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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the Quarterly Period Ended September 30, 2004

For the Transition Period From              to             

Commission File Number 000-49871

HEALTHETECH, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (303) 526-5085

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

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

As of November 9, 2004, the number of shares outstanding of the registrant’s common stock, par value $0.001 per share, 7,087,215.

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INDEX

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PART I. FINANCIAL INFORMATION

ITEM 1. Unaudited Financial Statements

HEALTHETECH, INC.

Balance Sheets

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

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HEALTHETECH, INC.

Statements of Operations

Unaudited

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

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HEALTHETECH, INC.

Statements of Cash Flows

Unaudited

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

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HEALTHETECH, INC.

NOTES TO UNAUDITED FINANCIAL STATEMENTS

(1) Business and Basis of Financial Statement Presentation

HealtheTech, Inc. (the Company or HealtheTech) was incorporated in February 1998 under the laws of the State of Delaware. The Company operates in one segment and develops and markets health solutions designed to give consumers simple, informative ways to improve and maintain health and wellness.

The accompanying financial statements as of September 30, 2004 and for the three months and nine months ended September 30, 2003 and 2004 are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States of America on a basis consistent with the December 31, 2003 audited financial statements and include normal recurring adjustments which are, in the opinion of management, necessary for a fair statement of the results of these periods. These statements should be read in conjunction with our financial statements and notes thereto included in our Form 10-K (Commission File No. 000-49871), filed on March 29, 2004. Operating results for the three months and nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for the full year.

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

The Company’s financial statements are based on several significant estimates, including the reserve for warranty obligations and product returns, provision for excess and obsolete inventory, provision for doubtful accounts and the estimated useful lives of long-lived assets, as well as the recoverability of the investment in long-lived assets.

(2) Significant Accounting Policies

(a) Cash and Cash Equivalents and Restricted Cash

All highly liquid investments purchased with original maturities of three months or less are considered to be cash equivalents.

(b) Reclassifications

Certain reclassifications have been made to prior years financial statements to conform to the 2004 presentation.

(c) Inventory

Inventory is stated at the lower of cost or market, using the first-in, first-out method and consists of purchased items or finished goods that were manufactured internally or for the Company by contract manufacturers. Our strategy utilizes both in-house and outsourced manufacturing, warehousing and shipping of our health monitoring devices, disposables and software to benefit from the resources of our contract manufacturers and fulfillment vendor where appropriate, in order to minimize the overall costs of our products. We rely on contractors for the manufacture, warehousing and shipping of the component parts for our devices.

(d) Intangible Assets

Intangible assets consist of purchased patents and legal fees to obtain patents and are recorded at cost. Amortization of intangible assets is calculated using the straight-line method over the estimated useful lives, generally five to ten years. Amortization expense was $55,404 and $110,595 for the three months ending September 30, 2003 and 2004, respectively and $331,893 and $209,613 for the nine months ending September 30, 2003 and 2004, respectively. The Company periodically evaluates the recoverability of intangible assets and takes into account events and circumstances that warrant revised estimates of useful lives or that indicate that impairment exists.

(e) Accrued liabilities

Accrued liabilities consist of the following:

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(f) Deferred Revenue

Deferred revenue primarily consists of payments received upon sale of our BalanceLog Pro software product which is recognized ratably over the contract period.

(g) Fair Value of Financial Instruments

The carrying amounts of the Company’s financial instruments, including, cash and cash equivalents, accounts receivable, accounts payable and accrued expenses, approximate fair value due to their short-term nature.

(h) Research and Development Costs and Software Development Costs

Research and development costs are expensed as incurred and consist of salaries and other direct costs. SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed, (SFAS No. 86) requires the capitalization of certain software development costs once technological feasibility is established. The Company’s software is deemed to be technologically feasible at the point a working model of the software product is developed. Through September 30, 2004, the period between achieving technological feasibility and general availability of such software has been short. Consequently, software development costs qualifying for capitalization have been insignificant.

(i) Revenue

The Company generates revenue from the sale of its products, measurements, software and licensing arrangements. Revenue from the sale of products is recognized when evidence of an arrangement exists, ownership transfers to the customer or distributor, the price is fixed and collectibility is probable. Revenue from the sale of measurements under the new pay per measurement sales model is recognized using the same criteria as product revenue. The software component of the Company’s products is considered incidental under Statement of Position (SOP) 97-2, Software Revenue Recognition.

Software fees are comprised of sales of prepackaged software that can be sold independently or in conjunction with product sales. Software fees are recognized according to the criteria of SOP 97-2, as amended. Revenue is recognized upon execution of a license agreement or signed written contract with fixed or determinable fees, shipment or electronic delivery of the product, and when collection of the receivable is probable.

Service revenue, including training and consulting services, is recognized as services are performed. Licensing fees are recognized ratably over the contract term.

Cost of product revenue consists primarily of purchases of products from contract manufacturers, warranty reserves, royalty payments, obsolescence reserves and costs of personnel directly related to managing the supply chain and related overhead. Cost of software revenue primarily consists of purchases of product. Additionally, costs of shipping are included in software and other costs of revenue.

The Company provides a 30 day right of return on software sales and a limited warranty on its software products for 90 days from the date of purchase. However, as returns and warranty claims have been insignificant, no reserve has been established.

In general, the Company does not provide price protection or a right of return on health monitoring devices. The Company provides a limited warranty on its devices for periods of 12 to 18 months.

(j) Stock-Based Charges

Through December 31, 2002, the Company accounted for its stock option plans in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Generally, compensation expense was recorded for options issued to employees and directors on the date of grant only if the current estimated fair value of the underlying common stock exceeded the exercise price of the option using the intrinsic value method. In the fourth quarter of 2003, retroactive to January 1, 2003, the Company adopted the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation (FASB 123) prospectively to all employee awards granted, modified, or settled after January 1, 2003. The adoption of FASB 123 was done in accordance with FASB 148.

The Company has four stock-based employee compensation plans and presently utilizes only two of such plans to make current stock option grants. The following table illustrates the effect on net loss if the Company had applied the fair value based measurement and recognition provisions of SFAS No. 123 to stock-based employee compensation for the three months and nine months ended September 30, 2003 and 2004. Stock-based employee compensation costs exclude charges recognized for the issuance of warrants.

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The Company accounts for non-employee stock based awards in accordance with SFAS No. 123 and related interpretations. Stock options are valued using the Black-Scholes option-pricing model. Prior to the Company’s initial public offering in July 2002, the fair value of equity instruments was determined by the Company’s Board of Directors. Subsequent to July 2002, the fair value is based on the closing price of the Company’s stock on the Nasdaq National Market.

(k) Income Taxes

The Company uses the asset and liability method of accounting for income taxes as prescribed by SFAS No. 109, Accounting for Income Taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The resulting deferred tax assets and liabilities are adjusted to reflect changes in tax laws or rates in the period of enactment.

(l) Advertising Costs

Advertising costs are expensed when media placements occur. Advertising expense was $0 and $31,118 for the three months ended September 30, 2003 and 2004, respectively and $3,332,100 and $31,118 for the nine months ended September 30, 2003 and 2004, respectively.

(m) Loss Per Share

Loss per share is presented in accordance with the provisions of SFAS No. 128, Earnings Per Share, (SFAS No. 128). Under SFAS No. 128, basic loss per share (EPS) excludes dilution for potential common stock issuances and is computed by dividing net loss by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that would occur if securities or other contracts to issue common stock were exercised or converted into common stock. Basic and diluted EPS are the same for all periods, as all potential common stock instruments, consisting of common stock options and warrants and convertible preferred stock, are anti-dilutive due to the net losses for each period.

The following is a reconciliation of the numerators and denominators of the basic and diluted EPS computations:

Potential common stock equivalents, consisting of options and warrants, for the nine months ended September 30, 2003 and 2004 were 1,807,521 and 2,601,760, respectively, and were excluded from the diluted loss per share calculation because their effect would be anti-dilutive.

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In December 2003, the Company effectuated a 1-for-5 reverse split of its outstanding common stock after the close of the markets on December 31, 2003. The reverse stock split was approved by the Company’s stockholders at a special meeting held on December 19, 2003. All shares and per share data have been restated to reflect this change.

(3) Restructuring Charge

During the second quarter of 2003, the Company decided to refocus its business on the medical markets and commercial weight loss, corporate wellness, and fitness markets and the products that support those markets. As a result of this refocus, the Company evaluated its operating expense levels and determined to restructure the business, resulting in a Company-wide cost reduction program achieved through a downsizing of the employee workforce, a significant reduction in use of contractors and outside service firms, and Company-wide temporary salary reductions. Restructuring charges include severance arrangements, early termination fees and legal costs. The cost reduction program was consummated in two steps with restructuring charges of approximately $529,000 and $249,000 in the second and fourth quarters of 2003, respectively. Additional costs of $272,057 and $105,102 were incurred in the first and second quarters of 2004, respectively, relating to the 2003 restructuring program, which included lease termination costs and severance arrangements. As of September 30, 2004, a balance of $30,260 remains in accrued liabilities representing salary expense to be paid by December 31, 2004.

(4) Property and Equipment

Property and equipment consist of the following:

(5) Line of Credit

On September 15, 2004, the Company replaced the credit facility that supports the lease of our corporate headquarters in Golden, Colorado. The new credit facility provides for a $1.2 million irrevocable letter of credit and requires that the Company maintain a $1.5 million cash balance in a restricted account. The new credit facility is renewable annually and expires on September 14, 2005. As of September 30, 2004, the only use of the credit facility was the provision of the $1.2 million letter of credit.

(6) Stockholders’ Equity

(a) Employee Stock Purchase Plan

The Company has an employee stock purchase plan for all eligible employees. Under the plan, shares of the Company’s common stock may be purchased at six-month intervals at 85% of the lower of the fair value on the first or the last day of each six-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. For the six-month offering period ended August 16, 2004, employees purchased 1,000 shares of common stock at a price of $1.37 per share.

(b) Stock Options

On March 29, 2004, the Company re-priced existing options to purchase 327,047 shares of common stock at an exercise price of $1.84 per share. These options retain their prior vesting schedule and expiration date. Additionally, the Company cancelled and reissued options to purchase 60,336 shares of common stock. These options have an exercise price of $1.84 per share and vest over four years and expire in March 2014. In addition, the Company granted two sets of options to certain officers, including (i) 500,000 options to purchase common stock were granted on March 29, 2004 at an exercise price of $1.84 per share to vest over four years and

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expire in March 2014, and (ii) 100,000 options were granted on May 14, 2004 at an exercise price of $2.20 per share to vest over four years and expire in May 2014. The fair value for these option grants and modifications totaled approximately $1.2 million and is being expensed over the vesting period of the options. The fair value was determined using the Black-Scholes Option Pricing model with the following assumptions: volatility 105%, no dividend yield, risk free interest rates of 0.83% to 3.25% and expected lives of 0 to 4 years.

The following table summarizes stock option activity and balances for the periods ended September 30, 2003 and 2004:

The following table summarizes information about stock options outstanding at September 30, 2004:

The following table includes grants of options for common stock whose exercise price was less than the fair value, for financial reporting purposes, of the underlying common stock at the date of grant, equal to the fair value at the date of grant or greater than the fair value at the date of grant. The weighted average fair value was determined using the Black-Scholes option-pricing model.

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The following table includes weighted average assumptions using the Black-Scholes option pricing model for determining the per share weighted average fair value of stock options granted:

(7) Significant Customers

Revenue earned from significant customers is as follows:

At September 30, 2003 and 2004, receivables from these customers represented 35% and 28% of total receivables, respectively.

(8) Related Party Transactions

None.

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

The following discussion of HealtheTech, Inc.’s (referred to herein as the Company, we, us or our) financial condition and results of operations should be read in conjunction with the financial statements and notes thereto included in Item 1 of Part 1 of this quarterly report and the audited consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 2003 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission. The following Management’s Discussion and Analysis of Financial Condition and Results of Operations, as well as information contained elsewhere in this report, contain statements that constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). You can identify these statements by forward-looking words such as “may,” “will,” “expect,” “intend,” “anticipate,” “believe,” “estimate,” “plan,” “could,” “should,” and “continue,” or similar words. Actual results could differ materially from those anticipated in these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those mentioned in the discussion below, the summary “Risk Factors” contained herein and those described in the “Risk Factors” discussion of our Annual Report on Form 10-K for the year ended December 31, 2003. As a result, you should not place undue reliance on these forward-looking statements. We do not intend to update or revise these forward-looking statements to reflect future events or developments.

Overview

We were incorporated in Delaware in February 1998. We design, develop and market technologically advanced and proprietary handheld medical devices and software for the measurement of resting metabolic rate and the monitoring of nutrition.

We have incurred losses since commencing operations and, as of September 30, 2004, we had an accumulated deficit of $98.4 million. Our net loss was $3.3 million and $1.9 million for the three months ended September 30, 2003 and 2004, respectively, and $21.7 million and $7.5 million for the nine months ending September 30, 2003 and 2004, respectively. We have not achieved profitability on a quarterly or annual basis. We intend to continue to develop and market our proprietary products and services and increase our focused sales efforts.

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We derive revenue from the sale of our health monitoring devices, single-use disposables, software products and license fees. We anticipate that our revenue will be generated primarily through direct sales and sales by our distributors and resellers into the medical, weight management and fitness markets. Beginning in the third quarter of 2004, our sales strategy is to utilize a combination of an expanded direct sales force as well as independent distributors or resellers that already possess the sales, marketing and distribution capabilities needed to reach our end users.

Beginning in 2004, we converted our future sales efforts to a “measurement” business model in which customers receive MedGem and BodyGem devices from us, either directly or through commissioned sales agents. These devices are “preloaded” with the ability to perform a specific number of metabolic measurements and can be reloaded with additional measurements. Customers also receive a corresponding number of disposable mouthpieces at no additional charge. The principal advantage of this model to our customers is that it lowers the initial acquisition cost of deploying the device in the customer’s business. As a result, we expect the model to accelerate the adoption, deployment and utilization rate of our devices, increasing our installed base of devices and, ultimately, positively impacting revenue and profitability. In the first year of deployment of this model, however, our revenue is likely to be lower than it would be under the traditional sales model, because the expected selling price of a set number of measurements is expected to be lower than the traditional selling price of a measurement device and quantity of disposable mouthpieces. This model has been in place since January 2004 and we expect that this system of selling measurements, rather than devices and disposables, will be the dominant form of business in 2004 and beyond.

In 2003 we refocused our business model on the medical, commercial weight loss and fitness markets and the products that support those markets. As a result of this market focus, we in turn have completed the first three quarters of 2004 on plan for lowering operating expenses. Despite the progress we made in reducing expenses, we will need to generate substantially higher revenue than that generated in past quarters and/or further reduce expenses in order to achieve and sustain profitability.

We are continuing to support our distribution network in the U.S. and Europe to represent our products in select markets in the United States and throughout the European, Middle Eastern and African fitness markets. In addition, we have established key relationships in the fitness market and have pilot programs underway in a number of other commercial fitness, weight loss and medical settings.

In December 2003, Malacca International Corporation, a subsidiary of Microlife Corporation filed suit against us alleging breach of contract. In February 2004, we filed our answer denying the material allegations in the complaint and asserted counterclaims against both Malacca and Microlife for breach of contract and unjust enrichment. See “Part II, Item 1: Legal Proceedings” for a further description of the dispute. While management currently believes that resolving this matter will not have a material adverse impact on the Company’s financial position or its results of operations, litigation is subject to inherent uncertainties and management’s view of these matters may change in the future. Were an unfavorable final outcome to occur, there exists the possibility of a material adverse impact on the Company’s financial position and the results of operations.

Results of Operations

Three Months and Nine Months Ended September 30, 2004 and 2003

Revenue. Revenue decreased $1.0 million, or 54%, to $0.8 million in the quarter ended September 30, 2004 from $1.8 million in the comparable quarter in 2003. Product and Measurement revenue increased $0.1 million, or 9.7%, to $0.7 million for the three months ended September 30, 2004 from $0.6 million in the comparable period in 2003. The increase is a result of our new measurement model gaining ground with a steady customer base. Software and other revenue decreased $1.0 million, or 89%, to $0.1 million in the third quarter of 2004 from $1.2 million in the comparable quarter of 2003. This decrease is due largely to our accelerated recognition of $0.8 million in license fees from Microlife in the third quarter of 2003.

Revenue decreased $2.0 million, or 44%, to $2.6 million for the nine months ended September 30, 2004 from $4.6 million in the comparable period in 2003. Product and Measurement revenue decreased $0.1 million, or 6%, to $2.1 million for the nine months ended September 30, 2004, from $2.2 million in the comparable period in 2003. The decrease reflects our strategy to move away from agreements that couple minimum purchase agreements with exclusivity, as we believe this will promote more competitiveness among our distributors in the market and also cause our reported revenue to better reflect the deployment and usage of our products. Under the new strategy, the shipment from our manufacturing facility is more closely aligned with the end user’s consumption of the unit’s measurements. Software and Other revenue decreased $1.9 million, or 79%, to $0.5 million for the nine months ended September 30, 2004, from $2.4 million in the comparable period in 2003. This decrease is due largely to our exit from the mass-market retail channel during the second quarter of 2003 and the $0.8 million in license fees from Microlife recognized in the third quarter of 2003. Software revenue was enhanced during the second quarter of 2004 by a $124,000 revenue recognition for revenue that had been deferred from a previous period. Certain reclassifications have been made for the first quarter between Software and Other revenue with Product and Measurement revenue to conform to the current period’s presentation.

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Revenue from customers outside the United States accounted for 2% and 56% of total revenue for the three months ended September 30, 2004 and 2003 respectively and 7% and 38% of total revenue for the nine months ended September 30, 2004 and 2003, respectively.

Cost of Revenue. Total cost of revenue increased to 90% of sales in the third quarter of 2004 from 57% of sales in the third quarter of 2003. Total cost of revenue for the nine months ended September 30, 2004 increased to 85% of sales from 72% of sales in the prior year period. Total cost of revenue was enhanced during the second quarter 2004 due the $124,000 deferred revenue recognition that resulted in a 100% margin. Cost of revenue in general has risen due to a change in the allocation of certain expenses, previously classified as operating expenses, into cost of sales and as a result of changes in our product mix.

Research and Development. Research and development expenses decreased $1.0 million, or 78%, to $0.3 million in the quarter ended September 30, 2004 from $1.3 million in the comparable quarter in 2003.

Research and Development expense decreased $3.6 million, or 67%, to $1.7 million for the nine months ended September 30, 2004 from $5.4 million in the comparable period of the prior year. The Company has reduced research and development headcount by 38% resulting from the cost reduction measures undertaken in the second and fourth quarters of 2003. In addition, we have reduced our use of outside service firms and contractors. We have focused our research and development efforts on a few key projects, which are now being handled with internal resources, and clinical validation studies conducted by outside providers. We believe that a continued commitment to research and development is essential in order to provide enhancements to and validation of existing products.

Selling, General and Administrative. Selling, general and administrative expenses decreased $0.5 million, or 23%, to $1.6 million in the quarter ended September 30, 2004 from $2.1 million in the comparable quarter of 2003.

Selling, general and administrative expense decreased $7.5 million, or 61%, to $4.9 million for the nine months ended September 30, 2004, from $12.4 million in the comparable period of the prior year. We significantly reduced marketing spending in the latter half of 2003. In late 2002, we were preparing for the launch of our BalanceLog software into the retail channel by hiring marketing firms to conduct consumer and medical studies, packaging firms for product redesign, and a marketing agency for promotion services. Although this activity was curtailed in early 2003 with our shift in distribution strategy away from retail, significant expense was still incurred in the first quarter of 2003. Subsequent to the first quarter of 2003, our marketing expenditures have been modest. Other reasons for the decrease in selling, general and administrative expenses include a 43% reduction in headcount, as a result of our second and fourth quarter 2003 cost reduction efforts. As a further cost efficiency, we are now using internal resources for most formerly contracted functions, such as web hosting, customer service, and investor and public relations.

Stock-based Charges. Stock-based charges decreased $0.5 million, or 80%, for the third quarter of 2004 to $0.1 million from $0.6 million in the comparable quarter of the prior year. Stock-based charges decreased $2.1 million, or 69%, for the nine months ended September 30, 2004, to $1.0 million from $3.1 million in the comparable period of the prior year. On March 29, 2004, the Company re-priced existing options to purchase 327,047 shares of common stock at an exercise price of $1.84 per share. These options retain their prior vesting schedule and expiration date. Additionally, the Company cancelled and reissued 60,336 options to purchase common stock. These options have an exercise price of $1.84 per share, vest over four years and have a life of ten years. In addition, the Company granted two sets of options to certain officers, including (i) 500,000 options to purchase common stock were granted on March 29, 2004 at an exercise price of $1.84 per share to vest over four years and expire in March 2014, and (ii) 100,000 options were granted on May 14, 2004 at an exercise price of $2.20 per share to vest over four years and expire in May 2014. The fair value for these option grants and modifications totaled approximately $1.2 million and are being amortized to expense over the vesting period of the options.

Liquidity and Capital Resources

Cash and cash equivalents totaled $11.3 million at September 30, 2004. Cash used in operating activities was $5.6 million in the nine months ended September 30, 2004 compared to $14.1 million in the comparable period of 2003. The decrease in usage reflects the improvement in our cost structure previously discussed in the Results of Operations section of this document.

Cash used in investing activities was $0.2 million in the nine months ended September 30, 2004, a change from $5.9 million provided in the comparable period of the prior year, primarily due to the sale of marketable equity securities during the first quarter of 2003 and the release of $1.2 million in restricted cash in the third quarter of 2003.

Cash flows from financing activities were $0.1 million in the nine months ended September 30, 2004, essentially the same as the $0.1 million recorded in the comparable period of the prior year. Net cash from financing activities primarily reflects proceeds from the sale of equity securities from our employee stock purchase plan and exercise of stock options.

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We have no notes payable or bank debt. Stockholders’ equity at September 30, 2004 was $15.6 million. We expect to continue to modestly invest in sales and marketing programs and research and development. We do not expect significant additions to property and equipment for the remainder of 2004.

The following table sets forth information concerning our material contractual obligations as of September 30, 2004:

Critical Accounting Policies and Estimates

We have disclosed in Note 2 to our financial statements those accounting policies that we consider to be significant in determining our results of operations and our financial position which are incorporated by reference herein.

The preparation of financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses. We evaluate our estimates, including those related to bad debts, inventories and warranty obligations, on an ongoing basis. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. The actual results may differ from these estimates under different assumptions or conditions.

The significant accounting policies which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:

Revenue recognition

We derive our revenue primarily from the sale of our health monitoring devices, the recurring sale of our single-use disposables and our companion software. Beginning in 2004 with the conversion of our future sales efforts to a measurement model, we recognize the revenue from pre-loaded devices containing measurements of 20 and 100 at the time the device is delivered. Our software revenue is recognized in accordance with Statement of Position 97-2, as amended by Statement of Position 98-9. We license our software products on a perpetual basis. We recognize revenue from the sale of our health monitoring devices and single-use disposables upon ownership transfer to the customer and when it is determined that a continuing service obligation no longer exists. We recognize revenue from the sale of our software, when persuasive evidence of an arrangement exists, the product is delivered, the price is fixed or determinable and collectibility is probable. For sales of our software over the Internet, we use a credit card authorization as evidence of an arrangement. Sales through our distributors are evidenced by a master agreement governing the relationship together with binding purchase orders on a transaction-by-transaction basis. Delivery generally occurs when the product is delivered to a common carrier. Service revenue, including training, is recognized as services are performed. We offer customers the right to return software products that do not function properly within a limited time after delivery, typically 90 days. We provide limited warranties on our health monitoring devices for a period of 12 months from the date of purchase and on our software products for 90 days from date of purchase, with certain limited exceptions.

Receivables are recorded net of allowance for doubtful accounts. We regularly review the adequacy of our accounts receivable allowance after considering the accounts receivable aging, the ages of each invoice, each customer’s expected ability to pay and our collection history with each customer. We review any invoice greater than 90 days past due to determine if an allowance is appropriate based on the risk category using the factors discussed above. The allowance for doubtful accounts represents our best estimate, but changes in circumstances relating to accounts receivable may result in additional allowances or recoveries in the near future.

Stock-based charges

At September 30, 2004, we had four stock-based employee compensation plans. Prior to 2003, we accounted for those plans under the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. Prior to 2003, stock-based employee compensation cost was reflected in net loss to the extent that options granted under the plan had an exercise price less than the fair value of the underlying common stock on the date of grant. Effective January 1, 2003, we adopted the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, prospectively to all awards granted, modified, or settled after January 1, 2003 under the employee compensation plans. The 2003 impact of the FASB 123 adoption, $1.8 million, was reported entirely in the fourth quarter of 2003. Awards under our employee compensation plans vest over periods ranging from zero to four years. Accordingly, the cost related to stock-based employee compensation included in the determination of net income (loss) for 2002 and prior years is less than that which would have been recognized if the fair value based method had been applied to all awards since the original effective date of Statement 123.

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Valuation allowances

Management makes estimates of potential future product returns and product warranties related to current period product revenue, based on historical returns, current economic trends and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns and other allowances. Significant management judgments and estimates must be made and used in connection with establishing the sales returns and other allowances in any accounting period. Significant differences may result in the amount and timing of our revenue for any period if management made different judgments or used different estimates.

Risk Factors

In addition to the other information contained in this report, we caution stockholders and potential investors that the following summary risk factors and those additional factors described in the “Risk Factors” discussion of our Annual Report on Form 10-K for the year ended December 31, 2003, in some cases have affected, and in the future could affect, our actual results of operations and could cause our actual operating results to differ materially from those expressed in any forward-looking statements made by or on our behalf. The following information is not intended to limit in any way the characterization of other statements or information under other captions or in the “Risk Factors” section of our Annual Report on Form 10-K for such purpose.

Following is a summary of the risk factors identified in our Form10-K for the year ended December 31, 2003, and updated to September 30, 2004, that could cause our financial condition to differ from projections:

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our interest income is sensitive to changes in the general level of interest rates in the United States, particularly since the majority of our investments are short-term in nature. Due to the nature of our short-term investments, we have concluded that we do not have material market risk exposure.

Our investment policy requires us to invest funds in excess of current operating requirements. At September 30, 2004, our cash and cash equivalents consisted primarily of short-term U.S. governmental securities with original maturities of three months or less. The recorded carrying amounts of cash and cash equivalents approximate fair value due to their short maturities.

Item 4. Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit to the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified by the Commission’s rules and forms, and that information is accumulated and communicated to our management, including our principal executive and principal financial officers (whom we refer to in this periodic report as our Certifying Officers), as appropriate to allow timely decisions regarding required disclosure. Our management evaluated, with the participation of our Certifying Officers, the effectiveness of our disclosure controls and procedures as of September 30, 2004, pursuant to Rule 13a-15(b) under the Exchange Act. Based upon that evaluation, our Certifying Officers concluded that, as of September 30, 2004, our disclosure controls and procedures were effective.

There were no changes in our internal control over financial reporting that occurred during our fiscal quarter ended September 30, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

In the ordinary course of business, we may from time to time become involved in certain legal proceedings. As of the date of this quarterly report, we are a party to one legal proceeding. On December 22, 2003, Malacca International Corporation, a subsidiary of Microlife Corporation (“Microlife”), filed suit against us in the United States District Court for the District of Colorado alleging breach of contract in connection with our International Distribution Agreement dated March 19, 2002. The complaint alleges that we breached the agreement by failing to maintain Microlife’s exclusivity and failed to have product available for distribution and seeks rescission of the agreement or an injunction and monetary damages. Microlife is also seeking an injunction prohibiting us from providing product to other distributors serving the markets covered by the agreement. We believe that we have meritorious defenses and that the specified claims are without merit and intend to vigorously contest this lawsuit. On February 2, 2004, we filed our answer denying the material allegations in Malacca’s complaint and asserted counterclaims against both Malacca and Microlife for breach of contract and unjust enrichment. The lawsuit is in the discovery stage at the present time.

While management currently believes that resolving this matter will not have a material adverse impact on our financial position or results of operations, litigation is subject to inherent uncertainties and management’s view of these matters may change in the future. Were an unfavorable final outcome to occur, there exists the possibility of a material adverse impact on our financial position and the results of operations.

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

None.

Item 3. Defaults Upon Senior Securities

None.

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Item 4. Submission of Matters to a Vote of Security Holders

None.

Item 5. Other Information

None.

Item 6. Exhibits

SIGNATURES

Pursuant to the requirements of the Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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