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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended September 27, 2003

For the transition period from ___________ to ___________

Commission file number: 0-24663

(617) 559-7000
(Registrant’s Telephone Number, Including Area Code)

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.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

The Registrant had 19,441,364 shares of Common Stock, $0.01 par value per share, outstanding as of November 3, 2003.

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ASPECT MEDICAL SYSTEMS, INC.

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PART I — FINANCIAL INFORMATION

Item 1. Financial Statements.

ASPECT MEDICAL SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these consolidated financial statements.

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ASPECT MEDICAL SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

The accompanying notes are an integral part of these consolidated financial statements.

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ASPECT MEDICAL SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

The accompanying notes are an integral part of these consolidated financial statements.

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ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

(1)

Basis of Presentation

     The accompanying unaudited consolidated financial statements of Aspect Medical Systems, Inc. (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all normal, recurring adjustments considered necessary for a fair presentation have been included. The consolidated financial statements and notes included herein should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2002 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”). Interim results of operations are not necessarily indicative of the results to be expected for the full year or any other interim period.

(2)

Summary of Significant Accounting Policies

     A summary of the significant accounting policies used by the Company in the preparation of its financial statements follows:

Principles of Consolidation

     The consolidated financial statements include the accounts of the Company and all wholly-owned subsidiaries. All material intercompany accounts and transactions have been eliminated.

Foreign Currency Translation

     The functional currency of the Company’s international subsidiaries is the U.S. dollar. Foreign currency transaction gains and losses are recorded in the consolidated statements of operations and have not been material.

Cash, Cash Equivalents and Marketable Securities

     The Company invests its excess cash in money market accounts, certificates of deposit, U.S. Treasury bills, high-grade commercial paper and debt obligations of various government agencies. The Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents.

     The Company accounts for its investments in marketable securities in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities. In accordance with SFAS No. 115, the Company has classified all of its investments in marketable securities as available-for-sale at September 27, 2003 and December 31, 2002. The marketable securities are reported at fair value, with any unrealized gains and losses excluded from earnings and reported as a separate component of stockholders’ equity as other comprehensive income (loss).

Revenue Recognition

     The Company recognizes revenue from equipment sales, disposable product sales and sales-type leases at the time of product shipment when collectibility is reasonably assured. Payments received prior to shipment are recorded as deferred revenue. The Company has entered into certain licensing and distribution agreements for which payments received in advance are recorded as deferred revenue. Revenue under these agreements is recognized as earned per the terms of the respective agreements. The Company does not record a provision for estimated sales returns because historically the Company has experienced only minimal returns that were not covered by warranty reserves. All shipping and handling costs are included in cost of revenue.

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ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

     In connection with the Stock Purchase Agreement with Boston Scientific Corporation (“BSC”) discussed in Note 9, the Company recorded approximately $6,300,000 of deferred revenue. The deferred revenue is being recognized ratably over the term of the OEM product development and distribution agreement with BSC. The term of this agreement continues until such time that BSC is no longer distributing the Company’s products, but in no event will extend beyond December 31, 2012.

Research and Development Costs

     The Company charges research and development costs to operations as incurred. Research and development costs include costs associated with new product development, product improvements and extensions, clinical studies and project consulting expenses.

Accounts Receivable

     Estimates are used in determining the Company’s allowance for doubtful accounts based on the Company’s historical collections experience, historical write-offs of its receivables, current trends, credit policy and a percentage of the Company’s accounts receivable by aging category. The Company also reviews the credit quality of its customer base as well as changes in the Company’s credit policies. The Company continually monitors collections and payments from its customers.

Inventory

     The Company values inventory at the lower of cost or estimated market, and determines cost on a first-in, first-out basis. The Company regularly reviews inventory quantities on hand and records a provision for excess or obsolete inventory primarily based on production history and on its estimated forecast of product demand. The medical industry in which the Company markets its products is characterized by rapid product development and technological advances that could result in obsolescence of inventory. Additionally, the Company’s estimates of future product demand may prove to be inaccurate, in which case it will need to change its estimate of the provision required for excess and obsolete inventory. If revisions are deemed necessary, the Company would recognize the adjustments in its costs of revenue at the time of the determination.

Investment in Sales-Type Leases

     The Company follows SFAS No. 13, Accounting For Leases, for its investment in sales-type leases. Under the Company’s sales-type leases, customers purchase BIS Sensors and the BIS monitor for the purchase price of the BIS Sensors plus an additional charge per BIS Sensor to pay for the purchase price of the BIS monitor and related financing costs over the term of the agreement. In accordance with SFAS No. 13, the minimum lease payment, consisting of the additional charge per BIS Sensor, less the unearned interest income, which is computed at the interest rate implicit in the lease, is recorded as net investment in sales-type leases. The cost of the BIS monitor acquired by the customer is recorded as costs of revenue in the same period.

     In addition, the Company periodically reviews and assesses the net realizability of its investment in sales-type leases. This review includes determining if a customer who entered into a sales-type lease is significantly underperforming relative to the customer’s committed level of BIS Sensor purchases. If this review results in a lower estimate of the net realizable investment balance, an allowance for the unrealized amount is established in the period in which the estimate is changed and is charged to revenue.

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ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Warranty

     Equipment that the Company sells is generally covered by a warranty period of one year. The Company accrues a warranty reserve for estimated costs to provide warranty services. The Company’s estimate of costs to service its warranty obligations is based on historical experience and an expectation of future conditions. Warranty expense for the three and nine months ended September 27, 2003, and accrued warranty cost, included in accrued liabilities in the consolidated balance sheet at September 27, 2003, was as follows:

Guarantees

     The Company guarantees operating lease obligations of its subsidiaries for the lease of office space and automobiles. The maximum potential future payment under these financial guarantees was approximately $139,000 at September 27, 2003.

Advertising Costs

     Advertising costs are expensed as incurred. These costs are included in sales and marketing expense in the consolidated statements of operations.

Property and Equipment

     Property and equipment is recorded at cost and depreciated using the straight-line method over the estimated useful lives of the related equipment. Equipment held under capital leases is stated at the lower of the fair market value of the equipment or the present value of the minimum lease payments at the inception of the lease and is amortized on a straight-line basis over the shorter of the lives of the related assets or the term of the leases. Repair and maintenance expenditures are charged to expense as incurred.

Income Taxes

     The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. Under this method, deferred tax assets and liabilities are recognized for the expected future tax consequences, utilizing currently enacted tax rates, of temporary differences between the carrying amounts and the tax basis of assets and liabilities. Deferred tax assets are recognized, net of any valuation allowance, for the estimated future tax effects of deductible temporary differences and tax operating loss and credit carryforwards.

Concentration of Credit Risk and Single or Limited Source Suppliers

     Financial instruments that potentially expose the Company to concentrations of credit risk primarily consist of cash, cash equivalents, accounts receivable, investment in sales-type lease receivables and marketable securities. To minimize the financial statement risk with respect to accounts receivable and investment in sales-type lease receivables, the Company maintains reserves for potential credit losses and such losses, in the aggregate, have not exceeded management’s expectations. The Company maintains cash, cash equivalents and investments in marketable securities with various financial institutions. The Company performs periodic evaluations of the relative credit quality of investments and Company policy is designed to limit exposure to any one institution or type of investment. The primary objective of the Company’s investment strategy is the safety of the principal invested. The Company does not maintain foreign exchange contracts or other off-balance sheet financial investments.

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ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

     The Company currently obtains certain key components of its products from single or limited sources. The Company purchases components pursuant to purchase orders rather than long-term supply agreements and generally does not maintain large volumes of inventory. The Company has experienced shortages and delays in obtaining certain components of its products in the past. There can be no assurance that the Company will not experience similar shortages or delays in the future. The disruption or termination of the supply of components or a significant increase in the costs of these components from these sources could have a material adverse effect on the Company’s business, financial position and results of operations.

Net Loss Per Share

     In accordance with SFAS No. 128, Earnings Per Share, basic and diluted net loss per share amounts for the three and nine months ended September 27, 2003 and September 28, 2002, were computed by dividing the net loss available to common stockholders by the weighted average number of shares of common stock outstanding during those periods.

     All shares of restricted common stock, stock options and warrants have been excluded from the calculation of diluted net loss per share since the inclusion of such amounts would be antidilutive.

Comprehensive Income (Loss)

     Comprehensive income (loss) is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. Other than the Company’s net loss, the only other element of comprehensive income (loss) impacting the Company is the unrealized gains (losses) on its marketable securities for all periods presented.

Stock-Based Compensation

     SFAS No. 123, Accounting for Stock-Based Compensation, requires the measurement of the fair value of stock options or warrants to be included in the statement of income or disclosed in the notes to financial statements. The Company accounts for stock-based compensation for employees under APB Opinion No. 25 and follows the disclosure-only alternative under SFAS No. 123. The Company has computed the weighted-average fair value of options granted in the three and nine months ended September 27, 2003 and September 28, 2002 using the Black-Scholes option-pricing model pursuant to SFAS No. 123. The following table shows the weighted average assumptions used in the applicable periods and the weighted average fair market value of the options granted in each period.

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ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

     If the Company had recognized compensation cost for these awards consistent with SFAS No. 123, the Company’s net loss and pro forma net loss per common share would have been increased to the following pro forma amounts:

     The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions, including expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. Also, because stock options vest over several years and the Company expects to grant stock options in future years, the above pro forma results of applying the provisions of SFAS No. 123 are not necessarily representative of the pro forma results in future years.

Use of Estimates

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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 amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Fair Value of Financial Instruments

     The estimated fair market values of the Company’s financial instruments, which include cash equivalents, marketable securities, accounts receivable, investment in sales-type leases, accounts payable and long-term debt, approximate their carrying values.

Reclassifications

     Certain amounts in the prior year’s financial statements have been reclassified to conform with the current-year presentation.

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ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Recent Accounting Pronouncements

     In November 2002, the Financial Accounting Standards Board (“FASB”) issued Financial Interpretation No. 45 (“FIN 45”), Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN 45 requires a guarantor to disclose (a) the nature of the guarantee, and the events or circumstances that would require the guarantor to perform under the guarantee; (b) the maximum potential amount of future payments under the guarantee; (c) the carrying amount of the liability, if any, for the guarantor’s obligations under the guarantee; and (d) the nature and extent of any recourse provisions or available collateral that would enable the guarantor to recover the amounts paid under the guarantee. FIN 45 also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability at fair value for the obligations it has undertaken in issuing the guarantee, including its ongoing obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. FIN 45 also addresses the disclosure requirements regarding product warranties. Instead of disclosing the maximum potential amount of future payments under the product warranty guarantee, a guarantor is required to disclose its accounting policy and methodology used in determining its liability for product warranties, as well as a tabular reconciliation of the changes in the guarantor’s product warranty liability for the reporting period. The Company adopted FIN 45 as of January 1, 2003. The adoption of FIN 45 did not have a material effect on the Company’s results of operations, cash flows or financial position.

     In January 2003, the FASB issued FIN 46, Consolidation of Variable Interest Entities. FIN 46 requires that if an entity has a controlling financial interest in a variable interest entity, the assets, liabilities and results of activities of the variable interest entity should be included in the consolidated financial statements of the entity. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period ending after December 15, 2003. The adoption of FIN 46 did not have a material effect on the Company’s results of operations, cash flows or financial position.

     In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. SFAS No. 150 establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The Company adopted SFAS No. 150 as of July 1, 2003. The adoption of SFAS No. 150 did not have a material effect on the Company’s results of operations, cash flows or financial position.

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ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

(3)

Comprehensive Income (Loss)

     The Company’s total comprehensive income (loss) is as follows:

(4)

Investment in Sales-Type Leases

     The components of the Company’s net investment in sales-type leases are as follows:

(5)

Inventory

     Inventory consists of the following:

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ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

(6)

Segment Information and Enterprise Reporting

     The Company operates in one reportable segment as it markets and sells one family of anesthesia monitoring systems. The Company does not disaggregate financial information by product or geographically, other than export sales by region and sales by product, for management purposes. Substantially all of the Company’s assets are located within the United States. All of the Company’s products are manufactured in the United States.

     Revenue by geographic destination and as a percentage of total revenue is as follows:

     The Company did not have sales in any individual country, other than the United States, that accounted for more than 10% of the Company’s total revenue for the three and nine months ended September 27, 2003 and September 28, 2002.

(7)

Related Party Transactions

     Through April 30, 2002, the Company loaned, on a full recourse basis, an aggregate of $1,441,000, to an officer, certain employees and a consultant of the Company. In May 2002, the Company loaned, on a full recourse basis, $50,000 to another officer of the Company, which together with accrued interest, was paid in full in March 2003, after that officer left the employ of the Company. All loans are evidenced by promissory notes bearing interest with rates ranging from 5.00% to 8.00% per annum. The loans are payable over periods ranging from one to five years and in each case are secured by assets of the borrower, including shares of the Company’s common stock owned by the borrower. The long-term portion of the loans is included in long-term notes receivable from related parties, and the short-term portion of approximately $288,000 and $128,000 at September 27, 2003 and December 31, 2002, respectively, is included in other current assets in the accompanying consolidated balance sheets. The aggregate outstanding balance on these loans at September 27, 2003 and December 31, 2002 was approximately $1,038,000 and $1,160,000, respectively.

     In January 2002, the Company entered into a consulting agreement with one of its directors to provide consulting, advisory and neurodiagnostics business planning services to the Company. Effective April 11, 2003, this director resigned from the Company’s Board of Directors. As of September 27, 2003, the Company has paid approximately $9,000 to this former director under this consulting agreement.

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ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

(8)

Loan Agreements

     In May 2001, the Company entered into an agreement with a commercial bank for a revolving line of credit. The Company is entitled to borrow up to $5,000,000 under the revolving line of credit, which expires in May 2004 and, subject to annual review by the commercial bank, may be extended at the discretion of the commercial bank. Interest on any borrowings under the revolving line of credit is, at the election of the Company, either the prime rate or at LIBOR plus 2.25%. Up to $1,500,000 of the $5,000,000 revolving line of credit is available for standby letters of credit. At September 27, 2003, the Company had outstanding standby letters of credit totaling $190,137.

     The revolving line of credit agreement contains restrictive covenants that require the Company to maintain liquidity and net worth ratios and is secured by certain investments of the Company, which are shown as restricted cash in the accompanying consolidated balance sheets, in an amount equal to 102% of the $5,000,000 commitment, or $5,100,000. At September 27, 2003, there was no outstanding balance under the revolving line of credit. In addition, the Company was in compliance with all covenants contained in the revolving line of credit agreement as of September 27, 2003. At September 27, 2003, the interest rate on the revolving line of credit was 4.00%.

     In August 2002, the Company entered into an agreement for a $5,000,000 revolving line of credit with BSC in connection with a strategic alliance (see Note 9).

(9)

Strategic Alliance with Boston Scientific Corporation

     On August 7, 2002, the Company formed a strategic alliance with BSC. In connection with this strategic alliance, the Company sold 1,428,572 shares of the Company’s common stock at a purchase price per share of $7.00 to BSC pursuant to a stock purchase agreement. In addition, the Company granted BSC an option under an OEM product development and distribution agreement to distribute newly developed technology for monitoring patients under sedation in a range of less-invasive medical specialties. Gross cash proceeds from this sale of common stock were $10,000,004. Approximately $5,685,000 of the aggregate purchase price is recorded as deferred revenue in the accompanying consolidated balance sheet at September 27, 2003, which represents the portion of the purchase price in excess of the closing price of the Company’s common stock on August 7, 2002. The deferred revenue will be recognized ratably over the term of the OEM agreement. Approximately $154,000 was recognized as revenue in the three months ended September 27, 2003 and approximately $461,000 was recognized as revenue in the nine months ended September 27, 2003. The term of the agreement continues until such time that BSC is no longer distributing the Company’s products, but in no event will extend beyond December 31, 2012.

     As part of the strategic alliance with BSC, the Company also entered into an agreement pursuant to which BSC has agreed to provide the Company a $5,000,000 revolving line of credit, which expires in August 2007 and may be extended at the discretion of BSC. Interest on any borrowings under this revolving line of credit is at a rate equal to the LIBOR rate at which BSC, under its own revolving credit facility, is entitled to borrow funds, plus any additional amounts payable thereon by BSC under such revolving credit facility, plus eighty basis points. The Company’s revolving line of credit with BSC is secured by the Company’s inventory and certain of the Company’s accounts receivable and contains certain restrictive covenants covering the collateral. At September 27, 2003, there was no outstanding balance under this revolving line of credit, and the Company was in compliance with all covenants contained in the revolving line of credit agreement.

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     This Quarterly Report on Form 10-Q contains, in addition to historical information, forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. These forward-looking statements involve risks and uncertainties and are not guarantees of future performance. Words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate” and variations of these words and similar expressions are intended to identify forward-looking statements. Our actual results could differ significantly from the results discussed in these forward-looking statements. In addition, subsequent events and developments may cause our expectations to change. While we may elect to update these forward-looking statements, we specifically disclaim any obligation to do so, even if our expectations change. See the important factors in the cautionary statements below under the heading “Factors Affecting Future Operating Results” that we believe could cause our actual results to differ materially from the forward-looking statements we make.

Overview

     We develop, manufacture and market an anesthesia monitoring system that we call the BIS® system. The BIS system is based on our patented core technology, the Bispectral Index, which we refer to as the BIS index. The BIS system provides information that allows clinicians to better assess and manage a patient’s level of consciousness in the operating room and intensive care settings and administer the precise amount of anesthesia needed by each patient. Our proprietary BIS system includes our BIS monitor, or our BIS Module Kit, which allows original equipment manufacturers to incorporate the BIS index into their monitoring products, and our single-use disposable BIS Sensors. We collectively refer to our group of disposable sensors as BIS Sensors.

     Our latest generation monitor, the A-2000® BIS Monitor, was cleared for marketing by the United States Food and Drug Administration, or the FDA, in February 1998. Our latest version of the BIS system, the BIS XP system, was cleared for marketing by the FDA in June 2001. In addition to our A-2000 BIS Monitor, we offer original equipment manufacturers our BIS Module Kit for integration into equipment sold by the original equipment manufacturers.

     We follow a system of fiscal quarters as opposed to calendar quarters. Under this system, the first three quarters of each fiscal year end on the Saturday closest to the end of the calendar quarter and the last quarter of the fiscal year always ends on December 31.

     We derive our revenue primarily from sales of monitors, BIS Module Kits, and related accessories, which we collectively refer to as Equipment, and sales of BIS Sensors. In the three months ended September 27, 2003 and September 28, 2002, revenue from the sale of Equipment represented approximately 33% and 31%, respectively, of our revenue, and revenue from the sale of BIS Sensors represented approximately 67% and 69%, respectively, of our revenue. In the nine months ended September 27, 2003 and September 28, 2002, revenue from the sale of Equipment represented approximately 32% and 34%, respectively, of our revenue, and revenue from the sale of BIS Sensors represented approximately 68% and 66%, respectively of our revenue.

     We believe our ability to grow our revenue is directly related to our ability to sell our Equipment to healthcare organizations and influence our customers to purchase and use our BIS Sensors. We believe the increase in our installed base of Equipment resulting from the sale of BIS monitors and the sale of original equipment manufacturers’ equipment incorporating our BIS Module Kit has been the primary reason for the growth in revenue from the sale of BIS Sensors. In order to successfully grow our business, we need to continue to focus on both selling our Equipment and improving our per monitor and per module sensor utilization rate. To achieve this growth, we continue to implement new sales and marketing programs. We expect that as we grow our business, revenue from the sale of BIS Sensors should contribute an increasing percentage of total revenue. Additionally, we believe that over time, revenue from the sale of BIS Module Kits will increase as a percentage of total Equipment revenue as healthcare organizations purchase our technology as part of an integrated solution offered by our original equipment manufacturers.

     For those healthcare organizations desiring to purchase our BIS monitors, we offer two options. Our customers have the option either to purchase BIS monitors outright or to acquire BIS monitors pursuant to a sales-type lease agreement whereby the customer contractually commits to purchase a minimum number of BIS Sensors per BIS monitor per year. Under this agreement, our customers purchase BIS Sensors and the BIS monitor for the purchase price of the BIS Sensors plus an additional charge per BIS Sensor to pay for the purchase price of the BIS monitor and related financing costs over the term of the agreement. These customers are granted an option to purchase the BIS monitors at the end of the term of the agreement, which is typically three to five years. Revenue related to BIS monitors sold pursuant to sales-type leases is recognized at the time of shipment of the BIS monitors. Sales-type leases accounted for approximately 3% and 4% of total revenue in both the three and nine month periods ended September 27, 2003 and September 28, 2002, respectively.

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     Under certain limited circumstances, we also offer customers the opportunity to use the BIS monitors under our Equipment Placement program, which we refer to as the EP program. Under the EP program, the customer is granted the right to use the BIS monitors for a mutually agreed upon period of time. During this period, the customer purchases BIS Sensors at a price that includes a premium above the list price of the BIS Sensors to cover the rental of the equipment, but without any minimum purchase commitments. At the end of the agreed upon period, the customer has the option of purchasing the BIS monitors, continuing to use them under the EP program or returning them to us. Beginning in 2002, we substantially reduced our focus and reliance on the EP program.

     Revenue from domestic sales in the three months ended September 27, 2003 and September 28, 2002 was approximately $9.2 million and $8.3 million, respectively, which represented approximately 82% and 83%, respectively, of our revenue for those periods. For the nine months ended September 27, 2003 and September 28, 2002, revenue from domestic sales was approximately $25.8 million and $24.7 million, respectively, which represented approximately 81% and 83%, respectively, of our revenue for those periods. Revenue from international sales in the three months ended September 27, 2003 and September 28, 2002 was approximately $2.0 million and $1.7 million, respectively, which represented approximately 18% and 17%, respectively, of our revenue for those periods. Revenue from international sales in the nine months ended September 27, 2003 and September 28, 2002 was approximately $6.2 million and $5.0 million, respectively, which represented approximately 19% and 17%, respectively, of our revenue for those periods.

     We have subsidiaries in The Netherlands and the United Kingdom to facilitate the sale of our products into the international market. We are continuing to develop our international sales and distribution program through a combination of distributors and marketing partners, including companies with which we have entered into original equipment manufacturer relationships. In January 1998, we entered into a distribution agreement with Nihon Kohden Corporation to distribute BIS monitors in Japan. In March 2000, Nihon Kohden received approval from the Japanese Ministry of Health, Labor and Welfare for marketing in Japan our A-1050 EEG Monitor with BIS and in May 2001, received approval for marketing in Japan our A-2000 BIS Monitor. Nihon Kohden has requested but has not yet received approval to market the BIS XP system in Japan. In January 2002, the Japanese Ministry of Health, Labor and Welfare granted reimbursement approval for use of our BIS monitors. With this approval, healthcare providers in Japan are eligible to receive partial reimbursement of 1,000 Yen each time BIS monitoring is used. In July 2002, the Japanese Ministry of Health, Labor and Welfare approved our BIS module for marketing in Japan. Sales to Nihon Kohden represented approximately 12% and 13%, respectively, of international revenue for the three and nine months ended September 27, 2003 and approximately 16% and 25%, respectively of international revenue for the three and nine months ended September 28, 2002.

     We believe that maintaining our gross margin and controlling the growth of our operating expenses are important factors for us to manage in order to successfully grow our business and achieve profitability. To maintain our gross margin we believe we must continue to focus on maintaining our average unit prices for both monitors and BIS Sensors, increase revenue from the sale of BIS Sensors as a percentage of total revenue, as BIS Sensors have a higher gross margin than Equipment, and continue to reduce the costs to manufacture our products.

     In addition, the transition from monitor placements to module placements has adversely impacted our gross margin on Equipment. However, we believe that this transition should, over time, improve our total gross margin as we expect module placements to be a contributing factor to increasing revenue from the sale of our BIS Sensors.

     In the fourth quarter of 2002, we reduced our headcount. We believe this headcount reduction, in combination with other cost reductions implemented in 2002 and our continuing focus on cost control in 2003, should drive us closer to our goal of achieving profitability.

     Various factors may adversely affect our quarterly operating results through the fourth quarter of 2003. These factors include a potentially adverse effect on Equipment revenue and gross margin on Equipment as we continue to shift the focus of our placements from BIS monitors to BIS modules. In addition, in Japan, Nihon Kohden is awaiting approval of the BIS XP system, and we believe customers may continue to delay purchases of our products or may choose not to purchase our products pending this approval. Finally, on November 1, 2003, our international master distribution agreement with Datex-Ohmeda expired. We plan to replace this agreement with country-specific distribution agreements with Datex-Ohmeda sales subsidiaries and other distributors. A delay in signing these country-specific distribution agreements may adversely affect Equipment revenue in the international market. To date, we have entered into several new country-specific distribution agreements, and we continue to negotiate others.

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Critical Accounting Policies

     Financial Reporting Release No. 60, which was released by the Securities and Exchange Commission, or SEC, in December 2001, proposes a rule that requires all companies to include a discussion of critical accounting policies or methods used in the preparation of financial statements. Note 2 of the Notes to Consolidated Financial Statements in this Quarterly Report on Form 10-Q includes a summary of our significant accounting policies and methods used in the preparation of our financial statements. In preparing these financial statements, we have made estimates and judgments in determining certain amounts included in the financial statements. The application of these accounting policies involves the exercise of judgment and use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates. We do not believe there is a great likelihood that materially different amounts would be reported under different conditions or using different assumptions. We believe that our critical accounting policies are as follows:

   Revenue Recognition

     Our revenue is recognized in accordance with SEC Staff Accounting Bulletin, or SAB, No. 101, Revenue Recognition in Financial Statements, which provides guidance related to revenue recognition in financial statements. We recognize revenue from Equipment sales, disposable product sales and sales-type leases at the time of product shipment when collectibility is reasonably assured. Payments received prior to shipment are recorded as deferred revenue. We have entered into certain licensing and distribution agreements for which payments received in advance are also recorded as deferred revenue. Revenue under these agreements is recognized as earned in accordance with the terms of the respective agreements.

     We do not record a provision for estimated sales returns because historically we have experienced only minimal returns that were not covered by warranty reserves. To the extent returns increase in future periods, we would be required to re-evaluate our revenue recognition policy in accordance with Statement of Financial Accounting Standards, or SFAS, No. 48, Revenue Recognition When Right of Return Exists.

   Accounts Receivable

     We determine our allowance for doubtful accounts by using estimates based on our historical collections experience, current trends, historical write-offs of our receivables, credit policy and a percentage of our accounts receivable by aging category. We also review the credit quality of our customer base as well as changes in our credit policies. We continuously monitor collections and payments from our customers. While credit losses have historically been within our expectations and the provisions established, our credit loss rates in the future may not be consistent with our historical experience. To the extent we experience a deterioration in our historical collections experience or increased credit losses, bad debt expense would likely increase in future periods.

   Inventories

     We value inventory at the lower of cost or estimated market, and determine cost on a first-in, first-out basis. We regularly review inventory quantities on hand and record a provision for excess or obsolete inventory primarily based on production history and on our estimated forecast of product demand. The medical industry in which we market our products is characterized by rapid product development and technological advances that could result in obsolescence of inventory. Additionally, our estimates of future product demand may prove to be inaccurate, in which case we will need to change our estimate of the provision required for excess and obsolete inventory. If revisions are deemed necessary, we would recognize the adjustments in our costs of revenue at the time of the determination. Therefore, although we continually update our forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and our results of operations in future periods.

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   Investment in Sales-Type Leases

     We follow SFAS No. 13, Accounting For Leases, for our investment in sales-type leases. Under our sales-type leases, customers purchase BIS Sensors and the BIS monitor for the purchase price of the BIS Sensors plus an additional charge per BIS Sensor to pay for the purchase price of the BIS monitor and related financing costs over the term of the agreement. In accordance with SFAS No. 13, the minimum lease payment, consisting of the additional charge per BIS Sensor, less the unearned interest income, which is computed at the interest rate implicit in the lease, is recorded as net investment in sales-type leases. The cost of the BIS monitor acquired by the customer is recorded as costs of revenue in the same period.

     In addition, we periodically review and assess the net realizability of our investment in sales-type leases. This review includes determining if a customer who entered into a sales-type lease is significantly underperforming relative to the customer’s committed level of BIS Sensor purchases. If this review results in a lower estimate of the net realizable investment balance, an allowance for the unrealized amount is established in the period in which the estimate is changed and charged to revenue. Therefore, if in any period where we determine that a significant number of customers who entered into sales-type leases are underperforming in their respective commitments, it could have an impact on our results of operations.

   Warranty

     Equipment that we sell is generally covered by a warranty period of one year. We accrue a warranty reserve for estimated costs to provide warranty services. Our estimate of costs to service our warranty obligations is based on our historical experience and expectation of future conditions. While our warranty costs have historically been within our expectations and the provisions established, to the extent we experience increased warranty claim activity or increased costs associated with servicing those claims, our warranty accrual will increase, and we would experience decreased gross profit margin.

Results of Operations

     The following table presents, for the three and nine month periods ended September 27, 2003 and September 28, 2002, certain information from our consolidated statements of operations expressed as a percentage of revenue. This information has been derived from our consolidated statements of operations included elsewhere in this Quarterly Report on Form 10-Q. You should not draw any conclusions about our future results from the results of operations for any period.

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Three and Nine Months Ended September 27, 2003 Compared to Three and Nine Months Ended September 28, 2002

     Revenue. Our revenue increased approximately 12% from approximately $11.2 million in the three months ended September 27, 2003 to approximately $10.0 million in the three months ended September 28, 2002. Our revenue increased approximately 8% to approximately $32.0 million in the nine months ended September 27, 2003 from approximately $29.7 million in the nine months ended September 28, 2002.

     Revenue from the sale of BIS Sensors increased approximately 9% from approximately $7.5 million in the three months ended September 27, 2003 to approximately $6.9 million in the three months ended September 28, 2002. The increase in revenue from the sale of BIS Sensors in the three months ended September 27, 2003 compared to the three months ended September 28, 2002 was attributable to an increase of approximately 7% in the average selling price of BIS Sensors and an increase of approximately 2% in the number of BIS Sensors sold as a result of growth in the installed base of monitors and modules. Revenue from the sale of Equipment increased approximately 18% to approximately $3.7 million in the three months ended September 27, 2003 from approximately $3.1 million in the three months ended September 28, 2002. The increase in Equipment revenue in the three months ended September 27, 2003 compared to the three months ended September 28, 2002 was primarily driven by an increase of approximately 166% in module revenue and an increase of approximately 9% in monitor revenue. The increase in module revenue for this period was a result of an approximate 152% increase in unit volume, as we shipped 740 modules to our original equipment manufacturers in the third quarter of 2003 as compared to 294 modules shipped to our original equipment manufacturers in the third quarter of 2002. The increase in monitor revenue in the same period was primarily due to an increase of approximately 8% in the average unit price on comparable unit volume. In the third quarter of 2003, we shipped 342 monitors as compared to 339 monitors in the third quarter of 2002. The increase in module and monitor revenue in the three months ended September 27, 2003 compared to the three months ended September 28, 2002 was partially offset by a decrease in revenue from the sale of XP upgrade kits and accessories of approximately 22%. The decrease in revenue from the sale of XP upgrade kits and accessories was primarily related to a decrease of approximately 24% in revenue from the sale of XP upgrade kits which resulted from a decrease of approximately 25% in the average unit price on comparable unit volume.

     In the nine months ended September 27, 2003, revenue from the sale of BIS Sensors increased approximately 10% to approximately $21.7 million from approximately $19.7 million in the nine months ended September 28, 2002. The increase in revenue from the sale of BIS Sensors for the nine month period ended September 27, 2003 compared to the nine month period ended September 28, 2002 resulted primarily from an increase of approximately 5% in the average selling price of BIS Sensors and an increase of approximately 5% in the number of BIS Sensors sold. Our installed base of monitors and modules increased approximately 21% at September 27, 2003 compared to September 28, 2002, to more than 18,600 units. In the nine months ended September 27, 2003, Equipment revenue increased approximately 3% to approximately $10.3 million from approximately $10.0 million in the nine months ended September 28, 2002. In the nine months ended September 27, 2003 compared to the nine months ended September 28, 2002, the increase in Equipment revenue was primarily driven by an increase in module revenue of approximately 133%. The increase in module revenue in this period was the result of an increase of approximately 113% in the number of module kits shipped to our original equipment manufacturers, from 827 module kits in the first nine months of 2002 to 1,758 module kits in the first nine months of 2003. The increase in module revenue in this same period was partially offset by a decrease in monitor revenue of approximately 19%. The decrease in monitor revenue in the nine month period resulted from a decrease of approximately 28% in unit volume, as we shipped 993 monitors in the nine months ended September 27, 2003 compared to 1,378 monitors in the nine months ended September 28, 2002. In this same period, domestic monitor sales decreased from 800 monitors to 575 monitors, a decrease of approximately 28%. Additionally, because Nihon Kohden is awaiting approval from the Japanese Ministry of Health, Labor and Welfare of the XP technology, sales of monitor units in Japan decreased from 200 monitors in the first nine months of 2002 to none in the first nine months of 2003.

     Our gross profit margin was approximately 75% of revenue in both the three and nine months ended September 27, 2003 compared to a gross profit margin of approximately 72% and 69% of revenue in the three and nine months ended September 28, 2002, respectively. The increase in gross profit margin for the three and nine months ended September 27, 2003 compared to the three and nine months ended September 28, 2002 was the result of four factors. First, we experienced increased sales of our BIS Sensors as a percentage of total revenue during the nine month period ended September 27, 2003 compared to the nine months ended September 28, 2002. In the three months ended September 27, 2003 compared to the three months ended September 28, 2002, sales of our BIS Sensors as a percentage of total revenue decreased slightly. However, in both the three and nine month periods there was an increase in the average unit price of BIS Sensors. BIS Sensors have a higher gross margin than Equipment. Second, we had a higher average unit price on monitors in both periods of 2003 compared to 2002. Third, we have had a reduction in depreciation expense related to monitors used in the EP program as the existing pool of monitors becomes fully depreciated and we substantially reduce our focus and reliance on the EP program. Finally, we recognized approximately $154,000 and $461,000 of deferred revenue in the three and nine months ended September 27, 2003 related to the strategic alliance with Boston Scientific Corporation without any corresponding costs of revenue, increasing the gross profit margin by approximately 2% in both the three and nine month periods.

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     Research and Development. Research and development expenses decreased approximately 14% to approximately $1.6 million in the three months ended September 27, 2003 from approximately $1.9 million in the three months ended September 28, 2002. Research and development expenses decreased approximately 8% to approximately $5.4 million in the nine months ended September 27, 2003 from approximately $5.8 million in the nine months ended September 28, 2002. The decrease in research and development expenses for the three months ended September 27, 2003 was primarily attributable to a decrease in clinical studies expenses of approximately $177,000 as a result of the completion of various multi-center, multinational studies to assess the incidence of awareness, and a decrease in payroll expense of approximately $80,000.

     The decrease in research and development expenses for the nine months ended September 27, 2003 was primarily attributable to a decrease in personnel and related payroll and other expenses of approximately $395,000 and a decrease in clinical studies expenses of approximately $186,000. These decreases were offset by increases in consulting expenses of approximately $152,000 and product development expenses of approximately $104,000. We expect research and development expenses to increase in the fourth quarter of 2003 compared to the third quarter of 2003 as we continue to invest in clinical studies and expand applications for our technology, including our initiatives into neuroscience.

     Sales and Marketing. Sales and marketing expenses decreased approximately 10% to approximately $6.3 million in the three months ended September 27, 2003 from approximately $7.0 million in the three months ended September 28, 2002. Sales and marketing expenses decreased approximately 13% to approximately $18.5 million in the nine months ended September 27, 2003 from approximately $21.3 million in the nine months ended September 28, 2002. The decrease in sales and marketing expenses in the three months ended September 27, 2003 was attributable to decreases in travel and entertainment expenses of approximately $165,000, operating expenses associated with our international subsidiaries of approximately $214,000 and approximately $288,000 in expenses related to advertising, public relations, tradeshows and the internet. These decreases were partially offset by an increase in commissions expense of approximately $239,000.

     The decrease in sales and marketing expenses for the nine months ended September 27, 2003 was primarily attributable to decreases in payroll expense of approximately $498,000, operating expenses associated with our international subsidiaries of approximately $1.0 million, approximately $691,000 in expenses related to advertising, public relations, tradeshows and the internet, travel and entertainment expenses of approximately $618,000 and approximately $134,000 in clinical education initiative expenses. These decreases were partially offset by an increase in commissions expense of approximately $783,000. The decrease of approximately $1.0 million in operating expenses associated with our international subsidiaries was driven by a decrease of approximately $644,000 in personnel related payroll and other expenses. We expect sales and marketing expenses in the fourth quarter of 2003 to decrease compared to the third quarter of 2003 as a result of cost reductions in various programs and improved control over discretionary spending.

     General and Administrative. General and administrative expenses increased approximately 6% to approximately $2.1 million in the three months ended September 27, 2003 from approximately $2.0 million in the three months ended September 28, 2002. General and administrative expenses increased approximately 11% to approximately $6.4 million in the nine months ended September 27, 2003 from approximately $5.7 million in the nine months ended September 28, 2002. The increase in general and administrative expenses for the three months ended September 27, 2003 was primarily attributable to an increase in personnel related payroll and other expenses of approximately $284,000. This increase was partially offset by a decrease of approximately $50,000 in our provision for doubtful accounts. In the nine months ended September 27, 2003, the increase in general and administrative expenses was due to an increase in personnel and related payroll and other expenses of approximately $752,000, which includes an accrual of approximately $367,000 related to the special bonus program for our chief executive officer, and an increase of approximately $98,000 primarily as a result of an increase in the annual premium for our directors and officers liability insurance coverage. These increases were offset by a decrease of approximately $150,000 in our provision for doubtful accounts due to improvements in our historical collection experience. We expect general and administrative expenses in the fourth quarter of 2003 to remain comparable to the third quarter of 2003.

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     Interest Income, Net. Net interest income decreased approximately 27% to approximately $167,000 in the three months ended September 27, 2003 from approximately $229,000 in the three months ended September 28, 2002. Net interest income decreased approximately 25% to approximately $546,000 in the nine months ended September 27, 2003 from approximately $732,000 in the nine months ended September 28, 2002. Interest income decreased approximately 26% to approximately $215,000 in the three months ended September 27, 2003 from approximately $290,000 in the three months ended September 28 2002. Interest income decreased approximately 24% to approximately $702,000 in the nine months ended September 27, 2003 from approximately $918,000 in the nine months ended September 28, 2002. The decrease in interest income was primarily attributable to lower cash and investment balances resulting from continued operating losses and our other uses of cash, and lower interest rates on our investments as a result of general interest rate declines.

     Interest expense decreased approximately 20% to approximately $48,000 in the three months ended September 27, 2003 from approximately $60,000 in the three months ended September 28, 2002. Interest expense decreased approximately 16% to approximately $156,000 in the nine months ended September 27, 2003 from approximately $186,000 in the nine months ended September 28, 2002. The decrease in interest expense in the three and nine months ended September 27, 2003 was a result of lower average outstanding debt obligations because we did not draw down on our lines of credit for the three and nine months ended September 27, 2003. We expect net interest income to decrease slightly in the fourth quarter of 2003 as compared to the third quarter of 2003 as a result of continuing low interest rates and a lower cash and investments balance.

     Net Loss. As a result of the factors discussed above, for the three and nine months ended September 27, 2003, we had a net loss of approximately $1.4 million and $5.7 million, respectively, as compared to a net loss of approximately $3.4 million and $11.8 million for the three and nine months ended September 28, 2002.

Liquidity and Capital Resources

     Our liquidity requirements have historically consisted of research and development expenses, sales and marketing expenses, capital expenditures, working capital and general corporate expenses. From our inception through January 2000, we financed our operations primarily from the sale of our convertible preferred stock. Through September 27, 2003, we raised approximately $77.6 million from private equity financings and have received approximately $3.4 million in equipment financing and approximately $5.1 million of financing related to our investments in sales-type leases. We also received approximately $2.8 million of financing under a term loan in December 1999. The outstanding principal on the equipment and term loans was paid in May 2001. In February 2000, we closed our initial public offering of an aggregate of 4,025,000 shares of common stock and received net proceeds of approximately $54.6 million. In May 2001, we entered into an agreement with Fleet National Bank for a $5.0 million revolving line of credit which expires in May 2004. The revolving line of credit agreement contains restrictive covenants that require us to maintain liquidity and net worth ratios and is secured by certain of our investments which are shown as restricted cash on our consolidated balance sheet. We are required to maintain restricted cash and securities with a net equity value equal to 102% of the $5.0 million commitment.

     In August 2002, we entered into a strategic alliance with Boston Scientific Corporation whereby we sold 1,428,572 shares of our common stock at a purchase price per share of $7.00 to Boston Scientific Corporation pursuant to a stock purchase agreement. Gross cash proceeds from this sale of common stock were $10,000,004.

     We also entered into an agreement with Boston Scientific Corporation for a revolving line of credit under which we are entitled to borrow up to $5.0 million under the revolving line of credit which expires in August 2007 and may be extended at the discretion of Boston Scientific Corporation. Interest on any borrowings under this revolving line of credit is at a rate equal to the LIBOR rate at which Boston Scientific Corporation, under its own revolving credit facility, is entitled to borrow funds plus any additional amounts payable thereon by Boston Scientific Corporation under such revolving credit facility, plus eighty basis points. Our revolving line of credit with Boston Scientific Corporation is secured by our inventory and certain of our accounts receivable and contains certain restrictive covenants covering the collateral. At September 27, 2003, there was no outstanding balance under this revolving line of credit.

     We expect to meet our short-term liquidity needs through the use of cash and short-term investments on hand at September 27, 2003.

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     We believe that the financial resources available to us, including our current working capital and available revolving lines of credit will be sufficient to finance our planned operations and capital expenditures through the end of 2004. However, our future liquidity and capital requirements will depend upon numerous factors, including the resources required to further develop our marketing and sales organization domestically and internationally, to finance our research and development programs, to implement new marketing programs, to finance our sales-type lease program and to meet market demand for our products.

     Working capital at September 27, 2003 was approximately $31.6 million compared to approximately $36.7 million at December 31, 2002. The decrease in working capital from December 31, 2002 to September 27, 2003 was primarily attributable to our continued net loss of approximately $5.7 million.

     We used approximately $4.9 million of cash for operations in the nine months ended September 27, 2003 as compared to approximately $8.9 million, excluding an increase in deferred revenue of approximately $6.3 million related to proceeds received in connection with the strategic alliance entered into in August 2002, in the nine months ended September 28, 2002. The $6.3 million of deferred revenue represents the portion of the purchase price of the shares of our common stock in excess of the closing price of our common stock on the date of the sale. Cash used for operations in the nine months ended September 27, 2003 was primarily driven by operating losses, an increase in accounts receivable of approximately $505,000, an increase in other assets of approximately $222,000 and a decrease in deferred revenue of approximately $698,000, offset by a decrease in inventory of approximately $699,000. In the nine months ended September 28, 2002 cash used for operations was primarily driven by operating losses offset by a decrease in inventory of approximately $2.3 million.

     We received approximately $3.6 million of cash from investing activities in the nine months ended September 27, 2003 as compared to approximately $12.6 million in the nine months ended September 28, 2002. The cash received from investing activities in the nine months ended September 27, 2003 was primarily the result of the sales and maturities of our investments in marketable securities. We received approximately $4.0 million, net, of proceeds from sales and maturities of marketable securities and invested approximately $492,000 primarily in our information systems in the nine months ended September 27, 2003. In the nine months ended September 28, 2002, we received approximately $13.4 million, net, of proceeds from sales and maturities of marketable securities and invested approximately $855,000 primarily in information systems and machinery and equipment.

     We used approximately $163,000 of cash for financing activities in the nine months ended September 27, 2003 primarily as a result of payments of principal on debt related to our investment in sales-type leases of approximately $738,000 offset by proceeds from the sale of our investment in sales-type leases of approximately $266,000, payments received on notes receivable from employees and directors of approximately $154,000 and the issuance of shares of our common stock upon the exercise of stock options and for purchases under our employee stock purchase plan of approximately $155,000. In the nine months ended September 28, 2002, we received approximately $893,000 of cash from financing activities primarily as a result of proceeds from the issuance of shares of our common stock in connection with a strategic alliance entered into in August 2002 of approximately $3.8 million and approximately $716,000 in proceeds from the sale of our investment in sales-type leases. These were offset by payment on our working capital line of credit of approximately $3.0 million and approximately $729,000 of payments of principal on debt related to our investment in sales-type leases.

     In May 2001, we entered into an agreement with Fleet National Bank for a revolving line of credit, which provides for borrowing of up to $5.0 million. The revolving line of credit expires in May 2004 and, subject to annual review by the bank, may be extended at the discretion of Fleet National Bank. Interest on any borrowings under the revolving line of credit is, at our election, either the prime rate or at LIBOR plus 2.25%. At September 27, 2003, the interest rate on the line of credit was 4.00%. The revolving line of credit agreement contains restrictive covenants that require us to maintain liquidity and net worth ratios and is secured by certain of our investments which are shown as restricted cash on our consolidated balance sheet. We are required to maintain restricted cash and securities with a net equity value equal to 102% of the $5.0 million commitment. Up to $1.5 million of the $5.0 million revolving line of credit is available for standby letters of credit. There was no outstanding balance under the line of credit at September 27, 2003. At September 27, 2003, we had standby letters of credit outstanding in the amount of $190,137.

     We guarantee approximately $139,000 of operating lease obligations of our subsidiaries for the lease of office space and automobiles.

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     In July 1999, we entered into an agreement under which we can sell a portion of our existing and future investments in sales-type leases to Americorp Financial, Inc. Through September 27, 2003, we sold approximately $5.1 million of our investments in sales-type leases. In accordance with SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities — A replacement of FASB Statement No. 125, the proceeds from these sales are classified as debt. Payments on the outstanding principal under this debt match the timing of the payments due on the underlying investments in sales-type leases. At September 27, 2003, approximately $1.4 million is recorded as debt on our consolidated balance sheet.

     We had capital expenditures of approximately $492,000 for the nine months ended September 27, 2003, primarily related to our information systems. At September 27, 2003, we did not have any commitments for capital expenditures. We anticipate that the level of capital expenditures in the fourth quarter of 2003 will be slightly higher than the level of capital expenditures in the third quarter of 2003.

     We have summarized below our contractual cash obligations as of September 27, 2003: