; and (2) original equipment manufacturers (“OEMs”) of transportation vehicles. The relative percentage of sales to end customers as compared to OEM customers varies widely and frequently from quarter to quarter and year to year and within products and product lines comprising our mix of total revenue in any given period.

Our law enforcement and surveillance segment serves customers in the U.S. federal, state, and local law enforcement agencies or organizations, as well as their counterparts abroad. We produce a line of digital audio filter systems and tape transcribers used to improve the quality and intelligibility of both live and recorded voices. We market our law enforcement and surveillance products domestically and internationally to law enforcement entities and other customers in, or that support, government organizations.

Sales to our customers are characterized by a lengthy sales cycle that generally extends for a period of two to 24 months. In addition, purchases by a majority of our customers are dependent upon federal, state and local funding that may vary from year to year and quarter to quarter.

We generally recognize product revenue upon shipment of products to customers and service revenue upon completion of the service. Because our operations are characterized by significant research and development expenses preceding product introduction, net sales and certain related expenses may not be recorded in the same period, thereby producing fluctuations in operating results. Our dependence upon large contracts and orders, as well as upon a small number of relatively large customers or projects, increases the magnitude of fluctuations in operating results particularly on a period- to-period, or period-over-period, comparison basis. For a more complete description of our business, including a description of our products, sales cycle and research and development, see “Item 1. Business,” in our 2003 Annual Report on Form 10-K/A (Amendment No. 2).

Critical Accounting Policies

Our significant accounting policies and methods used in the preparation of the Consolidated Financial Statements are discussed in Note 1 of the Notes to Consolidated Financial Statements presented in our 2003 Annual Report on Form 10-K/A (Amendment No. 2). The following is a listing of the Company’s critical accounting policies which have not been changed from the date of filing of the annual report:

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• Allowance for doubtful accounts

• Inventory valuation

• Intangible assets and goodwill

• Income taxes, including deferred tax assets

• Revenue recognition

Results of Operations

The following discussion provides an analysis of our results of operations and liquidity and capital resources. This should be read in conjunction with our unaudited consolidated financial statements and related notes thereto contained in Item 1 of this filing. The operating results of the three-month and nine-month periods presented were not significantly affected by inflation.

The following table sets forth the percentage of our revenues represented by certain items included in our Statements of Operations:

COMPARISON OF OUR RESULTS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003

Net Sales and Gross Profit

Our net sales for the three months ended September 30, 2004, increased $895,486 or 8.4 percent, from $10,612,407 for the three months ended September 30, 2003, to $11,507,893 for the three months ended September 30, 2004. Our gross profit for the three months ended September 30, 2004, increased $605,824, or 14.5 percent, from $4,169,727 for the three months ended September 30, 2003, to $4,775,551 for the three months ended September 30, 2004.

During the three months ended September 30, 2004, the Company recorded revenues associated with a software license agreement. Our net sales would have increased 3.8 percent from 2003 and our gross profit would have increased 2.8 percent from 2003 without the license revenues and the related gross profit.

Following is a discussion of these changes in net sales and gross profit by segment.

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Transportation Communications Segment For the three months ended September 30, 2004, sales of our transportation communications segment increased $602,327, or 5.8 percent, from $10,395,741 for the three months ended September 30, 2003, to $10,998,068 for the three months ended September 30, 2004. The change resulted from an increase in international sales of $637,488 partially offset by a decrease in U.S. domestic sales revenues of $35,161. The decrease in U.S. domestic sales is attributed to a decrease in sales of electronic destination sign systems resulting from a shift in the timing of orders which was partially offset by an increase in revenues for automatic voice announcement systems and system licensing revenues. The decrease related to the shift in the timing of orders may or may not be realized in 2004 and, to the extent realized, may not be incremental to the remainder of 2004 as planned. The licensing revenues for the three months ended September 30, 2004, represented 4.5 percent of total net sales for the Transportation Communications segment.

The net increase in international sales was primarily attributed to higher electronic destination sign systems sales in the Scandinavian and Australian markets, partially offset by lower sales in Germany. The increase in net sales due to foreign currency fluctuations was approximately $414,571 and is not expected to change significantly for the remainder of 2004, as compared to the prior year when foreign currency fluctuations were more volatile as the U.S. dollar continued to weaken. The Company has no control over the foreign currency fluctuations and does not utilize currency hedging tools as its foreign companies primarily transact business in their respective functional currencies, thereby reducing the impact of foreign currency translation differences. If the U.S. dollar strengthens compared to the foreign currencies converted, it is likely the total sales reported in U.S. dollars would decline. In general, sales prices on the majority of our products have remained relatively stable for the three months ended September 30, 2004.

Because of our already high market share in the U.S., we expect our sales growth in the transportation communications segment will be dependent upon the introduction of new product offerings and technology, as well as our expansion into new geographic areas.

Our transportation communications segment gross profit for the three months ended September 30, 2004, increased $393,293, or 9.7 percent, from $4,069,329 for the three months ended September 30, 2003, to $4,462,621 for the three months ended September 30, 2004. As a percentage of segment sales, our gross profit percentage improved to 40.6 percent of our net segment sales for the three months ended September 30, 2004, as compared to 39.1 percent for the three months ended September 30, 2003. The increase in gross profit of $393,293 was attributed to the Company’s international operations, which realized a gross profit increase of $123,609, and to U.S. operations, which realized a gross profit increase of $269,684. The licensing fee revenue gross profit accounted for 11.0 percent of the total gross profit for the three months ended September 30, 2004. The gross profit percentage would have been 37.8 percent excluding the license fee revenue. The U.S. gross profit percentage for the three months ended September 30, 2004, was 43.4 percent, as compared to 39.3 percent for the prior year. The U.S. gross profit percentage would have been 39.1 percent excluding the license fee revenue. The remaining 4.3 percent increase in average U.S. gross profit percentage is primarily the result of ongoing cost reduction and profit improvement programs initiated in the last half of 2003, as well as an increase in sales of higher gross profit systems.

The consolidated international operations realized average gross profit percentages of 35.7 percent and 38.8 percent in the three months ended September 30, 2004 and 2003, respectively. The decrease in gross profit percentages is attributable to product mix and the introduction in 2004 of the lower-priced all-LED sign systems in the European markets. The gross profits are affected by selling prices, which are expected to be relatively stable in the near term, and direct cost of materials and services to manufacture and assemble the Company’s products. The Company expects to realize gross profit improvements in future periods reflecting the full effect of 2004 initiatives through negotiations with suppliers to lower unit component costs, the introduction of technology improvements decreasing the overall system costs, and in-house production of sub-assemblies that were previously purchased from suppliers at higher costs. Notwithstanding the foregoing, we believe long term improvement in our gross profit percentage is dependent primarily upon overall economic and competitive conditions in the transportation sector, introduction of new technology products, and the continued success of on-going profit improvement initiatives.

Law Enforcement and Surveillance Segment For the three months ended September 30, 2004, sales for our law enforcement and surveillance segment increased $293,159 or 135.3 percent, from $216,666 for the three months ended September 30, 2003, to $509,825 for the three months ended September 30, 2004. The sales increase is primarily attributable to federal budget spending increases for our systems and products. During the three months ended

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