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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 30, 2003

Commission file number: 0-21154

CREE, INC.

(Exact name of registrant as specified in its charter)

(919) 313-5300

(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.    x  Yes    ¨  No

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

The number of shares outstanding of the registrant’s common stock, par value $0.00125 per share, as of April 17, 2003 was 73,294,925.

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CREE, INC.

FORM 10-Q

For the Quarter Ended March 30, 2003

INDEX

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PART I—FINANCIAL INFORMATION

Item 1—Financial Statements

CREE, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)

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

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CREE, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

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

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CREE, INC.

CONSOLIDATED STATEMENTS OF CASH FLOW

(In thousands)

(Unaudited)

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

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CREE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Basis of Presentation

The consolidated balance sheet as of March 30, 2003, the consolidated statements of operations for the three and nine months ended March 30, 2003 and March 24, 2002, and the consolidated statements of cash flow for the nine months ended March 30, 2003 and March 24, 2002 have been prepared by the Company and have not been audited. In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial position, results of operations and cash flow at March 30, 2003 and for all periods presented have been made. The consolidated balance sheet at June 30, 2002 has been derived from the audited financial statements as of that date.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. It is suggested that these condensed financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s fiscal 2002 Annual Report on Form 10-K. The results of operations for the period ended March 30, 2003 are not necessarily indicative of the operating results that may be attained for the entire fiscal year.

Accounting Policies

Principles of Consolidation

The consolidated financial statements include the accounts of Cree, Inc., and its wholly-owned subsidiaries, Cree Microwave, Inc. (“Cree Microwave”), Cree Lighting Company (“Cree Lighting”), Cree Funding, LLC, Cree Employee Services Corporation, CI Holdings, Limited, Cree Technologies, Inc., Cree Asia-Pacific, Inc. and Cree Japan, Inc. All material intercompany accounts and transactions have been eliminated in consolidation.

Business Combination

On December 29, 2000, the Company completed the acquisition of the UltraRF division of Spectrian Corporation, or Spectrian, through the purchase of assets of the business by Cree’s wholly owned subsidiary, now known as Cree Microwave, in a business combination accounted for under the purchase method. Under the terms of the Asset Purchase Agreement, Cree Microwave acquired substantially all of the assets of the business from Spectrian in exchange for a total of 2,656,917 shares of Cree common stock valued at $113.5 million. Of the total shares issued, 191,094 shares were placed in escrow and proceeds from the sale of such shares retained in escrow to secure Spectrian’s representations, warranties and covenants under the Asset Purchase Agreement. Under the terms of the escrow arrangement, one-half of the funds were released to Spectrian in June 2001 and the balance was released in December 2001 because no claims were made against the escrowed assets. The value of the Company’s common stock

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issued as consideration for the acquisition of Cree Microwave was determined based on the number of shares issued multiplied by the closing price of the Company’s common stock on November 20, 2000, which was the most recent market price prior to the announcement of the transaction. The results of operations of Cree Microwave have been included in the consolidated results of the Company since the date of acquisition.

In the third quarter of fiscal 2001, the Company recorded a $17.4 million charge for the value of in process research and development projects, or “IPR&D,” acquired from Spectrian. IPR&D represents the value assigned in a purchase business combination to research and development projects of the acquired business that had commenced but had not yet been completed at the date of acquisition and which have no alternative future use. In accordance with SFAS No. 2, “Accounting for Research and Development Costs,” as clarified by FASB Interpretation No. 4, amounts assigned to IPR&D meeting the above-stated criteria must be charged to expense as part of the allocation of the purchase price of the business combination. The income approach was utilized to value the IPR&D projects. Under the standard income approach, the fair value of an IPR&D project reflects the present value of the projected operating cash flows estimated to be generated by the project. Management is primarily responsible for this cash flow analysis and, as a part of its analysis, considers the cost to complete the project, the relative risk of the project, the contribution of other assets and an appropriate risk adjusted discount rate. For purposes of the Company’s analysis, the standard income approach was modified. This analysis included the stage of completion of each project, the exclusion of value related to research and development yet-to-be completed as part of the ongoing IPR&D projects and the inclusion of only the incremental operating cash flows attributable to the IPR&D. As of the acquisition date, two projects targeted for completion within six months were considered as IPR&D. One project was completed in fiscal 2001 the other project was abandoned in fiscal 2002.

Business Segments

The Company operates in two business segments, Cree and Cree Microwave. The Cree segment produces wide bandgap compound semiconductors using silicon carbide, or SiC, and gallium nitride, or GaN, technology. Products from this segment are used in cellular handsets, automotive backlighting, indicator lamps, full color LED displays and other lighting applications as well as microwave and power applications. The Cree segment also sells SiC material products to corporate, government and university research laboratories and generates revenue from contracts with agencies of the U.S. Federal government.

The Cree Microwave segment designs, manufactures and markets a line of silicon-based laterally diffused metal oxide semiconductors, or LDMOS, and bipolar radio frequency power semiconductors and modules, the critical component utilized in building power amplifiers for wireless infrastructure applications.

Summarized financial information concerning the reportable segments as of and for the three and nine months ended March 30, 2003 and March 24, 2002 is shown in the following table. The “Other” column represents amounts excluded from specific segments such as interest income. In addition, the “Other” column also includes corporate assets such as cash and cash equivalents, short-term investments held to maturity, marketable securities, interest receivable and long-term investments held to maturity which have not been allocated to a specific segment.

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Reclassifications

Certain fiscal 2002 amounts in the accompanying consolidated financial statements have been reclassified to conform to the fiscal 2003 presentation. These reclassifications had no effect on previously reported net loss or shareholders’ equity.

Fiscal Year

The Company’s fiscal year is a 52 or 53 week period ending on the last Sunday in the month of June. The Company’s 2003 fiscal year extends from July 1, 2002 through June 29, 2003 and is a 52-week fiscal year. The Company’s 2002 fiscal year extended from June 25, 2001 through June 30, 2002 and was a 53-week fiscal year.

Estimates

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities, at March 30, 2003 and June 30, 2002, and the reported amounts of revenues and expenses during the three and nine months ended March 30, 2003 and March 24, 2002. Actual amounts could differ from those estimates.

Revenue Recognition

Revenue on product sales is recognized when persuasive evidence of a contract exists, the price is fixed, title of the goods has transferred and there is a reasonable assurance of collection of the sales proceeds. We generally obtain written purchase orders or shipment authorizations from our customers for a specified amount of product at a specified price and consider delivery to have occurred at the time of shipment. The Company’s shipment terms are generally FOB shipping point, such that the Company fulfills the obligation to deliver when the carrier takes possession of the goods at the Company’s shipping dock. The Company invoices its customers only for those shipping costs incurred by the Company that are necessary to physically move the product from the Company’s place of business to the customer’s location. The costs primarily consist of overnight shipping charges. The Company accounts for such shipping costs as a part of cost of revenue and records the reimbursement of such costs by its customer as a direct offset and reduction of cost of revenue. If inventory is maintained at a consigned location, revenue is recognized when our customer removes product from the consigned inventory. Revenue is recognized upon shipment, and we record an allowance for estimated sales returns, which is reflected as a reduction of revenue at the time of revenue recognition. Certain of the Company’s distributor arrangements provide for limited product exchanges and price protections for the distributor. The Company defers revenue based on its estimates of product exchanges and other allowances in connection with these contractual arrangements and recognizes the related revenue when final sales amounts are determined under the contract terms.

Revenue from government contracts is recorded on the percentage-of-completion method as expenses for the contract are incurred. Contract revenue represents reimbursement by various U.S. Government entities to aid in the development of the Company’s technology. The

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applicable contracts generally provide that the Company may elect to retain ownership of inventions made in performing the work, subject to a non-exclusive license retained by the government to practice the inventions for government purposes. Contract revenue includes funding of direct research and development costs and a portion of the Company’s general and administrative expenses and other operating expenses for contracts under which funding is expected to exceed direct costs over the life of the contract. The specific reimbursement provisions of the contracts, including the portion of the Company’s general and administrative expenses and other operating expenses that are reimbursed, vary by contract. Such reimbursements are recorded as contract revenue. For contracts under which the Company anticipates that direct costs will exceed amounts to be funded over the life of the contract (i.e., certain cost share arrangements), the Company reports direct costs as research and development expenses with related reimbursements recorded as an offset to those expenses.

Cash and Cash Equivalents

Cash and cash equivalents consist of unrestricted cash accounts and highly liquid investments with an original maturity of three months or less when purchased.

Fair Value of Financial Instruments

The carrying amounts of cash and cash equivalents, short-term and long-term investments, available for sale securities, accounts and interest receivable, accounts payable, accrued expenses and other liabilities approximate fair values at March 30, 2003 and June 30, 2002.

Investments

Investments are accounted for in accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”). This statement requires certain securities to be classified into three categories:

At March 30, 2003, the Company held no marketable equity securities. During the second quarter of fiscal 2003, the Company sold its remaining position in two publicly traded companies. The Company sold 356,000 common shares in the first company purchased at an average cost of $40.10 per share, or a total purchase cost of $14.3 million. These shares were purchased through two transactions in May 1999 and April 2000. In June 2000, 162,600 shares were sold for $6.3 million, with a gain on the sale recognized for $3.6 million. The Company recorded a charge through non-operating expense on the consolidated statements of operations in June 2002, for an “other than temporary decline in value” which reduced the value of this investment to $5.23 per share, or $1,862,000, which was the market value as of June 28, 2002.

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These shares were sold during the three months ended December 29, 2002 for $1,826,000, with a net loss on the sale recognized for $36,000 during the second quarter of fiscal 2003.

The Company also sold 691,000 common shares in the second publicly traded company purchased at an average cost of $19.91 per share, or a total purchase cost of $13.8 million. These shares were purchased between June 2001 and October 2001. The Company recorded a charge through non-operating expense on the consolidated statements of operations in June 2002, for an “other than temporary decline in value” which reduced the value of this investment to $6.00 per share, or $4,146,000, which was the market value as of June 28, 2002. These shares were sold during the three months ended December 29, 2002 for $2,115,000, with a net loss on the sale recognized for $2,031,000 during the second quarter of fiscal 2003.

Management viewed both of these investments as strategic in nature and therefore the shares were accounted for as “available-for-sale” securities under SFAS 115. The Company carried these investments at fair value, based on quoted market prices, and unrealized gains and losses, net of taxes, were included in accumulated other comprehensive income (loss), which is reflected as a separate component of shareholders’ equity. Realized gains and losses are recognized upon sale or when declines in value are deemed to be “other than temporary” on the consolidated statements of operations. The Company reviews equity holdings on a regular basis to evaluate whether or not each security has experienced an “other-than-temporary” decline in fair value. This policy requires, among other things, the Company to review of each company’s cash position, earnings and revenue outlook, stock price performance, liquidity, ability to raise capital and management and ownership considerations. Based on this review, if the Company determined that an “other-than-temporary” decline existed in the value of marketable equity securities, it is the Company’s policy to write-down these equity investments to the respective market value. Any related write-down would then be recorded as an investment loss on the Company’s consolidated statements of operations. In the fourth quarter of fiscal 2002, the Company determined that an “other-than-temporary” decline in market value had occurred in both of these marketable equity investments. Accordingly, the Company wrote down these equity investments to their market values at June 30, 2002 and recorded the unrealized losses, previously recorded as a comprehensive loss in shareholders’ equity, as a non-operating loss on the Company’s consolidated statements of operations for the year then ended. The total amount of the charge to non-operating expenses in the consolidated statements of operations for the year ended June 30, 2002 relating to these investments was $22.0 million on a pre-tax basis. A corresponding amount that would have been recorded through other comprehensive income (loss) was $17.2 million on an after-tax basis. The amount reported through other comprehensive income (loss) on an after-tax basis was $15.8 million as the losses from the June 2002 period were directly charged to non-operating loss on the statement of operations. The Company recorded a combined net loss of $2.1 million to non-operating expense in the consolidated statement of operations for the nine months ended March 30, 2003 for the sale of these securities.

One of the companies in which the Company invested funded a research and development project for custom light emitting diodes, or LEDs and laser diodes. The amount of funding received by the Company was $1.4 million and $4.1 million for the three and nine months ended March 24, 2002, respectively. The amount of the research and development funding received from that company was recorded as an offset to research and development expense. There was no funding from this company during the three and nine months ended March 30, 2003 and the

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Company does not anticipate additional funding for research and development from this company in the future.

As of March 30, 2003, the Company’s short-term investments held to maturity included $69.6 million in high-grade corporate bonds and other debt securities that mature within one year. As of June 30, 2002, the Company’s short-term investments held to maturity totaled $32.4 million consisting of high-grade corporate bonds. The Company purchased these investments with a portion of the proceeds from its public stock offering in January 2000. The Company has the intent and ability to hold these securities until maturity; therefore, they are accounted for as “securities held-to-maturity” under SFAS 115. The securities are reported on the consolidated balance sheets at amortized cost, as a short-term investment with unpaid interest included in interest receivable. The Company believes that there is no difference between the amortized cost of these securities and their fair value at the time the security is purchased because premiums or discounts are assigned to the securities if a different interest rate is paid than the current prevailing market rate. This premium or discount is amortized or accreted over the remaining life of the security and charged as an increase or decrease to interest income. Over time if interest rates continue to decline, the fair value of the security may be higher than the book value as the interest rate less the premium may be higher than current interest rates.

As of March 30, 2003, the Company’s long-term investments held to maturity consisted of $67.3 million in high-grade corporate bond holdings and other debt securities that mature after March 29, 2004. As of June 30, 2002, the Company’s long-term investments held to maturity consisted of $64.2 million in high-grade corporate bond holdings and other debt securities that mature after June 29, 2003. The Company purchased the corporate bonds with a portion of the proceeds from the public stock offering in January 2000. The Company has the intent and ability to hold these securities until maturity; therefore, they are accounted for as “securities held-to-maturity” under SFAS 115. The securities are reported on the consolidated balance sheets at amortized cost, as a long-term held to maturity investment with unpaid interest included in interest receivable if interest is due in less than 12 months, and as a long-term other asset if interest is due in more than 12 months. These investments mature over periods ranging from 13 to 33 months.

As of March 30, 2003, the Company maintained $15.6 million of net investments in privately held companies, which are included in other assets on the consolidated balance sheet. Since the Company does not have the ability to exercise significant influence over the operations of these companies, these investment balances are carried at cost and accounted for using the cost method of accounting. Because the shares of stock the Company received in these investments are not publicly traded, there is no established market for these securities. The Company reviews the fair value of these investments on a regular basis to evaluate the carrying value of such investments. This review includes, but is not limited to, a review of each of the companies’ cash position, financing needs, earnings and revenue outlook, operational performance, management or ownership changes and competition. The evaluation process is based on information requested from the privately held companies by the Company. This information is not subject to the same disclosure regulations as U.S. public companies, and as such, the basis for these evaluations is subject to the timing and the accuracy of the data received from these companies. If the Company determines that the carrying value of an investment is at an amount in excess of fair value, it is the Company’s policy to record a write-down of the investment. This write-down is estimated based on the information described above, and it is recorded as an investment loss on the Company’s consolidated statement of operations. During fiscal 2002, the Company

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recorded write-downs of these investments of $20.4 million pre-tax, representing the Company’s best estimate of “other-than-temporary” declines in value, of which $12.4 million was written down in the second quarter of fiscal 2002. These impairment charges were included as an “other non-operating loss” on the consolidated statements of operations. During the three and nine months ended March 30, 2003, there were no additional write-downs taken on these investments and one of the private companies was sold to another company during the second quarter of fiscal 2003 with proceeds of $636,000 received from the sale. The Company’s investment in this company was written down to match the sale proceeds in the fourth quarter of fiscal 2002.

During fiscal 2002, two of the private companies in which the Company invested in funded development programs conducted by the Company. During the first quarter of fiscal 2003, one of the private companies in which the Company holds an investment completed funding of a development program that commenced in a prior year and was directed to the development of brighter LEDs. The other program funded in fiscal 2002, which also commenced in a prior year, was directed to the development of SiC RF transistors. The total amount of funding received by the Company from these companies was $0 and $750,000 for the three months ended March 30, 2003 and March 24, 2002, respectively. The total amount of funding received by the Company from these companies was $500,000 and $2.3 million for the nine months ended March 30, 2003 and March 24, 2002, respectively. The amount of the research and development funding received from the companies was recorded as an offset to research and development expense. The Company does not anticipate additional funding from these companies in the future as both programs have now ended.

Impairment of Property and Equipment

In accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed Of “ (“SFAS 144”), the Company reviews long-lived assets for impairment based on changes in circumstances that indicate their carrying amounts may not be recoverable. During the quarter ended December 29, 2002, the Company recorded an impairment charge for property and equipment totaling $1.4 million related to an asset, which was associated with a program that was discontinued. This program was under the direction of a privately held company that we had previously made an investment in; however, the investment was fully reserved for on the consolidated statement of operations in June 2002. The asset was not located on the Company’s premises and management determined that it would no longer support the program. The charge was included in “other operating expense” on the consolidated statement of operations.

During the quarter ended December 23, 2001, the Company recorded an impairment charge for property and equipment in accordance with Statement of Financial Accounting Standards No. 121, “Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed Of” (“SFAS 121”). The charge totaled $18.1 million related to assets that were disposed of, which was included in “other operating expense” on the consolidated statements of operations. This impairment charge was due to decisions to utilize different technologies resulting in the obsolescence of the assets. The majority of these assets were destroyed due to the proprietary nature of the assets. Disposal of the impaired assets was completed in the second half of fiscal 2002.

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Inventories

Inventories are stated at the lower of cost or market, with cost determined under the first-in, first-out (FIFO) method. It is the Company’s policy to record a reserve against inventory once it has been determined that conditions exist which may not allow the Company to sell the inventory for its intended purpose, the inventory’s value is determined to be less than cost, or it is obsolete. The charge for the inventory reserves is recorded in cost of revenue on the consolidated statement of operations. The Company evaluates inventory levels quarterly against sales forecasts on a part-by-part basis and evaluates its overall inventory risk. Reserves are adjusted to reflect inventory values in excess of forecasted sales as well as overall inventory risk assessed by management.

As of March 30, 2003, the Company maintained a $2.2 million reserve for inventory. Of the total reserve amount, $1.8 million is attributable to the Cree Microwave segment and $440,000 is attributable to the Cree segment.

The majority of the reserve at Cree Microwave was recorded during the second quarter of fiscal 2003 resulting from the termination of the supply agreement with Spectrian. In exchange for a one-time payment of $5.0 million recorded as “other non-operating income” on the consolidated statement of operations, the Company relieved Spectrian of further obligations to purchase product under the supply agreement that was originally signed in December 2000. For the three months ended December 29, 2002, Cree Microwave recorded an additional reserve of $1.3 million for inventory that was targeted for sale to Spectrian, including some customized parts. Additional reserves of $5.1 million were recorded in the third quarter of fiscal 2002, as contract negotiations at the time with Spectrian indicated that several parts on hand would not be salable. The Company destroyed all but approximately $136,000 of this inventory during the fourth quarter of fiscal 2002 and the first half of fiscal 2003 and the related items were taken out of inventory and the related reserve. There was no financial impact to the Statement of Operations when these items were destroyed. The Company still maintains some packaging materials that were reserved for, that are no longer available from third party suppliers or are available only with lengthy lead timeframes. These write-downs were recorded as a cost of revenue. In addition, $417,000 of LDMOS 8 product was also written off as research and development expense during the first quarter of fiscal 2003.

Cree segment results for the three months ended December 29, 2002 include a $784,000 additional reserve for LED and wafer inventories as management assessed the inventory to be slow moving or obsolete. During the first quarter of fiscal 2003, the Company recorded a $185,000 lower of cost or market adjustment to certain LED products based on management’s estimate of an average sales price for the products. Both of these adjustments were recorded to cost of revenue. During the first quarter of fiscal 2003, the Company wrote-off $1.0 million of the initial XBright^® chips that were developed during fiscal 2002. An improved chip has replaced these devices and this write down was recorded as a research and development expense as the initial devices were prematurely launched and not commercially viable.

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Inventories consist of the following:

Property and Equipment

Property and equipment are recorded at cost and depreciated on a straight-line basis over the estimated useful lives of the assets, which range from three to forty years. Leasehold improvements are amortized over the lesser of the asset life or the life of the related lease. Expenditures for repairs and maintenance are charged to expense as incurred. The costs for major renewals and improvements are capitalized and depreciated over their estimated useful lives. The cost and related accumulated depreciation of the assets are removed from the accounts upon disposition and any resulting gain or loss is reflected in operations.

Goodwill and Intangible Assets

During the third quarter of fiscal 2002, the Company determined that business conditions for its Cree Microwave segment had changed due to several factors. First, Cree Microwave amended its supply agreement with Spectrian effective March 31, 2002, which resulted in a significant reduction in quarterly revenue expectations. In addition, Cree Microwave’s outlook for acquiring additional customers in the near term weakened due to deteriorating economic conditions and long product qualification cycles. Also, many of the products that Spectrian initially indicated it would purchase in the future had not been released to production at the time. Under the amended supply agreement, if Cree Microwave was not able to produce qualified LDMOS 8 devices in a timely manner, revenue from Spectrian could be significantly reduced after the June 2002 quarter. Based on these impairment indicators, the Company performed an asset impairment analysis in accordance with SFAS 121, “Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed of”. As a result of this analysis, the remaining balance of goodwill and intangible assets of $76.5 million was deemed to be fully impaired and was written off during the third quarter of fiscal 2002. This write-off was recorded as “other expense” on the consolidated statement of operations.

Prior to the impairment charge that was recorded during the third quarter of fiscal 2002, intangible assets including goodwill, current technology and workforce-in-place associated with the acquisition of Cree Microwave were accounted for under the purchase method in December 2000. Goodwill was capitalized at $81.5 million and represented the excess of cost over the fair value of assets acquired and was amortized using the straight-line method over ten years. Current technology and workforce-in-place assets were assigned values of $5.5 million and $800,000, respectively. These intangibles were being amortized under the straight-line method over eight and five years, respectively. During the three and nine months ended March 24, 2002,

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prior to the impairment charge, the expense for intangible asset amortization was $2.2 million and $6.8 million, respectively.

Research and Development Accounting Policy

The U.S. Government provides funding through research contracts for several of the Company’s current research and development efforts. The contract funding may be based on either a cost-plus or a cost-share arrangement. The amount of funding under each contract is determined based on cost estimates that include direct costs, plus an allocation for research and development, general and administrative and the cost of capital expenses. Cost-plus funding is determined based on actual costs plus a set percentage margin. For the cost-share contracts, the actual costs are divided between the U.S. Government and the Company based on the terms of the contract. The government’s cost share is then paid to the Company. Activities performed under these arrangements include research regarding SiC and GaN materials and devices. The contracts typically require the submission of a written report that documents the results of such research, as well as some material deliverables.

The revenue and expense classification for contract activities is based on the nature of the contract. For contracts where the Company anticipates that funding will exceed direct costs over the life of the contract, funding is reported as contract revenue and all direct costs are reported as costs of contract revenue. For contracts under which the Company anticipates that direct costs will exceed amounts to be funded over the life of the contract, costs are reported as research and development expenses and related funding as an offset of those expenses. The following table details information about contracts for which direct expenses exceeded funding by period as included in research and development expenses:

Income Taxes