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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended April 3, 2005

OR

For the transition period from                      to                     

Commission file number 1-8402

IRVINE SENSORS CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

3001 Red Hill Avenue

Costa Mesa, California 92626

(Address of Principal Executive Offices) (Zip Code)

(714) 549-8211

(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, (the “Exchange Act”) 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 þ No ¨

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

As of May 2, 2005, there were 18,516,591 shares of common stock outstanding.

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IRVINE SENSORS CORPORATION

QUARTERLY REPORT ON FORM 10-Q

FOR THE FISCAL PERIOD ENDED APRIL 3, 2005

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PART I - FINANCIAL INFORMATION

IRVINE SENSORS CORPORATION

CONSOLIDATED BALANCE SHEETS

See Accompanying Condensed Notes to Consolidated Financial Statements.

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IRVINE SENSORS CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

See Accompanying Condensed Notes to Consolidated Financial Statements.

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IRVINE SENSORS CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

See Accompanying Condensed Notes to Consolidated Financial Statements.

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IRVINE SENSORS CORPORATION

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1 – General

The information contained in the following Condensed Notes to Consolidated Financial Statements is condensed from that which would appear in the annual consolidated financial statements for Irvine Sensors Corporation and its subsidiaries (the “Company”). The accompanying unaudited condensed consolidated financial statements do not include certain footnotes and other financial presentations normally required under accounting principles generally accepted in the United States of America. Accordingly, the consolidated financial statements included herein should be reviewed in conjunction with the consolidated financial statements and related notes thereto contained in the Annual Report on Form 10-K of the Company for the fiscal year ended October 3, 2004 (“fiscal 2004”). It should be understood that accounting measurements at interim dates inherently involve greater reliance on estimates than at year-end. The results of operations for the interim periods presented are not necessarily indicative of the results expected for the entire year.

The consolidated financial information as of April 3, 2005 and March 28, 2004 included herein is unaudited but includes all normal recurring adjustments which, in the opinion of management of the Company, are necessary to present fairly the consolidated financial position of the Company at April 3, 2005, the results of its operations for the 26-week periods ended April 3, 2005 and March 28, 2004, and its cash flows for the 26-week periods ended April 3, 2005 and March 28, 2004.

Summary of Significant Accounting Policies

Company Operations. The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and settlement of obligations in the normal course of business. The Company generated net losses of $4,166,900 and $1,310,100 in fiscal 2004 and the 26-week period ended April 3, 2005, respectively. However, the Company had working capital of $2,523,100 at April 3, 2005, which management believes will be adequate to meet the liquidity requirements of the Company’s operating plan for at least the next twelve months. In the event of plan variances that impose unforeseen liquidity needs, management believes, but cannot guarantee, that the Company will be able to raise additional working capital to fund the Company’s operations. This belief is based on the Company’s historical access to equity financing. The Company has been advised of new government contract awards for the fiscal year ending October 2, 2005 (“fiscal 2005”) that management expects will contribute to cash flow in subsequent periods of fiscal 2005. At April 3, 2005, the Company had total stockholders’ equity of $7,808,400.

Consolidation. The consolidated financial statements include the accounts of Irvine Sensors Corporation (“ISC”) and its subsidiaries, Novalog, Inc., MicroSensors, Inc. (“MSI”), RedHawk Vision, Inc., iNetWorks Corporation, 3D Microelectronics, Inc. and 3D Microsystems, Inc. 3D Microelectronics and 3D Microsystems are inactive wholly-owned corporations and do not have material assets, liabilities or operations. All significant intercompany transactions and accounts have been eliminated in the consolidation.

Fiscal Periods. The Company’s fiscal year ends on the Sunday nearest September 30. Fiscal 2004 ended on October 3, 2004 and included 53 weeks, a fiscal year duration that is generally repeated once every six years. Fiscal 2005 will end on October 2, 2005 and will include 52 weeks. The Company’s second fiscal quarter and first 26 weeks of fiscal 2005 ended on April 3, 2005. The Company’s second fiscal quarter and first 26 weeks of fiscal 2004 ended on March 28, 2004.

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Use of Estimates. The preparation of the 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 amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. The Company believes its estimates of inventory reserves and estimated costs to complete contracts, as further discussed below, to be the most sensitive estimates impacting financial position and results of operations in the near term.

Inventory Reserves. Each quarter, the Company evaluates its inventories for excess quantities and obsolescence. Inventories that are considered obsolete are written off. Remaining inventory balances are adjusted to the lower of cost or market value. The valuation of inventories at the lower of cost or market requires the use of estimates as to the amounts of current inventories that will be sold. These estimates are dependent on management’s assessment of current and expected orders from the Company’s customers.

From time to time, the Company capitalizes material, labor and overhead costs expected to be recovered from a probable new contract. Due to the uncertainty associated with new or follow-on research and development contracts, the Company maintains significant reserves for this inventory to avoid overstating its value. The Company has adopted this practice because it is typically able to more fully recover such costs under the provisions of government contracts by direct billing of inventory rather than by seeking recovery of such costs through permitted indirect rates.

Estimated Costs to Complete and Accrued Loss on Contracts. The Company reviews and reports on the performance of its contracts against the respective plans. These reviews are summarized in the form of estimates of costs to complete the contracts (“ETCs”). ETCs include management’s current estimates of remaining amounts for direct labor, material, subcontract support and allowable indirect costs based on each contract’s completion status and either the current or re-planned future technical requirements under the contract. If an ETC indicates a potential overrun against budgeted program resources, management generally seeks to revise the program plan in a manner consistent with customer objectives to eliminate such overrun and to secure necessary customer agreement to such revision. To mitigate the financial risk of such re-planning, the Company attempts to negotiate the deliverable requirements of its research and development contracts to allow as much flexibility as possible in technical outcomes. When re-planning does not appear possible within program budgets, an accrual for contract overrun is recorded based on the most recent ETC of the particular program. In fiscal 2004, the Company changed its operational processes to assign an increased level of accountability for contract financial performance to the contract’s program manager.

During the 26 weeks ended April 3, 2005, the Company increased its accrued losses on contracts in progress by $57,100. This increase reflects a change in the Company’s aggregate estimate (excluding contingencies), which management believes reflects ETCs for contracts in progress based on their completion status at April 3, 2005 and current and future technical requirements under the program contracts.

Revenues. The Company’s consolidated revenues during the first 26 weeks of fiscal 2005 were primarily derived from contracts to develop prototypes and provide research, development, design, testing and evaluation of complex detection and control defense systems. The Company’s research and development contracts are usually cost reimbursement plus fixed fee, which require the Company’s good faith performance of a statement of work within overall budgetary constraints, but with latitude as to resources utilized, or fixed price level of effort, which require the Company to deliver a specified number of labor hours in the performance of a statement of work. Revenues for both types of contracts are recognized as costs are incurred and include applicable fees or profits primarily in the proportion that

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costs incurred bear to estimated final costs. Costs and estimated earnings in excess of billings under government contracts are accounted for as unbilled revenues on uncompleted contracts. The Company provides for anticipated losses on contracts by a charge to income during the period in which a loss is first identified. The accrual for contract losses is adjusted quarterly based on a review of outstanding contracts. Unbilled revenues on uncompleted contracts are stated at estimated realizable value.

United States government contract costs, including indirect costs, are subject to audit and adjustment by negotiations between the Company and government representatives. Indirect contract costs have been agreed upon through fiscal 2001 and are currently being audited for fiscal 2002. Contract revenues have been recorded in amounts that are expected to be realized upon final determination of allowable direct and indirect costs for the affected contracts.

The Company’s revenues derived from product sales in the 26 weeks ended April 3, 2005 were primarily the result of shipments of stacked chip products, largely memory stacks, but also included limited shipments of Novalog’s wireless infrared chips and modules and, for the first time, initial shipments of infrared viewers, one of our camera products. Product orders for the Company’s products are generally priced in accordance with the Company’s established price list. Memory stack products and wireless infrared products are primarily shipped to Original Equipment Manufacturers (“OEMs”). Infrared viewers are system level products that are primarily intended to be shipped to end user customers, initially for military applications. Revenues are recorded when products are shipped. Terms are FOB shipping point. Wireless infrared products are generally shipped with a 90-day warranty, but the Company has not experienced significant returns of these products to date. RedHawk is the licensor of a shrink-wrapped software product that has no formal warranty and also has not experienced significant returns. Other products have been shipped for developmental and qualification use or have not been sold under formal warranty terms. The Company does not offer contractual price protection on any of its products. Accordingly, the Company does not presently maintain any reserves for returns under warranty or post-shipment price adjustments.

Research and Development Costs. A major portion of the Company’s operations is comprised of customer-funded research and prototype development or related activities that are recorded as cost of contract revenues. The Company also incurs costs for research and development of new concepts in proprietary products. Such unfunded research and development costs are charged to research and development expense as incurred.

Inventory. Product inventory is valued at the lower of cost or market. Cost is determined by the first-in, first-out method. Inventories are reviewed quarterly to determine salability and obsolescence. A reserve is established for slow moving and obsolete product inventory items. In addition, marketing of specific government budgets and programs is facilitated by the capitalization of material, labor and overhead costs that are recoverable under government research and development contracts. Due to the uncertainties associated with such contract awards, the Company maintains significant reserves for this inventory to avoid overstating its value. (See Note 5).

Equipment, Furniture and Fixtures. The Company capitalizes costs of additions to equipment, furniture and fixtures, together with major renewals and betterments. Some projects require several years to complete and are classified as construction in progress, including expansion of the Company’s clean room facilities and related equipment. In addition, the Company capitalizes overhead costs for all in-house capital projects. Maintenance, repairs, and minor renewals and betterments are charged to expense. When assets are sold or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized. Depreciation of equipment, furniture and fixtures is provided over the estimated useful lives of the assets, primarily using the straight-line method.

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The useful lives are three to five years. Leasehold improvements are amortized over the terms of the leases.

Accounting for Stock-Based Compensation. Under the recently released Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), Share Based Payment (“SFAS 123(R)”), commencing with its fiscal year beginning October 3, 2005 (“fiscal 2006”) (the “implementation date”), the Company will be required to expense against the Company’s reported earnings: (1) the fair value of all option grants or stock issuances made to employees or directors on or after the implementation date; and (2) a portion of the fair value of each option and stock grant made to employees or directors prior to the implementation date that represents the unvested portion of these share-based awards as of such date. These amounts will be expensed after the implementation date over the respective vesting periods of each award. Additionally, if it chooses to do so, SFAS 123(R) permits the Company to adopt the new share-based award accounting by retrospectively restating results for all periods presented to facilitate period-to-period comparison. The Company has not yet made a determination as to whether it will adopt SFAS 123(R) retrospectively.

Until the adoption of SFAS 123(R), the Company will continue to account for stock-based employee compensation as prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees, and, SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure (“SFAS 148”). SFAS 148 requires pro forma disclosures of net income (loss) and net income (loss) per share as if the fair value based method of accounting for stock-based awards had been applied for employee and director grants. It also requires disclosure of option status on a more prominent and frequent basis. The Company accounts for stock options and warrants issued to non-employees based on the fair value method, but has not elected this treatment for grants to employees and directors. Under the fair value method, compensation cost is recorded based on the value of the award at the measurement date, generally the grant date, and is recognized over the service period.

The exercise prices of the options granted during the 26-week period ended April 3, 2005 were equal to the closing price of the Company’s common stock as reported by the Nasdaq SmallCap Market at the date of grant.

Pursuant to SFAS 148, the Company is required to disclose the effects on the net loss and per share data as if the Company had elected to use the fair value approach to account for all of its employee stock-based compensation plans. Had the compensation cost for all of the Company’s option plans, including those of its subsidiaries, been determined using the fair value method, the compensation expense would have increased the Company’s net loss for the 13-week and 26-week periods ended April 3, 2005 and March 28, 2004 as shown below. (See Note 4 for calculation of shares used in determining diluted net loss per share.)

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The fair value of each option granted during the 13-week and 26-week periods of the respective fiscal year on its grant date was estimated using the Black-Scholes option-pricing model. In the 26-week period ended April 3, 2005, the Company applied assumptions of no dividend yield; risk-free interest rates ranging from 3.09% to 3.85%, which approximated the Federal Reserve Board’s rate for treasuries at the time granted; expected lives of one to four years; and volatility rates of 70.5% and 77.1%. In the 26-week period ended March 28, 2004, the Company applied assumptions of no dividend yield; risk-free interest rates ranging from 2.16% to 2.38% which approximated the Federal Reserve Board’s rate for treasuries at the time granted; expected lives of one to two years; and volatility rates of approximately 70%. There were no option grants by subsidiaries during the 26-week periods ended April 3, 2005 and March 28, 2004. During the 26-week period ended April 3, 2005, the Company granted options to purchase 1,262,000 shares of the Company’s common stock, with a weighted average exercise price of $2.19 per share, and at a weighted average fair value of $1.05 per share. During the 26-week period ended March 28, 2004, the Company granted options to purchase 780,000 shares of the Company’s common stock, with a weighted average exercise price of $3.44 per share, and at a weighted average fair value of $1.34 per share.

Software Development and Purchased Software. Software development and purchased software costs are capitalized when technological feasibility and marketability of the related product have been established. The Company amortizes capitalized software costs beginning when the product is available for general release to customers. Annual amortization expense is calculated using the straight-line method over the estimated useful life of the product, not to exceed five years. The Company evaluates the carrying value of unamortized capitalized software costs at each balance sheet date to determine whether any net realizable value adjustments are required.

Long-Lived Assets. The Company continually monitors events or changes in circumstances that could indicate that the carrying amount of long-lived assets to be held and used, including goodwill and intangible assets, may not be recoverable. The determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. When impairment is indicated for a long-lived asset, the amount of impairment loss is the excess of net book value over fair value. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell. At April 3, 2005, management believed no indications of impairment existed.

Intangible and Other Assets. Other assets consist principally of patents and trademarks related to the Company’s various technologies. Capitalized costs include amounts paid to third parties for legal fees, application fees and other direct costs incurred in the filing and prosecution of patent and trademark applications. These assets are amortized on a straight-line method over their estimated useful life of ten years.

Income Taxes. Deferred tax assets and liabilities are recorded for differences between the financial statement and tax basis of the assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense is recorded for the amount of income tax payable or refundable for the period increased or decreased by the change in deferred tax assets and liabilities during the period.

Basic and Diluted Net Loss per Share. Basic net loss per share is based upon the weighted average number of common shares outstanding. Diluted net loss per share is based on the assumption that options and warrants are included in the calculation of diluted earnings per share, except when their effect would be anti-dilutive. Dilution is computed by applying the treasury stock method. Under this method, options

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and warrants are assumed to be exercised at the beginning of the period (or at the time of actual issuance, if later), and as if funds obtained thereby were used to purchase common stock at the average market price during the period (See Note 4).

Statements of Cash Flows. For purposes of the Consolidated Statements of Cash Flows, the Company considers all demand deposits and certificates of deposit with original maturities of 90 days or less to be cash equivalents.

Fair Value of Financial Instruments. The carrying amounts reported in the balance sheets for cash and cash equivalents, accounts receivable and payable and other current liabilities approximate fair value due to the short-term nature of these items.

Concentration of Credit Risk. The Company has cash deposits at U.S. banks and financial institutions, which exceed federally insured limits at April 3, 2005. The Company is exposed to credit loss for amounts in excess of insured limits in the event of non-performance by the institution; however, the Company does not anticipate non-performance.

Reclassifications. Certain reclassifications have been made to the 2004 fiscal year interim financial statements to conform to the current year presentation.

Recently Issued Accounting Pronouncements. In November 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 151, Inventory Costs (“SFAS 151”), which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. SFAS 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company does not believe the adoption of SFAS 151 will have a material impact on its financial statements.

In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets (“SFAS 153”), which eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. SFAS 153 will be effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The Company does not believe the adoption of SFAS 153 will have a material impact on its consolidated financial statements.

In December 2004, the FASB issued SFAS 123(R), which establishes standards for transactions in which an entity exchanges its equity instruments for goods or services. This standard requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award and to record such amount as an expense over the related employee service period. SFAS 123(R) eliminates the alternative method of accounting for such awards using the intrinsic method previously allowable under APB Opinion No. 25. In April 2005, the SEC announced that registrants that are not small business issuers would be required to adopt SFAS 123(R) not later than the beginning of the first fiscal year starting after June 15, 2005, which in the case of the Company would be fiscal 2006. The Company is currently evaluating the financial statement impact of the adoption of SFAS 123(R) and has not determined whether to apply SFAS 123(R) retroactively to other periods presented.

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Note 2 – Common Stock and Common Stock Warrants

During the 26-week period ended April 3, 2005, the Company issued an aggregate of 699,500 shares of common stock in various transactions. Of this amount, 222,300 common shares were issued for cash, realizing aggregate gross proceeds of $223,400, and 477,200 shares were issued in non-cash transactions largely in connection with contributions to certain of the Company’s benefit plans in the aggregate amount of $1,049,900. These transactions are separately discussed below.

Cash Transactions

Of the 222,300 shares issued for cash during the 26-week period ended April 3, 2005, 219,400 shares of common stock were issued for gross proceeds of $219,500 pursuant to the exercise of outstanding warrants. The remaining 2,900 shares of common stock issued for cash were issued as a result of the exercise of stock options during the same 26-week period, realizing gross proceeds of $3,900.

Non-Cash Transactions

The 477,200 shares of common stock issued during the 26-week period ended April 3, 2005 in non-cash transactions were issued in November and December 2004 in the following amounts: (1) 363,600 shares were issued to effectuate a $800,000 non-cash contribution to the Company’s employee retirement plan, the Cash or Deferred & Stock Bonus Plan (“ESBP”), for fiscal 2005; (2) 12,200 shares were issued to effectuate a previously accrued $26,900 contribution to the ESBP for fiscal 2004; (3) 100,000 shares were issued to make a $220,000 non-cash contribution to the Company’s Non-Qualified Deferred Compensation Plan for fiscal 2005; and (4) 1,400 shares were issued as bonus stock to certain non-officer employees in consideration for past services rendered valued at $3,000 in the aggregate. Of the fiscal 2005 contributions to the Company’s ESBP and Non-Qualified Deferred Compensation Plan, $529,200 has been expensed through April 3, 2005 and the $490,800 balance is expected to be expensed during the balance of fiscal 2005. The value of these non-cash issuances of common stock was based on the closing sales price of the Company’s common stock on the dates that the various transactions were authorized by the Company’s Board of Directors.

Note 3 – Stock Option Plans, Employee Retirement Plan and Deferred Compensation Plan

At the Company’s Annual Meeting of Stockholders in March 2005, the Company’s stockholders approved an amendment to the Company’s 2003 Stock Incentive Plan, as amended, (the “2003 Plan”) increasing the number of shares of common stock available for issuance pursuant to options or restricted stock grants under the 2003 Plan from an aggregate of 2,400,000 shares to an aggregate of 4,900,000 shares. Under the 2003 Plan, options and restricted stock may be granted to the Company’s employees, directors and bona fide consultants.

In December 2004, the Board of Directors authorized a contribution to the Company’s ESBP in the amount of $800,000, which represented a contribution for fiscal 2005 equal to approximately 9.8% of the Company’s expected gross salary and wages for fiscal 2005. Historically, the Company has made contributions of approximately 10% or more of gross salary and wages in each fiscal year. It is contemplated that the Board of Directors will make an additional contribution to the ESBP later in fiscal 2005 to achieve at least this historical level once expected gross salary and wages for fiscal 2005 are known more precisely. As has been the Company’s practice, the $800,000 contribution for fiscal 2005 was made in shares of the Company’s common stock valued at the closing sales price of the Company’s common stock on the date that the contribution was authorized by the Board of Directors. Of the fiscal

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2005 contribution, $419,200 was amortized in the 26-week period ended April 3, 2005. The $380,800 portion of the fiscal 2005 contribution that had not been amortized at April 3, 2005 has been recorded as a prepaid ESBP contribution in equity and will be amortized over the remaining quarters of fiscal 2005. Pursuant to the ESBP provision, vesting requirements are met as services are performed and fulfilled at each fiscal year end.

The Company maintains a deferred compensation plan, the Non-Qualified Deferred Compensation Plan, for key employees with long-term service with the Company. Annual contributions of common stock of the Company are made to a Rabbi Trust under such plan to be held for the benefit of the deferred compensation plan participants. In December 2004, the Board of Directors authorized the fiscal 2005 contribution to the deferred compensation plan in the amount of 100,000 shares of common stock valued at $220,000. Of this contribution, $110,000 was amortized in the 26-week period ended April 3, 2005. The $110,000 portion of the fiscal 2005 contribution that had not been amortized at April 3, 2005 has been recorded as a prepaid contribution in equity and will be amortized over the remaining quarters of fiscal 2005. Participants’ potential distributions from the Rabbi Trust represent unsecured claims against the Company. The Rabbi Trust was established by the Company and is subject to creditors’ claims. Shares in this plan may be distributed to each plan beneficiary when they retire from service at an age permitted under the Company’s ESBP.

Note 4 – Loss per Share

As the Company had a net loss for the 13-week and 26-week periods ended April 3, 2005 and March 28, 2004, basic and diluted net loss per common share are the same.

The Company has excluded from the computation of diluted loss per common share the maximum number of shares issuable pursuant to outstanding, in-the-money stock options and warrants in the amounts of 2,166,000 shares and 3,222,400 shares of common stock as of April 3, 2005 and March 28, 2004, respectively, because the Company had a loss from continuing operations for both periods presented and to include the representative share increments would be anti-dilutive.

Note 5 – Inventories, Net

Inventories, net consisted of the following:

Title to all inventories remains with the Company. Inventoried materials and costs relate to work in process on customers’ orders and on the Company’s generic module parts and memory stacks, which the Company anticipates it will sell to customers including deliveries to customers under potential research and development contracts. Work in process includes amounts that may be sold as products or

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under contracts. Such inventoried costs are stated generally at the total of the direct production costs including overhead. Inventory valuations do not include general and administrative expenses. Inventories are reviewed quarterly to determine salability and obsolescence.

Costs on long-term contracts and programs in progress represent recoverable costs incurred. The Company’s marketing involves the identification and pursuit of research and development contracts pursuant to specific government budgets and programs. The Company is frequently involved in the pursuit of a specific anticipated contract that is a follow-on or related to an existing contract. The Company often determines that it is probable that a subsequent award will be successfully received, particularly if continued progress can be demonstrated against anticipated technical goals of the projected new program while the government goes through its lengthy process required to allocate funds and award contracts. When such a determination occurs, the Company capitalizes material, labor and overhead costs expected to be recovered from a follow-on or new contract. Due to the uncertain timing of such contracts, the Company maintains significant reserves for this inventory to avoid overstating its value. The net book value of such capitalized pre-contract costs included in work in process at April 3, 2005 and October 3, 2004 was $620,100 and $683,300, respectively.

Note 6 – Reportable Segments and Major Customers

Pursuant to the Company’s reorganization of its operations in fiscal 2003 to provide more effective access to its administrative, marketing and engineering resources across all sectors of its business and to reduce expenses, the Company began to manage its operations in fiscal 2004 in only two reportable segments, the contract research and development segment and the product segment. The Company’s management evaluates financial information to review the performance of the Company’s research and development contract business separately from the Company’s product business, but only to the extent of the revenues and the cost of revenues of the two segments. Because the various indirect expense operations of the Company, as well as its assets, now support all of its revenue-generating operations in a matrix manner, frequently in circumstances in which a distinction between research and development contract support and product support is difficult to identify, segregation of these indirect costs and assets is impracticable. The revenues and costs of revenues of the Company’s two reportable segments for the 13-week and 26-week periods ended April 3, 2005 and March 28, 2004 is shown in the following table. The accounting policies used to develop segment information correspond to those described in the summary of significant accounting policies.

The major customers for the Company’s research and development business segment in both the 26-week periods ended April 3, 2005 and March 28, 2004 were all agencies or laboratories of the U.S. government or U.S. government contractors. Such customers in the aggregate accounted for

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approximately 81% of the Company’s total revenues in the current year 26-week period and approximately 80% of the Company’s total revenues in the 26 weeks ended March 28, 2004. Approximately 40% and 18% of total revenues were realized from contracts with SAIC, a government contractor, and the U.S. Army, respectively, in the current 26-week period. No other customer accounted for more than 10% of the Company’s total revenues during the 26-week period ended April 3, 2005. Total revenues realized from contracts with the Defense Advanced Research Projects Agency (“DARPA”) and the U.S. Army were 31% and 22%, respectively, in the 26 weeks ended March 28, 2004. The major customer for the Company’s product business segment in both the 26-week period ended April 3, 2005 and the 26-week period ended March 28, 2004 was L-3 Communications, a government contractor, which accounted for approximately 5% of the Company’s total revenues and 43% of product sales in the current 26-week period and approximately 11% of the Company’s total revenues and 61% of product sales in the 26 weeks ended March 28, 2004.

Note 7 – Commitments and Contingencies

Government Expense Audits

The Company’s reimbursable indirect expense rates for government contracts have been audited through the fiscal year ended September 30, 2001. The Federal government has a proposed claim for recovery of $152,400 pursuant to the fiscal 2001 indirect rate audit. Pursuant to Federal Acquisition Regulations, the Company believes that it has a basis for waiver of this claim and has submitted a formal request for such waiver. Therefore, the accompanying consolidated financial statements do not include an accrual for potential loss, if any, related to this claim. This request is currently pending. The Federal government’s indirect rate audit for the fiscal year ended September 29, 2002 is presently underway, but indirect rate audits for the fiscal years ended September 28, 2003 and October 3, 2004 have not yet been scheduled.

Litigation

In August 2004, a consultant who was engaged by the Company’s iNetWorks subsidiary to locate capital for iNetWorks filed a lawsuit in the Orange County Superior Court for breach of contract against iNetWorks and against the Company as the alleged alter ego of iNetWorks. In the complaint, the consultant alleges that iNetWorks breached a Finder’s Agreement with the consultant and seeks an unspecific amount of damages. In discovery, the consultant claimed that he is owed $5.2 million; however, as the consultant did not raise any capital for iNetWorks, the Company believes this case is without merit and intends to vigorously defend this litigation. In September 2004, the Company filed an answer denying all of the allegations contained in the complaint. The Court has set a date of October 11, 2005 for trial of this matter.

The Company has been, and may from time to time, become a party to various legal proceedings arising in the ordinary course of its business. Management believes that the disposition of these matters will not have a material effect on the Company’s consolidated financial position, results of operations or liquidity.

Note 8 – Patents and Trademarks, Net

The Company’s intangible assets consist of patents and trademarks related to the Company’s various technologies, approximately 99% of which represents patents. Capitalized costs include amounts paid to third parties for legal fees, application fees and other direct costs incurred in the filing and prosecution of patent and trademark applications. These assets are amortized on a straight-line method

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over their estimated useful life of ten years. The Company reviews these intangible assets for impairment when and if impairment indicators occur in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. At April 3, 2005, management believed no indications of impairment existed.

Patents and trademarks at April 3, 2005 and March 28, 2004 are as follows:

The amortization expense for the 26-week period ended April 3, 2005 was $53,900. The amortization expense for fiscal 2004 was $96,200, of which $49,700 was incurred in the 26-week period ended March 28, 2004. The unamortized balance of patents and trademarks at April 3, 2005 is estimated to be amortized over the balance of this fiscal year and the next five fiscal years thereafter as follows:

Note 9 – Subsequent Events

In May 2005, the Company entered into a one-year consulting agreement with CTC Aero, LLC, of which one of the Company’s directors, Chris Toffales, is a principal. Under the terms of the consulting agreement, Mr. Toffales will provide strategic planning and business development support services at a rate of $15,000 per month plus reimbursement of reasonable out-of-pocket business expenses. In connection with the consulting agreement, CTC Aero, including Mr. Toffales, also has entered into a confidential information and invention assignment agreement with the Company.

In May 2005, the Company entered into a one-year consulting agreement with Robert G. Richards, one of the Company’s directors and its recently retired Chief Executive Officer. Under the terms of the consulting agreement, Mr. Richards will provide management consulting services at a rate of $100 per hour plus reimbursement of reasonable out-of-pocket business expenses. In connection with the consulting agreement, Mr. Richards also has entered into a confidential information and invention assignment agreement with the Company.

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This report contains forward-looking statements regarding Irvine Sensors which include, but are not limited to, statements concerning projected revenues, expenses, gross profit and income, mix of revenue, potential contract awards, market acceptance of our products and technologies, the competitive nature of our business and markets, the success and timing of new product introductions and commercialization of our technologies, product qualification requirements of our customers, the need for additional capital, our significant accounting policies and the outcome of pending litigation. These forward-looking statements are based on our current expectations, estimates and projections about our industry, management’s beliefs, and certain assumptions made by us. Words such as “anticipates,” “expects,” “intends,” “plans,” “predicts,” “potential,” “believes,” “seeks,” “estimates,” “should,” “may,” “will”, “with a view to” and variations of these words or similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. Such factors include, but are not limited to the following:

We do not undertake any obligation to revise or update publicly any forward-looking statements for any reason, except as required by law. Additional information on the various risks and uncertainties potentially affecting our operating results are discussed below and are contained in our publicly filed documents available through the SEC’s EDGAR database (www.sec.gov) or from our Investor Relations Department.

Overview

We design, develop, manufacture and sell miniaturized electronic products for defense, security and commercial applications. We also perform customer-funded contract research and development related to these products, mostly for U.S. government customers or prime contractors. Most of our business relates to application of our proprietary technologies for stacking either packaged or unpackaged semiconductors into more compact three-dimensional forms, which we believe offer volume, power, weight and operational advantages over competing packaging approaches.

Except for fiscal years 1999 through 2001, when we realized significant commercial product sales of wireless infrared transceivers, we have historically derived a substantial majority of our total revenues from government-funded research and development contracts rather than from product sales. We

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anticipate that a majority of our total revenues will continue to be derived from government-funded sources in fiscal 2005. With a few exceptions, our government-funded research and development contracts to date have largely been early-stage in nature and relatively modest in size. As a result, our revenues from this source have improved to a limited degree from increases in the U.S. defense budget. However, we are also placing more emphasis on deploying our marketing efforts on government programs that we believe have potential to lead to production contracts, which we believe to be both larger and more profitable than funded research and development contracts. If we are successful in securing government production contracts, an outcome that we cannot guarantee, our revenues may become more related to changes in U.S. defense budgets. We are also attempting to increase our revenues from product sales by introducing new products with commercial applications, in particular, stacked computer memory chips. We are currently transitioning into a new generation of such products, with a view to increasing sales of such products, but we cannot assure you that we will be able to complete development or successfully launch any such products on a timely basis, if at all. We use contract manufacturers to produce these products, and all of our other current operations occur at a single, leased facility in Costa Mesa, California.

We have a history of unprofitable operations, largely as a result of discretionary investments that we have made to commercialize our technologies and to maintain our technical staff and corporate infrastructure at levels that we believe are required for future growth. Our investments to commercialize our technologies have yet to produce sustainable profitable product sales. With respect to our investments in staff and infrastructure, the advanced technical and multi-disciplinary content of our proprietary technologies places a premium on a stable and well-trained work force. As a result, we tend to maintain our work force even when anticipated government contracts are delayed, a circumstance that occurs with some frequency and may, from time to time, result in under utilization of our labor force for revenue generation. We believe that this pattern can be overcome by the achievement of greater contract backlog and are seeking growth in our research and development contract revenue to that end. To date, however, we have not yet achieved sufficient revenues to realize profitable operations. Our ability to recover our investments through the cost-reimbursement features of our government contracts are subject to both regulatory and competitive pricing considerations.

During fiscal 2003, we consolidated all of our operations to more effectively use our administrative, marketing and engineering resources and to reduce expenses. None of our subsidiaries presently account for more than 10% of our total revenues or total assets, or have separate employees or facilities. We currently report our operating results and financial condition segmented only between our research and development business and our product business. (See Note 6 to the Consolidated Financial Statements).

Critical Accounting Estimates

Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. As such, management is required to make judgments, estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. The significant accounting policies that are most critical to aid in fully understanding and evaluating reported financial results include the following:

Revenue Recognition. Our consolidated total revenues during the first 26 weeks of fiscal 2005 were primarily derived from contracts to develop prototypes and provide research, development, design, testing and evaluation of complex detection and control defense systems. Our research and development contracts are usually cost reimbursement plus a fixed fee or fixed price with billing entitlements based on level of effort expended. For such research and development contracts, revenues are recognized as we

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incur costs and include applicable fees or profits primarily in the proportion that costs incurred bear to estimated final costs. Upon the initiation of each such contract, a detailed cost budget is established for direct labor, material, subcontract support and allowable indirect costs based on our proposal and the required scope of the contract as may have been modified by negotiation with the customer, usually a U.S. government agency or prime contractor. A program manager is assigned to secure the needed labor, material and subcontract in the program budget to achieve the stated goals of the contract and to manage the deployment of those resources against the program plan. Our accounting department collects the direct labor, material and subcontract charges for each program on a weekly basis and provides such information to our respective program managers and senior management.

The program managers review and report the performance of their contracts against the respective program plans with our senior management, including our President and Chief Executive Officer, on a monthly basis. These reviews are summarized in the form of estimates of costs to complete the contracts. If an ETC indicates a potential overrun against budgeted program resources, it is the responsibility of the program manager to revise the program plan in a manner consistent with customer objectives to eliminate such overrun and to seek necessary customer agreement to such revision. To mitigate the financial risk of such re-planning, we attempt to negotiate the deliverable requirements of our research and development contracts to allow as much flexibility as possible in technical outcomes. Given the inherent technical uncertainty involved in research and development contracts, in which new technology is being invented, explored or enhanced, such contractual latitude is frequently achievable. When re-planning does not appear possible within program budgets, senior management makes a judgment as to whether we plan to supplement the customer budget with company funds or whether the program statement of work will require the additional resources to be expended to meet contractual obligations. If either determination is made, an accrual for the anticipated contract overrun is recorded based on the most recent ETC of the particular program.

We provide for anticipated losses on contracts by incurring a charge to income during the period in which a potential for loss is first identified. We adjust the accrual for contract losses quarterly based on the review of outstanding contracts. Upon completion of the contracts, any associated accrual of anticipated loss is reduced as the previously recorded obligations are satisfied. Costs and estimated earnings in excess of billings under government contracts are accounted for as unbilled revenues on uncompleted contracts. Unbilled revenues on uncompleted contracts are stated at estimated realizable value.

We consider many factors when applying accounting principles generally accepted in the United States of America related to revenue recognition. These factors generally include, but are not limited to:

Each of the relevant factors is analyzed to determine its impact, individually and collectively with other factors, on the revenue to be recognized for any particular contract with a customer. Management is required to make judgments regarding the significance of each factor in applying the revenue recognition standards, as well as whether or not each factor complies with such standards. Any misjudgment or error by management in its evaluation of the factors and the application of the standards could have a material adverse affect on our future operating results.

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Revenue from product sales is recognized upon shipment, provided (1) there are no unfulfilled contingencies associated with the sale; (2) the Company has a sales contract or purchase order with the customer; and (3) the Company is reasonably assured that the sales price can be collected. The absence of any of these conditions would cause revenue recognition to be deferred.

Inventory. Inventories are stated at the lower of cost or market. Each quarter, we evaluate our inventories for excess quantities and obsolescence. We write off inventories that are considered obsolete and adjust remaining inventory balances to approximate the lower of cost or market value. The valuation of inventories at the lower of cost or market requires the use of estimates as to the amounts of current inventories that will be sold. These estimates are dependent on our assessment of current and expected orders from our customers.

Costs on long-term contracts and programs in progress represent recoverable costs incurred. The marketing of our research and development contracts involves the identification and pursuit of specific government budgets and programs. We are frequently involved in the pursuit of a specific anticipated contract that is a follow-on or related to an existing contract. We often determine that it is probable that a subsequent award will be successfully received, particularly if continued progress can be demonstrated against anticipated technical goals of the projected new program while the government goes through its lengthy process required to allocate funds and award contracts. When such a determination occurs, we capitalize material, labor and overhead costs expected to be recovered from a follow-on or new contract. Due to the uncertainties associated with new or follow-on research and development contracts, we maintain significant reserves for this inventory to avoid overstating its value. We have adopted this practice because we believe that we are typically able to more fully recover such costs under the provisions of government contracts by direct billing of inventory rather than by seeking recovery of such costs through permitted indirect rates, which may be more subject to competitive market pressures.

Valuation Allowances. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. 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. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance.

Results of Operations

Contract Research and Development Revenue. Contract research and development revenue consists of amounts realized or realizable from customer funded research and development contracts, largely from U.S. government agencies and government contractors. Contract research and development revenues for both the 13-week and 26-week periods ended April 3, 2005 increased materially over the comparable revenues of the 13-week and 26-week periods ended March 28, 2004 and also continued to represent the dominant contributor to our total revenues as shown in the following tables:

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The increase in contract research and development revenue for both the 13-week and 26-week periods ended April 3, 2005 was the result of a changing emphasis toward application-oriented research and development contracts in the first 26 weeks of fiscal 2005 as opposed to the first 26 weeks of fiscal 2004. We believe that this increase was primarily the result of the increasing maturity of our development stage technologies, which has in turn, led to the receipt of more development contracts oriented toward possible production. Typically, such contracts are larger in dollar value than early stage research and development contracts. We have been advised that additional government contracts of this nature are pending. As such, we anticipate additional contracts will be awarded in future periods, which we believe will further increase our contract research and development revenue, although we cannot guarantee this outcome. Based on our current backlog and notices of pending awards, we expect that our contract revenue will continue to represent a majority of our total revenue for the remainder of fiscal 2005.

Cost of Contract Research and Development Revenue. Cost of contract research and development revenue consists of labor, subcontractor and vendor expenses directly incurred in support of research and development contracts, plus associated indirect expenses permitted to be charged pursuant to the relevant contracts. Our cost of contract research and development revenue for the 13 weeks and 26 weeks ended April 3, 2005 as compared to the 13 weeks and 26 weeks ended March 28, 2004 is shown in the following tables:

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The dollar increase in cost of contract research and development revenue in both the 13-week and 26-week periods ended April 3, 2005 reflects the fact that, to a large extent, our research and development contracts are of a cost reimbursement plus fixed fee nature. Accordingly, our costs of contract research and development revenue generally increase as such revenue increases. The disproportionate increase in the 26-week period ended April 3, 2005 reflects the fact that the 26 weeks ended March 28, 2004 included a $316,200 reduction in our accrued loss on contracts resulting from improved program management procedures, and no comparable reduction occurred in the 26 weeks ended April 3, 2005. Absent this effect, the cost of contract research and development revenue as a percentage of such revenue would have been 73% in the 26 weeks ended March 28, 2004. The 26-week period-to-period proportional difference in cost of contract research and development revenue also reflects the different mix between internal and external resources generally required to satisfy the requirements of larger contracts, such as were active during the first 26 weeks of fiscal 2005. As contract values increase, we are more likely to require additional support from external vendors, independent contractors or subcontractors to meet contractual delivery requirements. Such external support is generally more costly than use of internal resources. Since we anticipate an increasing contribution to our revenues from such larger contracts in the balance of fiscal 2005, we also anticipate that we may need to continue to rely on external support in future periods, which may continue to increase our research and development costs in absolute dollars in future periods.

Product Sales. Product sales are comprised of revenues derived from sales of chips, modules, thermal viewers, stacked chip products and chip stacking services. Product sales for the first 13-week and 26-week periods of fiscal 2005 and fiscal 2004 are shown in the following tables:

The increase in product sales for both the 13 weeks and 26 weeks ended April 3, 2005 was largely due to an increase in orders for our stacked chip products from commercial customers. Sales of such products to our aerospace customers during the current year periods was modestly decreased over the comparable prior year periods largely due to timing of orders from an aerospace OEM, L-3 Communications. In the 26-week period ended March 28, 2004, a large shipment of stacked chip products was made to L-3 Communications to meet the schedule requirements of one of their programs. No comparably scheduled large delivery was required by L-3 Communications in the 26 weeks ended April 3, 2005. However, based on orders received from L-3 Communications subsequent to April 3, 2005,

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we believe that this comparative difference between the current and prior year 26-week periods is simply a timing effect and not a trend. As a result of the substantial increase in total revenue during the 26-week period ended April 3, 2005 as compared to the first 26 weeks of fiscal 2004, L-3 Communications was not a material customer in the current 26-week period in which it accounted for $555,000, or 5% of our consolidated total revenues and 43% of our product sales, as contrasted to the 26-week period ended March 28, 2004 in which it accounted for approximately $646,500, or 11%, of our consolidated total revenues and 61% of our product sales.

Stacked chip product sales accounted for $1,089,300, or 84%, of our product sales in the 26 weeks ended April 3, 2005 as opposed to $882,300, or 84%, of our product sales in the 26 weeks ended March 28, 2004. Approximately $91,500, or 7%, of our product sales in the 26-week period ended April 3, 2005 and $95,200, or 9%, or our product sales in the 26-week period ended March 28, 2004 were derived from sales of wireless infrared transceiver chips and module products to various customers, sold under the Novalog brand, reflecting the erosion of sales of our infrared transceivers for use in personal digital assistants. Because of the difficulty of securing cost-effective sources of supply to service this declining demand, we do not presently plan to pursue additional sales of our wireless infrared transceiver products. Product sales for the 26-week period ended April 3, 2005 included, for the first time, a contribution from sales of thermal viewer and camera products. Sales of such products accounted for $106,300, or 8%, of product sales in this period.

Cost of Product Sales. Cost of product sales consists of labor, subcontractor and vendor expenses directly incurred in the manufacture of products sold, plus related overhead expenses. Our cost of product sales for the 13 weeks and 26 weeks ended April 3, 2005 as compared to the 13 weeks and 26 weeks ended March 28, 2004 is shown in the following tables:

The cost of product sales in the 13-week period ended April 3, 2005 increased primarily as a result of the increase in product sales in the current period. However, because the current 13-week period reflected the impact of discontinuation of older wireless infrared products that were no longer economic and production learning curve improvements associated with our stacked memory products, the costs of product sales in the 13 weeks ended April 3, 2005 increased substantially less than the increase in product sales during that period, resulting in positive gross margins on product sales in the current period as opposed to negative gross margins in the comparable prior year period. For largely the same reasons,

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there was also a transformation to positive gross margins on product sales in the 26-week period ended April 3, 2005 as compared to the product sales in the 26-week period ended March 28, 2004, although the gross margin improvement was less pronounced because of the relatively smaller product sales in the second fiscal quarter of fiscal 2004. We expect, but cannot guarantee, that our product sales will increase in subsequent periods of fiscal 2005, which we expect will allow us to continue to achieve economies of scale that contribute to improved gross margins on product sales.

General and Administrative Expense. General and administrative expense generally consists of labor, subcontractor and vendor expenses not directly related to the production of revenue or to internally funded research and development and includes such internal expenses as executive, administrative, financial and marketing labor and labor-related expenses and such external expenses as legal and accounting. General and administrative expense for the 13 weeks and 26 weeks ended April 3, 2005 as compared to the 13 weeks and 26 weeks ended March 28, 2004 are shown in the following tables:

General and administrative expense in the 13-week period ended April 3, 2005 as compared to the 13-week period ended March 28, 2004 remained relatively unchanged largely due to a decrease in general and administrative labor and labor-related expenses in the current year period offset by increases in other categories of general and administrative expense. The decrease in general and administrative labor was primarily a consequence of higher utilization of our technical staff on funded research and development contracts, which resulted in such labor costs being included in cost of contract research and development revenue. Accordingly, lesser amounts of technical labor costs were included in general and administrative expense. Since the increase in our contract research and development efforts was more pronounced in the second 13 weeks of fiscal 2005 than the first 13-week period, this direct labor utilization effect had less proportional impact on the 26-week period ended April 3, 2005 than the 13-week period ending on that same date, resulting in a $20,000 increase in overall categories of general and administrative labor and labor-related expenses in the current year 26-week period compared to the first 26 weeks of fiscal 2004. This modest increase in general and administrative labor and labor-related expenses contributed to the overall increase in general and administrative expense for the 26-week period ended April 3, 2005 compared to the 26-week period ended March 28, 2004.

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The largest element contributing to the increase in general and administrative expense in the 26 weeks ended April 3, 2005 and offsetting the decrease in general and administrative labor and labor-related expenses in the 13 weeks ended April 3, 2005 was an increase in general and administrative costs which are not deemed allowable for cost reimbursement under our contracts with the U.S. government. Of this increase, $110,000 was due to recognition of expense resulting from a contribution to our Non-Qualified Deferred Compensation Plan in the 26-week period ended April 3, 2005 rather than in a later fiscal period as was the case in fiscal 2004. Additionally, $40,000 of the current 26-week increase was related to a reduction in our reserve for uncollectible receivables in the 26-week period ended March 28, 2004 that did not recur in the 26-week period ended April 3, 2005. The total increase in such unallowable expenses during the 13-week and 26-week periods ended April 3, 2005, as compared to the 13-week and 26-week periods ended March 28, 2004, was $125,800 and $240,900, respectively.

During the 26-week period ended April 3, 2005, we also experienced an $87,000 increase in general and administrative service costs, largely consisting of accounting expenses, primarily incurred as a result of implementation of the requirements associated with Section 404 of the Sarbanes-Oxley Act. Although, as a non-accelerated filer, our deadline for compliance with Section 404 has now been extended to October 1, 2006, the end of our fiscal 2006, we anticipate that we will continue to experience some increase in this category of our general and administrative expense in the balance of fiscal 2005. Another source of increase in our general and administrative expense in the current year periods compared to the 13-week and 26-week periods ended March 28, 2005 was an increase of $53,100 and $96,600 for the 13-week and 26-week periods ended April 3, 2005, respectively, in our selling and marketing expenses to support our plans for revenue growth.

Research and Development Expense. Research and development expense consists of labor, subcontractor and vendor expenses directly incurred in support of internally funded research and development projects, plus associated overhead expenses. Research and development expense for the 13 weeks and 26 weeks ended April 3, 2005 as compared to the 13 weeks and 26 weeks ended March 28, 2004 decreased as shown in the following tables:

The substantial decrease in research and development expense in both the 13 week and 26 week periods ended April 3, 2005 was primarily the result of the reduced availability of direct labor for

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internally funded research projects in those periods compared to the comparable periods of fiscal 2004 due to the large increase in customer funded research and development. We use the same technical staff for both internal and customer funded research and development projects, and we generally prioritize the deployment of this labor to revenue-producing projects whenever possible. Because of the increase in contract research and development projects in the fiscal 2005 periods, we had less discretionary direct labor being deployed to internally funded research and development projects than in the fiscal 2004 periods. We anticipate that the utilization of our direct labor force for funded research and development contract work will increase in absolute dollars in subsequent periods of fiscal 2005. If that occurs, we expect corresponding reductions in our internally funded research and development expense during such periods.

Net Loss. Largely due to the gross margins on our increases in our contract research and development revenue, our net loss in both the 13-week and 26-week periods ended April 3, 2005 decreased from the comparable periods of fiscal 2005 as shown in the following tables:

These improvements, although substantial, continue to reflect the fact that our contract research and development revenue for both the 13-week and 26-week periods ended April 3, 2005 was not yet at the level required to fully support our technical staff and related infrastructure. We believe that further increases in our contract research and development revenue may improve the revenue production efficiency of our technical staff and further improve our operating results. If we are successful in the marketing of new products, an outcome we cannot guarantee, we anticipate that we could also realize further improvements in our operating results from the gross margins on increased product sales.

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Liquidity and Capital Resources

Our liquidity as measured by both our consolidated cash and cash equivalents and our working capital at the end of fiscal 2004 and at the end of the first 26 weeks of fiscal 2005 is shown in the following table:

Although both our cash and working capital positions decreased in the first 26 weeks of fiscal 2005, our working capital actually improved $190,100 in the 13 weeks ended April 3, 2005. This was largely due to the fact that our net loss of $134,000 was substantially less than the $693,700 of our non-cash expenses during that same 13-week period. For the full 26-week period ended April 3, 2005, our non-cash expenses aggregated to $1,390,500, consisting of $861,300 of depreciation and amortization and $529,200 of common stock contributions to employment retirement plans. These non-cash expenses substantially reduced the cash impact of our $1,310,100 net loss during the 26 weeks ended April 3, 2005. Increases to operational use of cash and working capital during the 26-week period ended April 3, 2005 were various timing effects largely related to revenue growth. Substantial effects in this category included an increase of $806,700 in unbilled revenues on uncompleted contracts due to timing of invoices on current contracts, a $565,800 increase in accounts receivable and a $115,600 increase in inventory in anticipation of expected new contracts. Conversely, substantial timing effects that mitigated the use of cash in the current 26-week period included a $860,400 increase in accounts payable and accrued expenses primarily resulting from increased subcontractor and vendor use on larger contracts, a $111,600 increase in deferred revenues resulting from advanced payments on new product orders and a $57,100 increase in accrued loss on contracts, a projected future effect with no immediate impact on cash. The aggregate effect of these positive and negative timing factors, our net loss and our non-cash operating expenses was a $380,700 net use of cash in operating activities for the 26-week period ended April 3, 2005. The aggregate effect of these factors in the 13-week period ended April 3, 2005 was to generate, rather than use, net cash in operating activities in the amount of $255,300.

Also contributing to the net use of cash in the 26 weeks ended April 3, 2005 were the net $806,400 of cash used for the acquisition of capital facilities and equipment and the $61,700 of cash used for acquisition of patents. Of the capital facilities and equipment expenditures, $120,500 was for equipment, $26,900 was for leasehold improvements, $49,300 was for software programs, and $609,700 was for construction in progress. At April 3, 2005, approximately 35% of our construction in progress was primarily related to our current research and development contract business, approximately 19% was primarily related to our stacking products and services and approximately 46% was primarily related to our camera products. Except for lease agreements for the acquisition of capital equipment, we had no other material capital commitments as of April 3, 2005.

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At April 3, 2005, our contractual obligations were as follows:

Partially mitigating the net use of cash in the 26 weeks ended April 3, 2005 was the approximate net $157,700 of cash provided by financing activities, consisting of $223,400 of gross proceeds from the exercise of warrants and options, which was offset by $65,700 of principal payments made on capitalized equipment leases.

We believe, but cannot guarantee, that our government-funded contract business will increase in the balance of fiscal 2005, and will therefore be an improved source of liquidity through both operating margins and the recovery of indirect costs as permitted under government contracts. This belief stems from our visibility into budgetary decisions of various government agencies and our present backlog. At April 3, 2005, our funded backlog was approximately $13.0 million compared to approximately $2.0 million at March 28, 2004. We expect that a substantial majority of our funded backlog at April 3, 2005 will result in revenue recognized in fiscal 2005. In addition, our government contracts typically include unfunded backlog, which is funded when the previously funded amounts have been expended. As of May 1, 2005, our total backlog, including unfunded portions, was approximately $13.8 million. Furthermore, we have been advised of additional government contract awards that we expect to receive in fiscal 2005 subsequent to April 3, 2005, although we cannot assure you that such potential contract awards will be received.

Contracts with government agencies may be suspended or terminated by the government at any time, subject to certain conditions. Similar termination provisions are typically included in agreements with prime contractors. Since our inception, we have experienced such termination of our contracts on three occasions, the latest of which was April 1999. We cannot assure you that we will not experience suspensions or terminations in the future. Any such termination, if material, could cause a disruption of our revenue stream, adversely affect our liquidity and results of operations and could result in employee layoffs.

We also believe, but cannot guarantee, that our revenues from product sales will grow in the second half of fiscal 2005. Initially, we believe this growth will likely use rather than generate cash because of the time lag between incurring the expenses to manufacture the products and collecting the receivables generated by shipments of those products.