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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

OR

For the transition period from              to             

Commission file number: 0-9023

COMDIAL CORPORATION

(Exact name of Registrant as specified in its charter)

106 Cattlemen Road, Sarasota, Florida 34232

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: (941) 554-5000

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  ¨

The number of shares outstanding of each of the issuer’s classes of common stock, as of November 10, 2004 was 9,819,038 shares, all of one class (common stock), par value $0.01 per share.

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COMDIAL CORPORATION AND SUBSIDIARIES

INDEX

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COMDIAL CORPORATION AND SUBSIDIARIES

PART 1. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Condensed Consolidated Statements of Operations - (Unaudited)

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

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COMDIAL CORPORATION AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

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

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COMDIAL CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows - (Unaudited)

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

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COMDIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NINE MONTHS ENDED SEPTEMBER 30, 2004 - (Unaudited)

NOTE A. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The accompanying unaudited condensed consolidated financial statements of Comdial Corporation and subsidiaries (“the Company” or “Comdial”) have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.

Operating results for the three and nine months ended September 30, 2004, are not necessarily indicative of the results that may be expected for the year ended December 31, 2004.

The balance sheet at December 31, 2003, has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2003.

Reclassifications

The Company has reclassified certain amounts on the December 31, 2003 balance sheet to conform to the September 30, 2004 presentation. These reclassifications had no effect on operating or net income.

The reclassifications related to certain debt discount on the 2002 Private Placement Notes and the 2002 Private Placement Winfield Notes, which were reclassified from deferred financing costs to debt discount, an offset to debt as recorded.

Accounting For Stock-Based Compensation

Comdial accounts for stock-based compensation using the intrinsic value method under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” In the first quarter of 2004, the Company recorded stock compensation expense of approximately $215,000 in connection with modifications of stock option agreements for two former officers, of which $213,000 is reported as restructuring expense in the accompanying condensed consolidated statement of operations (see Note I). The following table illustrates the effect on net loss if the Company had applied the fair value recognition provisions of Financial Accounting Standards Board (“FASB”) Statement No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation”, as amended by FASB Statement No. 148 (“SFAS 148”), Transition and Disclosure, an Amendment of SFAS 123, to stock-based employee compensation, expensed on a straight-line basis:

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Recognition of Net Periodic Benefit Cost

Prior to September 2000, Comdial provided a defined pension benefit to its employees. In September 2000, the Company froze this plan. The following table sets forth the net periodic benefit cost recognized during the three and nine months ended September 30, 2004 and September 30, 2003:

NOTE B. SOUNDPIPE ACQUISITION

On June 6, 2003, Comdial Acquisition Corp. (“CAC”), a Delaware corporation and a wholly-owned subsidiary of Comdial, completed the acquisition of substantially all of the assets of Soundpipe Inc. (“Soundpipe”), a privately held Delaware corporation with its sole office in Santa Clara, California. Soundpipe was primarily engaged in the design and development of telecommunications equipment utilizing voice over Internet Protocol (“VoIP”) technology. The assets acquired include all of Soundpipe’s intellectual property, including, but not limited to equipment prototypes, software source code and several patent applications and trade secrets, and certain physical assets including computer equipment and office furnishings.

The acquisition involved the issuance of a total of 250,000 unregistered shares of the common stock of Comdial, par value $0.01 (the “Stock”), the payment of $15,000 in cash to East Peak Advisors LLC, advisors to Soundpipe, the payment of $20,000 in legal fees incurred by Soundpipe in the transaction, and the assumption of certain specified operating liabilities.

CAC also extended offers of employment to eight then current or former employees of Soundpipe, and issued a total of 500,000 options to acquire the common stock of Comdial. Included in the foregoing, CAC has entered into one-year employment agreements with the three principal founders of Soundpipe and issued a total of 330,000 of the aforementioned stock options pursuant to those employment agreements. In addition to the acquisition of the assets of Soundpipe, CAC also assumed certain executory contracts of Soundpipe, including certain software licenses and Soundpipe’s office lease.

Comdial accounted for the acquisition in accordance with Financial Accounting Standards Board Statement No. 141, Business Combinations (“Statement 141”). The acquisition was measured on the basis of the fair values exchanged. The Company acquired current assets with an estimated fair value of $12,900 and property and equipment with an estimated fair value of $61,000. Comdial assumed certain operating liabilities with an estimated fair value of $120,000 and issued 250,000 shares of common stock, which were valued at the closing stock price on June 6, 2003 of $2.00 per share, for a fair value of $500,000. To determine the fair value of the acquired technology, Comdial measured the projected discounted net cash flows for the next two years and estimated that the fair market value of the technology significantly exceeded the cost of the acquisition. In accordance with Statement 141, since the total fair value of assets acquired and liabilities assumed exceeded the total cost of the acquisition (the “excess”), the excess was reduced from the fair value assigned to the purchased technology. Consequently, the amount assigned to the acquired technology was $546,000 and is reported in capitalized software development costs in the accompanying condensed consolidated balance sheets.

Prior to the Soundpipe acquisition, Comdial had two development projects that had reached technological feasibility and software development costs were being capitalized. As a result of the Soundpipe acquisition, management reviewed all current development projects in process and, in order to maximize benefits from development funds expended, placed emphasis on the Soundpipe technology acquired. Therefore, management decided to discontinue these two historical Comdial development projects. The software that had been developed is not expected to be used in any future product development and will not generate any future cash flows. As a result, the amounts that had been capitalized related to those two projects of $365,000 were written off in June 2003 and are recorded as impairments of long-lived assets in the condensed consolidated income statement.

NOTE C. INVENTORIES

Inventories, net of allowances, consist of the following:

Comdial records provisions for product obsolescence, which reduce gross margin. Allowances for inventory obsolescence amounted to $1.7 million and $2.3 million as of September 30, 2004 and December 31, 2003, respectively. Changes in reserves will be dependent on management’s estimates of the recoverability of costs from inventory.

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As of September 30, 2004, the Company purchases substantially all of its finished goods from four outsource manufacturers.

NOTE D. DEBT

Long-term debt consists of the following:

On March 30, 2004, the Company and RFC reached agreement to further reduce the total payments due under the capital leases from a combined balance of approximately $1.2 million to a payout schedule over 12 months totaling approximately $0.5 million. For the first 11 months, the monthly payment is $40,000, with a final payment of $90,000, which includes $50,000 representing the purchase price of the equipment. Based on the new agreement, the Company recognized a gain on lease restructuring of $0.6 million during the first quarter of 2004. In April 2004, the Company purchased a certificate of deposit to secure an irrevocable Standby Letter of Credit in the amount of $530,000 as required by RFC. This amount was recorded as restricted cash in the Company’s balance sheet. On a quarterly basis, as payments are made to RFC under the agreement, the Letter of Credit and the certificate of deposit can be reduced by the amount of the payments made during the respective quarter.

The 2004 Bridge Notes are subordinate to the senior subordinated secured convertible notes that were issued by the Company pursuant to the private placement the Company consummated in 2002 for gross proceeds of $13.3 million described in (3) below and the private placement the Company consummated with Winfield Capital Corp. in 2002 of $2.0 million described in (4) below and to any senior credit facility or other secured obligations the Company enters into with a bank, insurance company, finance company or other institutional lender, including the credit facility the Company obtained in April 2004 and described in (5) below.

The holders of the 2004 Bridge Notes have the right to convert the 2004 Bridge Notes into common stock at the conversion price of $2.50 per share at any time prior to the maturity of the notes, in whole or in part. The Company may convert the 2004 Bridge Notes into common stock at $2.50 per share if (i) the average closing price of the common stock equals or exceeds $5.00 per share for 20 consecutive trading days, (ii) the average daily trading volume during such 20 days is at least 50,000 shares, (iii) the common stock is then trading on a national stock exchange such as the Nasdaq National Market or the Nasdaq SmallCap Market, (iv) the shares into which the 2004 Bridge Notes would be converted are registered with the Securities and Exchange Commission (“SEC”) or are exempt from registration pursuant

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to SEC Rule 144(k), and (v) the shares are not subject to any contractual restrictions on trading, such as a lock-up agreement with an underwriter. The 2004 Bridge Notes mature on the earlier of (i) the later of September 27, 2005 or the maturity of the 2002 Placement Notes or (ii) the occurrence of certain events.

The 2004 Bridge Warrants are exercisable by the holder at any time until February 17, 2007 at an exercise price of $3.38 per share, either by paying such amount in cash to the Company or on a cashless exchange basis. The Company can redeem the 2004 Bridge Warrants by paying the holder $0.01 per share upon five business days notice, if: (a) the closing price of the common stock is at least $6.76 for 20 consecutive trading days; (b) the common stock is trading on the Nasdaq SmallCap, Nasdaq National Market or another national securities exchange; (c) the average daily trading volume during such 20 day period equals or exceeds 50,000 shares; and (d) the shares issuable upon exercise of the 2004 Bridge Warrants are covered under an effective registration statement or are otherwise exempt from registration.

Because the 2004 Bridge Notes were issued with detachable warrants, the proceeds were allocated to the debt securities and the warrants based on their relative fair values. The 2004 Bridge Warrants, which were valued using the Black Scholes method, were recorded as additional paid-in capital. Because the 2004 Bridge Notes are convertible at a price less than the Company’s market price per share on the closing date, they contain a beneficial conversion feature for accounting purposes. Based on the stock price on the closing date the beneficial conversion feature was calculated using the intrinsic method and equaled an amount in excess of the proceeds allocated to the 2004 Bridge Notes. Therefore, the entire remaining proceeds from the 2004 Bridge Notes were recorded as additional paid-in capital, reducing the net debt balance as recorded to zero at its issuance. Based on the allocation of proceeds to the warrants and the beneficial conversion feature, the resulting debt discount of $9.0 million is being accreted over the term of the debt, using the effective interest method, and this accretion is included in interest expense. As of September 30, 2004, $0.0 million of the 2004 Bridge Notes has been accreted.

As of September 30, 2004, Comvest, Shea Ventures, LLC and Neil P. Lichtman, our CEO, all of which are related parties, hold a total of $2.4 million face value of the 2004 Bridge Notes and 2004 Bridge Warrants to purchase 0.5 million shares of common stock.

In connection with the 2004 Bridge Financing, the Company entered into an amendment to the Placement Notes that extends the maturity of the notes by one year to September 27, 2006. This amendment resulted in no gain or loss being recognized at the time of the amendment. In addition, the Placement Notes may in the future be convertible under certain circumstances at the option of the Company if the common stock of the Company trades at or above $10.00 per share for 20 consecutive trading days. The initial conversion price of the Placement Notes is $4.95 per share. The conversion price of the Placement Notes is subject to downward adjustment in the event of certain defaults. The amendment also grants certain registration rights to the holders of the Placement Notes.

The entire principal amount of the Placement Notes is payable on the maturity date. The Placement Notes contain a provision under which the Company is required to prepay a portion of the notes equal to 50% of the amounts raised in excess of $5 million from any subsequent financing transaction. Any such repayment is subordinated in right of payment to the prior payment in full of the principal and interest of the Winfield Notes (defined below) and therefore, the Placement Notes were shown as long-term debt at March 31, 2004. In the second quarter of 2004, the Company obtained a waiver of the prepayment provision under the Placement Notes solely with respect to the 2004 Bridge Financing. Interest-only at 7% is payable quarterly in arrears. The Placement Notes are secured by a second lien (subordinated to the first lien of Winfield Capital Corp. described in (4) below) on substantially all of the Company’s assets. While the notes are outstanding, the Company is restricted from declaring or paying any dividends or distributions on its outstanding common stock.

As of September 30, 2004, Comvest and Shea Ventures, LLC, which are related parties, hold a total of $6.6 million face value of the Placement Notes.

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Corp. of $2.0 million (the “Winfield Transaction”). The Winfield Transaction consisted of 12% subordinated secured convertible promissory notes (the “Winfield Notes”) and warrants to purchase 0.4 million shares of common stock at an exercise price of $0.15 per share (the “Winfield Warrants”) at any time through September 27, 2004. Because the Winfield Notes were issued with detachable warrants, the proceeds were allocated to the debt securities and the warrants based on their relative fair values. The Winfield Warrants, which were valued at $0.3 million using the Black Scholes method, have been recorded as discount on the Winfield Notes and are being accreted over the term of the debt, using the effective interest method, and this accretion is included in interest expense. As of September 30, 2004, $0.1 million of the Winfield Notes have been accreted.

The Winfield Notes may in the future be convertible under certain circumstances at the option of the Company if the common stock of the Company trades at or above $15.00 per share for 20 consecutive trading days. The initial conversion price of the Winfield Notes is $4.95 per share. The conversion price of the Winfield Notes is subject to downward adjustment in the event of certain defaults.

The Winfield Note contains a provision under which the Company is required to prepay a portion of the Note equal to 50% of the amount raised in excess of $5 million from any subsequent financing transaction. Accordingly, as of March 31, 2004, $1.7 million of the Winfield Note’s outstanding principal balance was recorded as current maturities of long-term debt. In the second quarter of 2004, the Company entered into an amendment to the Winfield Notes (the “Amendment”) that changed the maturity date to March 27, 2006 and changed the Company’s option to extend the maturity date of the notes to up to six months (versus up to one year under the original note agreement). This amendment resulted in no gain or loss being recognized at the time of the amendment. The amendment also included a waiver of the mandatory prepayment provision in the original note, solely with respect to the 2004 Bridge Financing. Accordingly, the outstanding principal balance was recorded in full as long-term debt as of June 30, 2004.

The principal amount of the Winfield Notes is payable on the maturity date. Interest at 12% is payable quarterly in arrears. The Winfield Notes are senior in right of payment and security to the Placement Notes and the 2004 Bridge Notes. While the Winfield Notes are outstanding, the Company is restricted from declaring or paying any dividends or distributions on its outstanding common stock.

Interest expense, net was comprised of the following during the three and nine months ended September 30, 2004 and 2003:

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NOTE E. PRODUCT WARRANTY LIABILITY

In most cases, we provide a two-year warranty to our customers, including repair or replacement of defective equipment. Our outsource manufacturing partners are responsible for the first year of the warranty repair work. We use a third party contractor to perform much of this warranty. We provide for the estimated cost of product warranties at the time the revenue is recognized. We calculate our warranty liability based on historical product return rates and estimated average repair costs. While we engage in various product quality programs and processes, our warranty obligation may be affected by product failure rates, the ability of our outsource manufacturers to satisfy warranty claims and the cost of warranty repairs charged by the third party contractor. The outcome of these items could differ from our estimates and revisions to the warranty estimates could be required. The table below summarizes the changes in the Company’s product warranty liability for the nine months ended September 30, 2004 and 2003:

During the nine months ended September 30, 2004 and 2003, the Company recorded a decrease in its warranty liability, which increased gross margin by $0.2 million and $0.1 million, respectively. The reduction to the warranty liability was due to several factors, including a reduction in product repair return rates and a reduction in the sales volume.

NOTE F. LOSS PER SHARE

Basic loss per share is computed by dividing net loss by the weighted average number of common shares outstanding during the period. Diluted loss per share is computed by dividing net loss by the weighted average number of common and potentially dilutive common shares outstanding during the period.

Unexercised options to purchase 2,714,072 and 1,573,951 shares of common stock and warrants to purchase 1,817,708 and 905,510 shares of common stock for the three and nine months ended September 30, 2004 and 2003, respectively, were not included in the computations of diluted loss per share because assumed exercise would be anti-dilutive.

The following table discloses the quarterly information for the three and nine months ended September 30, 2004 and 2003:

During the three months ended September 30, 2004 and 2003, 5,351 and 0 stock options were exercised at a weighted average exercise price of $0.98 and $0, respectively. During the three months ended September 30, 2004 and 2003, 728,233 and 0 warrants were exercised at a weighted average exercise price of $0.15 and $0, respectively.

NOTE G. SEGMENT INFORMATION

During the first nine months of 2004 and 2003, substantially all of the Company’s sales, net loss, and identifiable net assets were attributable to the telecommunications industry with virtually 100% of sales occurring in the United States.

The Company organizes its product segments to correspond with the industry background of primary business and product offerings which fall into three categories: (1) voice switching systems for small to mid-size businesses, (2) voice messaging systems, and (3) computer telephony integration (“CTI”) applications and other. Each of these categories is considered a business segment, and with respect to their financial performance, the costs associated with these segments can only be quantified and identified to the gross profit level for each segment. These three product segments comprise substantially all of Comdial’s sales to the telecommunications market.

The information in the following tables is derived directly from the segment’s internal financial reporting used for management purposes. Unallocated costs include operating expenses, interest expense, other miscellaneous expenses, gains on restructurings and income tax expense. Comdial does not maintain information that would allow assets, liabilities, or unallocated costs to be broken down into the various product segments as most of these items are shared in nature.

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The following table shows segment information for the nine months ended September 30, 2004 and 2003:

NOTE H. COMMITMENTS AND CONTINGENT LIABILITIES

Comdial currently and from time to time is involved in litigation arising in the ordinary course of its business. The Company believes that certain of these may have a significant impact on the Company and these claims are described below. Comdial can give no assurance that the resolution of any particular claim or proceeding would not have a material adverse effect on its results of operations, cash flows or financial condition.

In a suit filed against the Company in Sebastian County, Arkansas in June 2004, a customer alleges a breach of warranty claim and a violation of the Arkansas Deceptive Trade Practices Act in relation to a Comdial telecommunications system purchased by the customer. The total damages alleged are approximately $0.1 million. Comdial believes it has adequate substantive and procedural defenses against all claims made against Comdial in this matter and no amounts have been accrued in the Company’s financial statements for any losses.

During late 2002, the Company began discussions with a third party concerning a potential claim of patent infringement that such party has indicated it may bring against the Company. Although the Company expects to settle such claim prior to litigation, there can be no assurance that such settlement will be reached, or, even if settlement is reached, that the terms of such settlement will not have a material adverse affect on the Company. If settlement is not reached, and if litigation is filed against the Company, defense of such case will likely result in material expenditures and could have a material adverse affect on the Company. Further, there can be no assurance that the Company would prevail in such litigation, and a finding against the Company could reasonably be expected to have a material adverse affect on the Company. The Company has accrued its estimate of the probable settlement amount with respect to this matter, which is not material to the financial statements.

In suits filed against the Company and Allegheny Voice & Data, Inc. (“Allegheny”) in Kanawha County, West Virginia since November 2002, several former tenants of a commercial building, through their insurance carriers, allege that a telecommunications system sold by Comdial and installed by Allegheny caused a fire resulting in damage to the building. The total damages sought against Comdial and Allegheny by all claimants is approximately $1.1 million. After substantial investigation into this matter, the Company believes its equipment was not the cause of the fire, and has denied all of the substantive claims made against it in this matter. Motions are pending to consolidate these cases. No amounts have been accrued in the Company’s financial statements for any losses.

In November 2002, the Company filed a demand for arbitration with the American Arbitration Association against Boundless Manufacturing Services, Inc. (“Boundless”). Among other things, the Company contends that Boundless breached its contractual obligations to the Company by failing to meet the Company’s orders for the delivery of products manufactured by Boundless. The Company’s demand seeks damages in excess of $6.0 million. On February 6, 2003, Boundless responded to the Company’s demand by denying substantially all of the Company’s claims and asserting counterclaims totaling approximately $8.2 million, including approximately $0.8 million in past due invoiced amounts. The Company believes that Boundless’ claims are substantially without merit and that it has adequate substantive and procedural defenses against such claims. On March 13, 2003, Boundless announced that it has filed for protection pursuant to Ch. 11 of the U.S. Bankruptcy Code, causing a stay in the arbitration matter. It is not known at this time whether this filing will have any long-term impact on the arbitration, or whether the arbitration will eventually proceed. No amounts have been accrued in the Company’s financial statements for any losses.

On March 5, 2001, William Grover, formerly a senior vice president of Comdial, filed suit in state court in Charlottesville, Virginia alleging breach of an employment contract and defamation, and seeking compensatory, punitive and exemplary damages in the total amount of $1.9 million, plus interest. Among other things, Mr. Grover claimed that the for-cause termination of

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his employment was unjustified and that he is therefore entitled to all benefits accrued to him pursuant to the Company’s executive retirement plan. In pre-trial proceedings, the court dismissed all claims except for the tortious interference claim. On March 18, 2004, following a jury trial on that claim, the court granted Comdial’s motion to dismiss and the case was ended without jury deliberations. In late March, Mr. Grover filed a motion for reconsideration, which was denied and Mr. Grover subsequently appealed this decision on July 30, 2004. It is unknown at this time whether Mr. Grover’s appeal will be granted. Comdial believes it has adequate substantive and procedural defenses against all claims made against Comdial in this matter and no amounts have been accrued in the Company’s financial statements for any losses.

NOTE I. RESTRUCTURING

In connection with the Company’s continued focus on improving cash flow from operations, the Company initiated a restructuring plan (the “Plan”) during the first quarter of 2004. Pursuant to the Plan, approximately 20 employees were notified as of March 15, 2004 that their positions would be eliminated. These employees will receive severance based on length of service with the Company and/or employment agreements, as applicable. Until March 2004, Nickolas A. Branica served as the Company’s CEO. In March 2004, Mr. Branica’s employment relationship with the Company terminated. Pursuant to Mr. Branica’s employment agreement as amended, he will receive as severance an amount equal to twelve months of his annual base salary at the rate in effect on the date his employment ended. Mr. Branica will receive medical, life and other insurance benefits for a period of up to twelve months following his employment separation. During the three and nine months ended September 30, 2004, the Company made cash severance payments of $0.1 million and $0.2 million, respectively. As of September 30, 2004, the Company has remaining obligations of $0.1 million related to severance and related benefits. These amounts are included in restructuring expenses in the accompanying condensed consolidated statement of operations for the nine months ended September 30, 2004.

In addition to his severance as outlined above, all of Mr. Branica’s stock options were immediately vested at the time of his termination. In connection with the modification of Mr. Branica’s stock option agreement, the Company recorded stock compensation expense of approximately $0.2 million for the quarter ended March 31, 2004. This amount is also included in restructuring expenses in the accompanying condensed consolidated statement of operations for the nine months ended September 30, 2004.

NOTE J. SUBSEQUENT EVENTS

On October 7, 2004, the Company announced that it had entered into a Business Loan and Security Agreement (the “Agreement”) with a voice and data solutions provider (the “Borrower”). Per the Agreement, Comdial loaned the Borrower $800,000, bearing interest at 8 percent; with a maturity date of September 30, 2005. The loan is secured by all of the assets of the Borrower and certain other collateral. As part of the Agreement, Comdial received warrants to purchase an equity interest equal to 3% of the outstanding common stock of the Borrower.

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COMDIAL CORPORATION AND SUBSIDIARIES

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

The following discussion is intended to assist the reader in understanding and evaluating the financial condition and results of operations of Comdial Corporation and its subsidiaries (the “Company” or “Comdial”). This review should be read in conjunction with the condensed consolidated financial statements and accompanying notes continued herein. This analysis attempts to identify trends and material changes that occurred during the periods presented.

Comdial is a Delaware corporation based in Sarasota, Florida. Comdial’s common stock is quoted on the Over the Counter Bulletin Board under the symbol “CMDZ.OB”.

Comdial designs and markets sophisticated voice communications solutions for small to mid-sized offices. Comdial’s products consist of business telephone systems, unified and voice messaging, call processing, and computer telephony integration solutions. Comdial has shipped approximately 400,000 business phone systems and 4 million telephones.

As part of our restructuring program, we have outsourced substantially all of our manufacturing requirements. Outsourced manufacturing is carried out in three principal locations: Asia, Mexico and the United States. During June 2003, Comdial purchased the technology and assets of Soundpipe Inc. (“Soundpipe”). Soundpipe was primarily engaged in the design and development of communication solutions utilizing voice over Internet Protocol (“VoIP”) technology and the acquisition enhanced Comdial’s development efforts in this area.

Overview

During the past four years, Comdial’s net sales levels have decreased from the previous year’s activity. Primary causes for the decrease include, but are not limited to:

The decline in revenue from enterprise voice communications systems is attributable in part to the significant investments in these systems made by enterprises in the late 1990s in anticipation of Year 2000. We believe enterprises have been reluctant to make additional investments in voice communications systems until their existing investments have been fully amortized over their 7-10 year useful life. In addition, we believe many customers are hesitant to invest in traditional voice communications systems as they are anticipating the widespread adoption of next-generation communications systems, such as IP telephony systems.

Since the third quarter 2002 financial restructuring, the Company has focused a significant amount of management’s efforts at stabilizing the business, increasing market share, re-establishing its relationships with its wholesale distributors and dealer partners, focusing its product development efforts on IP-PBX related products, and improving gross margins and cash flow from operations.

The Key/hybrid voice switching market that Comdial has primarily operated in historically has declined in system line shipments since 2000. As reported by Phillips Infotech (InfoTrack for Enterprise Communications, Third Quarter 2003 Report), the IP-PBX market that much of Comdial’s primary product development efforts are focused on, however, is expected to increase in system line shipments 35%, 23%, 25%, and 22% for the years 2004 through 2007, respectively. In the future, it will be important for Comdial to increase its market share in the IP-PBX market.

In the first quarter of 2004, the Company hired a new president and CEO, Neil P. Lichtman, to lead the Company in its efforts to increase revenue from both current and new channels as well as business development and to bring additional products and services to our channel.

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Recent Developments

On October 7, 2004, the Company announced that it had entered into a Business Loan and Security Agreement (the “Agreement”) with a voice and data solutions provider (the “Borrower”). Per the Agreement, Comdial advanced the Borrower $800,000, bearing interest at 8 percent; with a maturity date of September 30, 2005. The loan is secured by all of the assets of the Borrower and certain other collateral. As part of the Agreement, Comdial received warrants to purchase an equity interest equal to 3% of the outstanding common stock of the Borrower.

Critical Accounting Policies and Estimates

The condensed consolidated financial statements of the Company are prepared in accordance with accounting principles generally accepted in the United States, which requires the use of estimates and assumptions. Management believes the following critical accounting policies, among others, affect its more significant judgments and estimates used in the preparation of its condensed consolidated financial statements.

Revenue Recognition

We recognize revenue using the guidance from SEC Staff Accounting Bulletin No. 101 “Revenue Recognition in Financial Statements”, Staff Accounting Bulletin No. 104, “Revenue Recognition, Corrected Copy”, and the American Institute of Certified Public Accountants Statement of Position No. 97-2, as amended, on “Software Revenue Recognition.” We allow our distributors to return unsold product when they meet Company-established criteria as outlined in the Company’s trade terms. Under these guidelines, we estimate the amount of product returns based upon actual historical return rates and any additional unique information and reduce our revenue by these estimated future returns. Returned products, which are recorded as inventories, are valued based upon expected realizability. If the historical data we use to calculate these estimates does not properly reflect future returns, these estimates could be revised.

Rebates and Incentives

We record estimated reductions to revenue for customer programs and incentive offerings including special pricing agreements, promotions, distributor price protection and other volume-based incentives. If market conditions were to decline, we may take actions to increase rebates and incentive offerings possibly resulting in incremental reduction of revenue at the time the incentive is offered.

Warranty

In most cases, we provide a two-year warranty to our customers, including repair or replacement of defective equipment. In the third quarter of 2004, the Company began selling five-year extended warranties on certain of its products. Our outsource manufacturing partners are responsible for the first year of the warranty repair work. We are using a third party contractor to perform much of this warranty. We provide for the estimated cost of product warranties at the time the revenue is recognized. We calculate our warranty liability based on historical product return rates and estimated average repair costs. While we engage in various product quality programs and processes, our warranty obligation may be affected by product failure rates, the ability of our outsource manufacturers to satisfy warranty claims and the cost of warranty repairs charged by the third party contractor. The outcome of these items could differ from our estimates and revisions to the warranty estimates could be required.

Allowance for Doubtful Accounts

We provide allowances for doubtful accounts for estimated losses from the inability of our customers to satisfy their accounts as originally contemplated at the time of sale. We calculate these allowances based on the detailed review of certain individual customer accounts, historical rates and our estimation of the overall economic conditions affecting our customer base. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Inventory

We measure our inventories at lower of cost or market. For those items that we manufacture, cost is determined using standards that we believe approximate first-in, first-out (“FIFO”) method including material, labor and overhead. We also provide allowances for excess and obsolete inventory equal to the difference between the cost of our inventory and the estimated market value based upon assumptions about product life cycles, product demand and market conditions. If actual product life cycles, product demand, or market conditions are less favorable than those projected by management, additional inventory allowances or write-downs may be required.

Deferred Income Taxes

We estimate our actual current tax exposures together with our temporary differences resulting from differing treatment of items for accounting and tax purposes. These temporary differences

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result in deferred tax assets and liabilities. We then must assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent that we believe that recovery is not likely, based on the guidance in Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes”, we establish a valuation allowance. As of September 30, 2004 and December 31, 2003, all net deferred tax assets were reduced by a valuation allowance. In later years, after the Company ceases to have cumulative tax losses for three years, management will need to assess the continuing need for a full or partial valuation allowance. Significant judgment is required in this calculation and changes in this assessment could result in income tax benefits, in later periods, or the continued provision of valuation allowances until the realizability is more likely than not.

Long-lived Assets, including Goodwill and Other Intangibles

Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”) establishes a single accounting model for long-lived assets to be disposed of by sale. For long-lived assets that are held for use, the Company compares the forecasted undiscounted net cash flows to the carrying amount. If the long-lived asset is determined to be unable to recover the carrying amount, then it is written down to fair value. A considerable amount of judgment is required in calculating this impairment charge, principally in determining financial forecasts. Unanticipated changes in market conditions could have a material impact on the Company’s projected cash flows. Differences in actual cash flows as compared to the projected cash flows could require us to record an impairment.

SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”) includes requirements to test goodwill and indefinite lived intangible assets for impairment rather than amortize them. Goodwill and other indefinite lived intangible assets must be tested for impairment on at least an annual basis. Each October 1, impairment of goodwill is tested using a two step method. The first step is to compare the fair value of the reporting unit to its book value, including goodwill. Fair value is determined based on discounted cash flows, appraised values or management’s estimates, depending upon the nature of the assets. If the fair value of the unit is less than its book value, the Company then determines the implied fair value of goodwill by deducting the fair value of the reporting unit’s net assets from the fair value of the reporting unit. If the book value of goodwill is greater than its implied fair value, the Company writes down goodwill to its implied fair value. The Company’s goodwill relates to the messaging business segment. The Company performed its annual impairment review in October 2003 and determined that no goodwill impairment charge needed to be recorded; however, there can be no assurances that subsequent reviews will not result in material impairment charges. A considerable amount of judgment is required in calculating this impairment analysis, principally in determining discount rates, financial forecasts, and allocation methodology. Unanticipated changes in market conditions could have a material impact on the Company’s projected cash flows. Differences in actual cash flows as compared to the projected discounted cash flows could require us to record an impairment loss.

Retirement and Other Postretirement Benefit Plans

Prior to September 2000, we provided a defined pension benefit to our employees. In September 2000, we froze this plan. We accrue benefit obligations based on an independent actuarial valuation. This valuation has a number of variables, not only to estimate our benefit obligation, but also to provide us with minimum funding requirements for the retirement plan. The actuarial estimates include the expected rate of return on the retirement plan assets, the rate of compensation increases to eligible employees and the interest rate used to discount estimated future payments to retirement participants. Differences in actual experience as compared to these estimates or future changes in these estimates could require us to make changes to these benefit accruals or recognize under funding in our pension plan.

On December 31, 2003, the projected benefit obligations exceeded the market value of the plan assets (adjusted for accruals) by $8.4 million. The Company’s actuarial estimates have not been updated since December 31, 2003. If the Company’s investment return and other actuarial assumptions remain unchanged, no contributions are projected to be required through 2004.

Commitments and Contingencies

Management’s current assessment of the claims that have been asserted against the Company is based on our review of the claim, our defenses and consultation with certain of our external legal counsel. Changes in this assessment could result as more information is obtained or as management decides that a settlement is more advantageous to the Company than a protracted legal process. These changes in our estimates of the outcome could require us to make changes in our conclusions or our accruals for these contingencies.

Special Note Regarding Forward-Looking Statements

Some of the statements included or incorporated by reference into our Securities and Exchange Commission filings, press releases, and shareholder communications and other information provided periodically in writing or orally by our officers, directors or agents, including this Form 10-Q, are forward-looking statements that are subject to risks and uncertainties. These forward-looking statements are not historical facts but rather are based on certain expectations, estimates and projections about our industry, our beliefs and our assumptions. These risks could cause our actual results for 2004 and beyond to differ materially from those expressed, implied or

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forecasted in any forward-looking statement made by, or on behalf of, us. The risks and uncertainties include, but are not limited to, those discussed in “Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995” set forth on page 19.

Results of Operations

The following table sets forth for the periods indicated the percentage of revenues represented by certain items reflected in our statements of operations:

Third Quarter 2004 vs. 2003

Comdial’s net sales for the third quarter of 2004 were $11.9 million compared to $12.5 million in the third quarter of 2003, primarily due to market contraction. As of September 30, 2004 Comdial’s backlog for future product deliveries was $1.1 million as compared with $1.3 million as of September 30, 2003. This decrease can be attributable to larger than normal sales orders shipped in the last part of the quarter ending September 30, 2004.

Gross profit for the third quarter of 2004 was $4.8 million compared to $4.8 million in the third quarter of 2003. Gross profit, as a percentage of sales, was 40% for the third quarter of 2004 compared to 39% for the same period of 2003. This small increase is due in part to a change in product mix, as the Company sold more higher margin products in the third quarter of 2004 compared with the same period of 2003.

Selling, general and administrative expenses (“SG&A”) remained relatively the same for the third quarter of 2004, compared with the third quarter of 2003. SG&A expenses, as a percentage of sales, increased to 32% for the third quarter of 2004 compared with 31% for the same period of 2003, primarily due to lower net sales in the third quarter of 2004 compared with the same period of 2003.

Engineering, research and development expenses remained relatively the same for the third quarter of 2004, compared with the third quarter of 2003, at $0.9 million. Engineering expenses, as a percentage of sales, increased to 8% for the third quarter of 2004 compared with 7% for the third quarter of 2003, due to lower net sales in the third quarter of 2004 compared with the same period of 2003. Comdial continues to emphasize new product development, primarily associated with the CONVERSip^TM product line.

Interest expense, net decreased for the third quarter of 2004 by 19% to $0.7 million, compared with $0.8 million in the third quarter of 2003 due to the timing of interest recognition of high effective rate debt, when using the effective interest method.

The net loss for the third quarter of 2004 was $0.6 million compared with $0.8 million for the third quarter of 2003, primarily as a result of the decrease in interest expense.

First Nine months of 2004 vs 2003

Comdial’s net sales for the first nine months of 2004 were $30.3 million compared to $37.8 million in the first nine months of 2003 primarily due to market contraction and turnover in the sales force.

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Gross profit for the first nine months of 2004 was $11.3 million compared to $14.4 million in the first nine months of 2003. Gross profit, as a percentage of sales, was 37% for the first nine months of 2004 compared to 38% for the same period of 2003. This decrease is due in part to a change in product mix, as the Company sold more lower margin products in the nine months ending September 30, 2004 compared with the same period of 2003.

Selling, general and administrative (“SG&A”) expenses increased for the first nine months of 2004 by 1% to $12.1 million, compared with $12.0 million in the first nine months of 2003. SG&A expenses, as a percentage of sales, increased to 40% for the first nine months of 2004 compared with 32% for the same period of 2003. This increase in SG&A expense as a percentage of net sales is primarily a result of lower net sales in the first nine months of 2004 compared with the same period of 2003.

Engineering, research and development expenses for the first nine months of 2004 decreased by 4% to $2.6 million, compared with $2.7 million for the first nine months of 2003. This decrease is primarily a result of increased capitalization of costs associated with new product development, primarily the CONVERSip^TM product line. Engineering expenses, as a percentage of sales, increased to 8% for the first nine months of 2004 compared with 7% for the first nine months of 2003.

In connection with the Company’s continued focus on improving cash flow from operations the Company initiated a restructuring plan during the first quarter of 2004 resulting in severance and related expenses of $0.5 million (see Note I).

Prior to the Soundpipe acquisition (see Note B), Comdial had two development projects that had reached technological feasibility and software development costs were being capitalized. As a result of the Soundpipe acquisition, management reviewed all current development projects in process and, in order to maximize benefits from development funds expended, placed emphasis on the Soundpipe technology acquired. Therefore, management decided to discontinue these two historical Comdial development projects. The software that had been developed is not expected to be used in any future product development and will not generate any future cash flows. As a result, the amounts that had been capitalized related to those two projects of $365,000 were written off in June 2003 and are recorded as impairments of long-lived assets in the condensed consolidated income statement.

Interest expense decreased for the first nine months of 2004 by 23% to $1.9 million, compared with $2.5 million in the first nine months of 2003 due to the timing of interest recognition of high effective rate debt, when using the effective interest method.

The net loss for the first nine months of 2004 was $5.2 million compared with $3.1 million for the first nine months of 2003, as a result of lower than anticipated sales due to market contraction offset by a decrease in interest expense.

Liquidity and Capital Resources:

Historically, the Company’s liquidity and capital resources have been highly dependent on cash funding from external sources of interest-bearing capital. Until the Company’s operations generate sufficient positive cash flow from operations to cover capital expenditures and debt service, the Company will be required either to convert interest-bearing debt securities to equity securities or to raise additional cash through additional debt or equity-based capital transactions. Management believes improvements in cash flow from operations will be based, to a large extent, on moving the Company further into the IP-PBX market, which is anticipated to grow in the next four years, on improving gross margins for the IP-PBX products and on minimizing the overhead costs associated with its operations. The expansion of the Company’s IP-PBX net sales activity will be based on the recently introduced CONVERSip^TM product lines. Management believes that CONVERSip^TM sales will increase sequentially quarter to quarter for the remainder of 2004.

The following table sets forth Comdial’s cash and cash equivalents, current maturities on debt, and working capital at the dates indicated:

The Company’s net sales and working capital can be impacted by the extent of product inventories carried by the Company’s wholesale distribution partners at a given point in time. Fluctuations of these inventory levels can have a dramatic impact on the Company’s cash position.

In March 2004, the Company closed a bridge financing transaction (“2004 Bridge”) resulting in gross proceeds to the Company of $9.0 million (net proceeds of $8.2 million) and in April 2004, the Company obtained a $2.5 million asset-backed credit facility. The accompanying financial statements have been prepared on the going concern basis. Management believes that its cash flow from operations, combined with cash and working capital on hand, will be sufficient to allow the Company to meet its operating expenses, debt service and capital expenditure requirements for at least the next year.

As of September 30, 2004, the Company’s cash and cash equivalents were higher than December 31, 2003 by $4.9 million primarily due to the cash received from the 2004 Bridge financing. Working

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capital increased by $3.0 million primarily due to the 2004 Bridge financing and an increase in accounts receivable of $1.3 million, partially offset by a $1.2 million decrease in on-hand inventory and a $2.1 million increase in current maturities of long term debt.

The Company has a Master Lease Agreement with Relational Funding Corporation and its assignees (collectively “RFC”). This agreement covers certain leases related to an abandoned software implementation and hardware for internal use. On March 30, 2004, the Company and RFC reached agreement to further reduce the total payments due under the capital leases from a combined balance of approximately $1.2 million to a payout schedule over 12 months totaling approximately $0.5 million. In April 2004, the Company purchased a certificate of deposit to secure an irrevocable Standby Letter of Credit in the amount of $0.53 million as required by RFC. This amount is recorded as restricted cash in the Company’s balance sheet. On a quarterly basis, as payments are made to RFC under the agreement, the Letter of Credit and the certificate of deposit can be reduced by the amount of the payments made during the respective quarter.

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