**Exhibit13**

 

**AKSYS,LTD.**

 

**INDEX TOCONSOLIDATED FINANCIAL STATEMENTS**

 
| Independent Auditors’  Report                    |
|-------------------------------------------------------|
|                                                  |
| Consolidated Balance Sheets                           |
|                                                  |
| Consolidated  Statements of Operations                |
|                                                  |
| Consolidated  Statements of Stockholders’ Equity |
|                                                  |
| Consolidated  Statements of Cash Flows                |
|                                                  |
| Notes to  Consolidated Financial Statements           |

 

----

 

**IndependentAuditors’ Report**

 

The Board of Directors and Stockholders

Aksys, Ltd.:

 

We have audited the accompanying consolidated balance sheets of Aksys,Ltd. and subsidiary as of December 31, 2002 and 2001, and the relatedconsolidated statements of operations, stockholders’ equity, and cash flows foreach of the years in the three-year period ended December 31, 2002.  These consolidated financial statements arethe responsibility of Aksys, Ltd.’s management.  Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

 

We conducted our audits in accordance with auditing standards generallyaccepted in the United States of America. Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of Aksys, Ltd.and subsidiary as of December 31, 2002 and 2001, and the results of theiroperations and their cash flows for each of the years in the three-year periodended December 31, 2002 in conformity with accounting principles generallyaccepted in the United States of America.

 
| **KPMG  LLP**                         |
|---------------------------------------|
|                                  |
| Chicago, Illinois                     |
| March 20, 2003, except as to note 12, |
| which is as of March 27, 2003         |

 

1

----

**AKSYS,LTD. AND SUBSIDIARY**

 

Consolidated Balance Sheets

 

December 31, 2002 and 2001

 
|                                                                                                                                                           |   | **December 31,  2002** |       | **December 31,  2001** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|------------|------------------------|--------|
| **Assets**                                                                                                                                                     |   |                   |       |                   |   |
| Current assets:                                                                                                                                                |   |                   |       |                   |   |
| Cash and cash equivalents                                                                                                                                      |   | $                      | 953,779    |                   | $      | 10,240,414 |   |
| Short-term investments                                                                                                                                         |   | 10,555,978             |       | 1,009,521              |   |
| Accounts receivable                                                                                                                                            |   | 126,811                |       | —                 |   |
| Other receivables                                                                                                                                              |   | 130,129                |       | 231,888                |   |
| Inventories                                                                                                                                                    |   | 2,681,691              |       | —                 |   |
| Prepaid expenses                                                                                                                                               |   | 126,173                |       | 58,387                 |   |
| Deposits with vendors                                                                                                                                          |   | 11,998                 |       | 700,000                |   |
| Total current assets                                                                                                                                           |   | 14,586,559             |       | 12,240,210             |   |
|                                                                                                                                                           |   |                   |       |                   |   |
| Long-term investments                                                                                                                                          |   | 600,000                |       | 780,000                |   |
| Leased assets, net                                                                                                                                             |   | 278,667                |       | —                 |   |
| Property and equipment, net                                                                                                                                    |   | 1,019,302              |       | 1,365,774              |   |
| Other assets                                                                                                                                                   |   | 24,964                 |       | 68,519                 |   |
|                                                                                                                                                           |   | $                      | 16,509,492 |                   | $      | 14,454,503 |   |
|                                                                                                                                                           |   |                   |       |                   |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                 |   |                   |       |                   |   |
| Current liabilities:                                                                                                                                           |   |                   |       |                   |   |
| Accounts payable                                                                                                                                               |   | $                      | 1,971,356  |                   | $      | 1,057,909 |   |
| Accrued liabilities                                                                                                                                            |   | 732,218                |       | 633,904                |   |
| Other liabilities                                                                                                                                              |   | 10,645                 |       | —                 |   |
| Total current liabilities                                                                                                                                      |   | 2,714,219              |       | 1,691,813              |   |
|                                                                                                                                                           |   |                   |       |                   |   |
| Other long-term liabilities                                                                                                                                    |   | 147,644                |       | 159,061                |   |
| Total liabilities                                                                                                                                              |   | 2,861,863              |       | 1,850,874              |   |
|                                                                                                                                                           |   |                   |       |                   |   |
| Stockholders’ equity:                                                                                                                                     |   |                   |       |                   |   |
| Preferred stock, par value $.01 per share, 1,000,000 shares  authorized, 0 shares issued and outstanding in 2002 and 2001                                      |   | —                 |       | —                 |   |
| Common stock, par value $.01 per share, 50,000,000 shares authorized,  25,500,097 and 22,097,524 shares issued and outstanding in 2002 and 2001,  respectively |   | 255,001                |       | 220,975                |   |
| Additional paid-in capital                                                                                                                                     |   | 120,030,647            |       | 103,313,209            |   |
| Accumulated other comprehensive income                                                                                                                         |   | 8,503                  |       | 11,423                 |   |
| Accumulated deficit                                                                                                                                            |   | (106,646,522           | )          | (90,941,978            | )      |
| Total stockholders’ equity                                                                                                                                |   | 13,647,629             |       | 12,603,629             |   |
|                                                                                                                                                           |   | $                      | 16,509,492 |                   | $      | 14,454,503 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

2

----

**AKSYS,LTD. AND SUBSIDIARY**

 

Consolidated Statements ofOperations 

 

Years ended December 31, 2002, 2001 and 2000

 
|                                  |   | **2002**    |        | **2001**    |   | **2000**    |   |
|---------------------------------------|--------|-------------|-------------|-------------|--------|-------------|--------|
| Revenue:                              |   |        |        |        |   |        |   |
| Product                               |   | $           | 276,680     |        | $      | —      |   | $ | — |   |
| Service and supplies                  |   | 21,986      |        | —      |   | —      |   |
| Joint development income              |   | —      |        | —      |   | 3,434,809   |   |
| Total revenue                         |   | 298,666     |        | —      |   | 3,434,809   |   |
|                                  |   |        |        |        |   |        |   |
| Cost of sales:                        |   |        |        |        |   |        |   |
| Product                               |   | 1,685,562   |        | —      |   | —      |   |
| Service and supplies                  |   | 577,478     |        | —      |   | —      |   |
| Total cost of sales                   |   | 2,263,040   |        | —      |   | —      |   |
|                                  |   |        |        |        |   |        |   |
| Operating expenses:                   |   |        |        |        |   |        |   |
| Research and development              |   | 5,792,446   |        | 10,882,796  |   | 14,541,873  |   |
| Sales and marketing                   |   | 2,543,324   |        | 1,753,499   |   | 1,025,315   |   |
| General and administrative            |   | 5,699,356   |        | 5,121,223   |   | 4,738,737   |   |
| Total operating expenses              |   | 14,035,126  |        | 17,757,518  |   | 20,305,925  |   |
|                                  |   |        |        |        |   |        |   |
| Operating loss                        |   | (15,999,500 | )           | (17,757,518 | )      | (16,871,116 | )      |
|                                  |   |        |        |        |   |        |   |
| Interest income                       |   | 294,956     |        | 515,892     |   | 1,159,961   |   |
|                                  |   |        |        |        |   |        |   |
| Net loss                              |   | $           | (15,704,544 | )           | $      | (17,241,626 | )      | $ | (15,711,155 | ) |
|                                  |   |        |        |        |   |        |   |
| Net loss per share, basic and diluted |   | $           | (0.65       | )           | $      | (0.94       | )      | $ | (0.93 | ) |
|                                  |   |        |        |        |   |        |   |
| Weighted average shares outstanding   |   | 24,301,029  |        | 18,418,410  |   | 16,934,532  |   |

 

See accompanying notes to consolidatedfinancial statements.

 

3

----

**AKSYS,LTD. AND SUBSIDIARY**

 

Consolidated Statements ofStockholders’ Equity

 

Years ended December 31, 2002, 2001 and 2000

 
|                                               |   | **Common stock** |   | **Additional  paid-in  capital** |    | **Accumulated  other  comprehensive  income** |   | **Accumulated  deficit** |   | **Other  comprehensive  income** |   | **Total  stockholders’  equity** |   |
|----------------------------------------------------|--------|------------------|--------|----------------------------------|---------|-----------------------------------------------|--------|--------------------------|--------|----------------------------------|--------|---------------------------------------|--------|
| **Shares**                                         |   | **Amount**       |   |                             |    |                                          |   |
| Balance at December 31, 1999                       |   | 15,076,996       |   | $                                | 150,770 |                                          | $      | 70,448,778               |   | $                                | 13,030 |                                  | $      | (57,989,197 | ) |   |   | $ | 12,623,381 |   |
|                                               |   |             |   |                             |    |                                          |   |                     |   |                             |   |                                  |   |   |   |
| Comprehensive income:                              |   |             |   |                             |    |                                          |   |                     |   |                             |   |                                  |   |   |   |
| Net loss                                           |   |             |   |                             |    |                                          |   |                     |   | (15,711,155                      | )      | (15,711,155                           | )      | (15,711,155 | ) |
| Other comprehensive income                         |   |             |   |                             |    |                                          |   |                     |   |                             |   |                                  |   |   |   |
| Foreign currency translation adjustment            |   |             |   |                             |    |                                          |   | (68                      | )      |                             |   | (68                                   | )      | (68 | ) |
| Comprehensive income                               |   |             |   |                             |    |                                          |   |                     |   |                             |   | (15,711,223                           | )      |   |   |
| Issuance of common stock                           |   | 2,801,478        |   | 28,015                           |    | 20,542,986                                    |   |                     |   |                             |   |                                  |   | 20,571,001 |   |
| Exercise of stock options                          |   | 381,662          |   | 3,816                            |    | 1,650,458                                     |   |                     |   |                             |   |                                  |   | 1,654,274 |   |
| Issuance of shares to Employee Stock Purchase Plan |   | 57,810           |   | 578                              |    | 211,007                                       |   |                     |   |                             |   |                                  |   | 211,585 |   |
|                                               |   |             |   |                             |    |                                          |   |                     |   |                             |   |                                  |   |   |   |
| Balance at December 31, 2000                       |   | 18,317,946       |   | 183,179                          |    | 92,853,229                                    |   | 12,962                   |   | (73,700,352                      | )      |                                  |   | 19,349,018 |   |
|                                               |   |             |   |                             |    |                                          |   |                     |   |                             |   |                                  |   |   |   |
| Comprehensive income:                              |   |             |   |                             |    |                                          |   |                     |   |                             |   |                                  |   |   |   |
| Net loss                                           |   |             |   |                             |    |                                          |   |                     |   | (17,241,626                      | )      | (17,241,626                           | )      | (17,241,626 | ) |
| Other comprehensive income                         |   |             |   |                             |    |                                          |   |                     |   |                             |   |                                  |   |   |   |
| Foreign currency translation adjustment            |   |             |   |                             |    |                                          |   | (1,539                   | )      |                             |   | (1,539                                | )      | (1,539 | ) |
| Comprehensive income                               |   |             |   |                             |    |                                          |   |                     |   |                             |   | (17,243,165                           | )      |   |   |
| Issuance of common stock                           |   | 3,195,230        |   | 31,952                           |    | 9,729,475                                     |   |                     |   |                             |   |                                  |   | 9,761,427 |   |
| Exercise of stock options                          |   | 484,784          |   | 4,848                            |    | 202,973                                       |   |                     |   |                             |   |                                  |   | 207,821 |   |
| Issuance of shares to Employee Stock Purchase Plan |   | 99,564           |   | 996                              |    | 527,532                                       |   |                     |   |                             |   |                                  |   | 528,528 |   |
|                                               |   |             |   |                             |    |                                          |   |                     |   |                             |   |                                  |   |   |   |
| Balance at December 31, 2001                       |   | 22,097,524       |   | 220,975                          |    | 103,313,209                                   |   | 11,423                   |   | (90,941,978                      | )      |                                  |   | 12,603,629 |   |
|                                               |   |             |   |                             |    |                                          |   |                     |   |                             |   |                                  |   |   |   |
| Comprehensive income:                              |   |             |   |                             |    |                                          |   |                     |   |                             |   |                                  |   |   |   |
| Net loss                                           |   |             |   |                             |    |                                          |   |                     |   | (15,704,544                      | )      | (15,704,544                           | )      | (15,704,544 | ) |
| Other comprehensive income                         |   |             |   |                             |    |                                          |   |                     |   |                             |   |                                  |   |   |   |
| Foreign currency translation adjustment            |   |             |   |                             |    |                                          |   | (2,920                   | )      |                             |   | (2,920                                | )      | (2,920 | ) |
| Comprehensive income                               |   |             |   |                             |    |                                          |   |                     |   |                             |   | (15,707,464                           | )      |   |   |
| Issuance of common stock                           |   | 3,325,636        |   | 33,257                           |    | 16,507,779                                    |   |                     |   |                             |   |                                  |   | 16,541,036 |   |
| Exercise of stock options                          |   | 52,098           |   | 521                              |    | 85,135                                        |   |                     |   |                             |   |                                  |   | 85,656 |   |
| Issuance of shares to Employee Stock Purchase Plan |   | 24,839           |   | 248                              |    | 124,524                                       |   |                     |   |                             |   |                                  |   | 124,772 |   |
|                                               |   |             |   |                             |    |                                          |   |                     |   |                             |   |                                  |   |   |   |
| Balance at December 31, 2002                       |   | 25,500,097       |   | $                                | 255,001 |                                          | $      | 120,030,647              |   | $                                | 8,503  |                                  | $      | (106,646,522 | ) |   |   | $ | 13,647,629 |   |

 

See accompanyingnotes to consolidated financial statements.

 

4

----

**AKSYS,LTD. AND SUBSIDIARY**

 

Consolidated Statements ofCash Flows

 

Years ended December 31, 2002, 2001 and 2000

 
|                                                                         |   | **2002**    |        | **2001**    |   | **2000**    |   |
|------------------------------------------------------------------------------|--------|-------------|-------------|-------------|--------|-------------|--------|
| Cash flows from operating activities:                                        |   |        |        |        |   |        |   |
| Net loss                                                                     |   | $           | (15,704,544 | )           | $      | (17,241,626 | )      | $ | (15,711,155 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |   |        |        |        |   |        |   |
| Depreciation and amortization                                                |   | 566,285     |        | 753,338     |   | 864,011     |   |
| Compensation expense related to stock options                                |   | —      |        | —      |   | 423,340     |   |
| Issuance of stock in exchange for services received                          |   | 35,007      |        | —      |   | 30,625      |   |
| Changes in assets and liabilities:                                           |   |        |        |        |   |        |   |
| Accounts receivable                                                          |   | (126,811    | )           | —      |   | —      |   |
| Other receivables                                                            |   | 101,759     |        | (227,793    | )      | 294,472     |   |
| Inventories                                                                  |   | (2,681,691  | )           | —      |   | —      |   |
| Prepaid expenses                                                             |   | (67,786     | )           | 6,695       |   | (21,967     | )      |
| Deposits with vendors                                                        |   | 688,002     |        | (574,216    | )      | (76,310     | )      |
| Accounts payable                                                             |   | 913,447     |        | (79,313     | )      | 108,560     |   |
| Deferred revenue                                                             |   | 1,326       |        | —      |   | (4,390,687  | )      |
| Accrued and other liabilities                                                |   | 93,295      |        | (910,354    | )      | 933,076     |   |
| Net cash used in operating activities                                        |   | (16,181,711 | )           | (18,273,269 | )      | (17,546,035 | )      |
|                                                                         |   |        |        |        |   |        |   |
| Cash flows from investing activities:                                        |   |        |        |        |   |        |   |
| Purchases of investments                                                     |   | (25,406,457 | )           | (1,009,521  | )      | —      |   |
| Proceeds from maturities of investments                                      |   | 16,040,000  |        | —      |   | 10,518,853  |   |
| Purchases of equipment leased to others                                      |   | (280,000    | )           | —      |   | —      |   |
| Purchases of property and equipment                                          |   | (174,924    | )           | (96,269     | )      | (156,651    | )      |
| Net cash provided by (used in) investing activities                          |   | (9,821,381  | )           | (1,105,790  | )      | 10,362,202  |   |
|                                                                         |   |        |        |        |   |        |   |
| Cash flows from financing activities:                                        |   |        |        |        |   |        |   |
| Proceeds from issuance of common stock                                       |   | 16,716,457  |        | 10,497,776  |   | 21,982,895  |   |
| Net cash provided by financing activities                                    |   | 16,716,457  |        | 10,497,776  |   | 21,982,895  |   |
|                                                                         |   |        |        |        |   |        |   |
| Net increase (decrease) in cash and cash equivalents                         |   | (9,286,635  | )           | (8,881,283  | )      | 14,799,062  |   |
| Cash and cash equivalents at beginning of period                             |   | 10,240,414  |        | 19,121,697  |   | 4,322,635   |   |
| Cash and cash equivalents at end of period                                   |   | $           | 953,779     |        | $      | 10,240,414  |   | $ | 19,121,697 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

5

----

Exhibit 13

AKSYS, LTD. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

**December31, 2002, 2001 and 2000**

 

**(1)****                                 Summaryof Significant Accounting Policies**

 

***Organization and Nature of Business***

 

Aksys, Ltd. (the Company) was originally incorporatedin Illinois on January 18, 1991. In March 1993, the Company merged into a Delaware corporation.  During the quarter ended September 30, 2002,the Company commenced commercial activities and is no longer considered to be inthe development stage.  The Company isinvolved in the sale and marketing of its sole product, the PHD System.  In addition, the Company continues devotingsome of its efforts to product development. The Company operates in one industry segment and substantially all ofits long-lived assets are located in the United States.

 

Certain reclassifications have been made to the 2000and 2001 financial statements in order to conform to the 2002 presentation.

 

A summary of the significant accounting policies appliedin the preparation of the accompanying financial statements of the Companyfollows:

 

***(a) Principles of Consolidation***

 

On April 18, 1996 the Company established asubsidiary in Tokyo, Japan.  Theconsolidated financial statements include the financial statements of theCompany and its wholly-owned subsidiary. All significant intercompany transactions and balances have beeneliminated in consolidation.

 

***(b) Use of Estimates***

 

The preparation of the consolidated financialstatements and accompanying notes requires management of the Company to make anumber of estimates and assumptions required under accounting principlesgenerally accepted in the United States of America.  Actual results could differ from those estimates.

 

***(c) Cash Equivalents***

 

Cash equivalents are comprised of certain highlyliquid investments with maturities of less than three months when purchased.

 

6

----

 

(***d) Investment Securities***

 

Investments at December 31, 2002 and 2001 consist ofdebt securities that are classified as short-term (mature in more than 91 daysbut no more than one year) or long-term (maturities beyond one year but no morethan 18 months).  Such investments areclassified as held-to-maturity, as the Company has the ability and intent tohold them until maturity.  Investmentsheld-to-maturity are carried at amortized cost, adjusted for the amortizationor accretion of discounts or premiums without recognition of gains or lossesthat are deemed to be temporary. Discounts and premiums are amortized or accreted over the lives of therelated instruments as an adjustment to yield. Interest income is recognized when earned.  At December 31, 2002 and 2001, long-term investments includecertificates of deposit to secure a letter of credit for the required securitydeposit on the Company’s leased facilities. Fair value of investments is calculated as market value, based on quotedmarket prices, and approximates carrying value for all investments.

 

***(e) Inventories***

 

Inventories are stated at the lower of cost or market.Cost is determined using the first-in, first-out method (FIFO) forall inventories.

 

***(f) Long-Lived Assets***

 

Property, equipment and leased assets are recorded atcost and depreciated using the straight-line method over the estimated usefullives of the assets, ranging from three to seven years.  Leasehold improvements are amortized overthe life of the lease. The Company leases PHD Systems to customers on ashort-term basis (12 months or less). Leased assets include PHD Systems currently on operating leases andmachines held for leases.  Expendituresfor repairs and maintenance are charged to operations as incurred.

 

In August 2001, the Financial Accounting StandardsBoard issued SFAS No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*, which requires that long-lived assets, such asproperty, plant, and equipment and purchased intangibles subject toamortization be reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. Recoverability of assets to be held and used is measured by acomparison of the carrying amount of an asset to future net cash flows expectedto be generated by the asset. If the carrying amount of an asset exceeds itsestimated future cash flows, an impairment charge is recognized by the amountby which the carrying amount of the asset exceeds the fair value of the asset.Assets to be disposed of are reported at the lower of the carrying amount orfair value less costs to sell. The Company adopted the provisions of SFAS No.144 on January 1, 2002, which did not have an impact on the consolidatedfinancial statements.

 

Intangible assets not subject to amortization aretested annually for impairment, and are tested for impairment more frequentlyif events and circumstances indicate that the

 

7

----

 

asset might be impaired.  An impairment loss is recognized to the extent that the carryingamount exceeds the asset’s fair value.

 

***(g)******                                 RevenueRecognition***

 

The Company recognizes revenue in accordance withStaff Accounting Bulletin (SAB) No. 101, *Revenue Recognition in Financial Statements*,and its related interpretations. Revenue is recognized when the following conditions exist: (1) there ispersuasive evidence of an arrangement, (2) the product has been delivered andaccepted or services and supplies have been provided to the customer, (3) thesales price is fixed or determinable and (4) collectability is reasonablyassured.

 

The Company recognizes revenue from product sales atthe time of delivery and acceptance by the customer of the PHD System.  Service and supplies revenue is recognizedwhen services are rendered and supplies are delivered.     The Company also leases the PHD System tocustomers on a short-term basis (12 months or less) and recognizes revenue onthese contracts on a straight-line basis over the lease term.    The Company has no contracts withdistributors and sells its product directly to its customers through its ownsales force. 

 

On June 21, 1999, the Company entered into aco-development and license agreement (the “Agreement”) with Teijin Limited ofOsaka, Japan.  Under the terms of theAgreement, Teijin paid the Company a $7.0 million co-development fee relatingto the PHD System.  Use of the proceedsfrom the co-development fee was restricted to development costs incurred on thePHD System and could not be used for other general corporate purposes.  Amounts paid under the co-developmentarrangement were recognized as revenue as development costs on the PHD Systemwere incurred.  During the year endedDecember 31, 2000, the Company recognized revenue of $3.4 million related toco-development of the PHD System. During 2000, the Agreement was amended. The final revenue related to theco-development of the PHD System under the Agreement was recognized in 2000(and there was no joint development income in fiscal 2001).  The remaining unspent amount was recorded asan amount due to Teijin of approximately $660,000 at December 31, 2000(included in other liabilities) and was subsequently spent exclusively ondevelopment activities by Teijin’s research employees.

 

All payments made by Teijin were non-refundable, andno amounts have been or will be refunded to Teijin.  The Company has completed all of its co-development obligationsand has no current or future specific development obligations under any of itsagreements with Teijin.  The Company isentitled to royalty payments from future product sales in Japan, which will****berecognized when future sales are made and royalties are realizable and earned.

 

***(h)******                                 Researchand Development Costs***

 

Research and development costs are charged to expensewhen incurred.

 

8

----

 

***(i)******                                    IncomeTaxes***

 

Deferred tax assets and liabilities are recognized forthe future tax consequences attributable to the difference between thefinancial statement carrying amount of existing assets and liabilities andtheir respective tax bases and operating loss and tax creditcarryforwards.  Deferred tax assets andliabilities are measured using enacted tax rates expected to apply to taxableincome in the years in which those temporary differences are expected to be recoveredor settled.  The effect on deferred taxassets and liabilities of a change in tax rates is recognized in income in theperiod that includes the enactment date.

 

***(j)******                                    Computationof Net Loss per Share***

 

Net loss per share is based on the weighted averagenumber of shares outstanding with common equivalent shares from stock optionsand warrants excluded from the computation because their effect isantidilutive.  At December 31, 2002,2001, and 2000, the number of common equivalent shares from stock options andwarrants excluded from the computation were 1,800,653, 1,465,984, and 945,023,respectively.

 

**(k)  Stock-BasedCompensation**

 

The Company applies the intrinsic-value-based methodof accounting prescribed by Accounting Principles Board (APB) OpinionNo. 25, *Accounting for Stock Issued to Employees,* and relatedinterpretations including FASB Interpretation No. 44, *Accounting for Certain Transactionsinvolving Stock Compensation, an interpretation of APB Opinion No. 25,*issued in March 2000, to account for its fixed-plan stock options. Under thismethod, compensation expense is recorded on the date of grant only if thecurrent market price of the underlying stock exceeded the exercise price.SFAS No. 123, *Accounting for Stock-Based Compensation,*established accounting and disclosure requirements using a fair-value-basedmethod of accounting for stock-based employee compensation plans. As allowed bySFAS No. 123, the Company has elected to continue to apply theintrinsic-value-based method of accounting described above, and has adopted onlythe disclosure requirements of SFAS No. 123.

 

The per share weighted-average fair value of stockoptions granted during 2002, 2001 and 2000 was $5.16, $7.55 and  $6.40, respectively, on the dates of grantusing the Black Scholes option-pricing model with the followingweighted-average assumptions:  2002 –expected dividend yield of 0%, expected volatility of 131%, risk-free interestrate averaging 1.20% and an expected life of 5 years; 2001 - expected dividendyield of 0%, expected volatility of 113%,risk-free interest rate of 3.89%, andan expected life of 5 years; 2000 – expected dividend yield of 0%, expectedvolatility of 83%, risk-free interest rate of 5.80%, and an expected life of 5years.

 

Had the Company determined compensation cost based onthe fair value of the stock options as of the grant date, the Company’s netloss would have been increased to the pro forma amounts indicated below:

 
|                                                                                                           |   | **2002**   |        | **2001**   |    | **2000**    |    |
|----------------------------------------------------------------------------------------------------------------|--------|------------|-------------|------------|---------|-------------|---------|
| Net loss as  reported                                                                                          |   | $          | (15,704,544 | )     | $       | (17,241,626 | )  | $ | (15,711,155 | )  |
| Add: Total  stock-based employee compensation expense determined under fair value based  method for all awards |   | (1,947,768 | )      | (1,603,144 | )  | (1,581,728  | )  |
| Pro forma net  loss                                                                                            |   | $          | (17,652,312 | )     | $       | (18,844,770 | )  | $ | (17,292,883 | )  |
|                                                                                                           |   |       |        |       |    |        |    |
| Loss per share  as reported                                                                                    |   | $          | (0.65       | )     | $       | (0.94       | )  | $ | (0.93 | )  |
| Pro forma loss  per share                                                                                      |   | $          | (0.73       | )     | $       | (1.02       | )       | $ | (1.02 | )  |

 

 

In December 2002, the FASB issued SFAS No. 148, *Accountingfor Stock-Based**Compensation - Transition and Disclosure, anamendment of FASB Statement**No. 123*. This Statement amends FASBStatement No. 123, *Accounting for**Stock-Based Compensation,* toprovide alternative methods of transition for a voluntary change to the fairvalue method of accounting for stock-based employee compensation.  In addition, this Statement amends the disclosurerequirements of Statement No. 123 to require prominent disclosures in bothannual and interim financial statements. Certain of the disclosure modifications are required for fiscal yearsending after December 15, 2002 and are included in the notes to theseconsolidated financial statements.

 

9

----

 

***(l)******                                    RecentlyIssued Accounting Pronouncements***

 

In November 2002, the FASB issued Interpretation No.45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness to Others*, *an interpretation of FASB StatementsNo. 5, 57 and 107 and a rescission of FASB Interpretation No. 34*.This Interpretation elaborates on the disclosures to be made by a guarantor inits interim and annual financial statements about its obligations underguarantees issued.  The Interpretationalso clarifies that a guarantor is required to recognize, at inception of aguarantee, a liability for the fair value of the obligation undertaken. Theinitial recognition and measurement provisions of the Interpretation areapplicable to guarantees issued or modified after December 31, 2002 and are notexpected to have any impact on the Company’s financial statements.  The disclosure requirements are effectivefor financial statements of interim and annual periods ending after December15, 2002.

 

**(2)****                                 Short-TermInvestments**

 

Short-term investments consisted of commercial paper,corporate bonds, and U.S. Treasury securities at December 31, 2002 with a marketvalue of $10,569,469 and amortized cost of $10,555,978.  Short-term investments consisted ofcorporate bonds at December 31, 2001 with a market value of $1,027,410 andamortized cost of $1,009,521.

 

10

----

 

**(3)****                                 Inventories**

 

Inventories at December 31, 2002 were as follows:

 
|                               |   | **December 31,  2002** |      |
|------------------------------------|--------|------------------------|-----------|
| PHD machines – finished goods |   | $                      | 2,200,000 |   |
| PHD machines spare parts           |   | 274,686                |      |
| Consumables                        |   | 162,478                |      |
| Raw materials                      |   | 44,527                 |      |
|                               |   | $                      | 2,681,691 |   |

 

The cost of producing the PHD System is currently inexcess of its market price.  During theyear ended December 31, 2002, an inventory adjustment was recorded as productcost of sales in the amount of $1,322,197, in order to value the PHD machinesproduced and purchased during the year in inventory at the lower of cost ormarket.

 

**(4)****                                 Property,Equipment and Leased Assets**

 

Property, equipment and leased assets at December 31,2002 and 2001, respectively, are as follows:

 
|                                            |   | **Estimated  useful life** |   | **2002**   |      | **2001**   |   |
|-------------------------------------------------|--------|----------------------------|--------|------------|-----------|------------|--------|
|                                            |   |                       |   |       |      |       |   |
| Leased assets                                   |   | 5 years                    |   | $          | 280,000   |       | $      | — |   |
| Furniture and  fixtures                         |   | 7 years                    |   | 1,238,586  |      | 1,238,586  |   |
| Leasehold  improvements                         |   | 10 years                   |   | 1,146,511  |      | 1,146,511  |   |
| Equipment                                       |   | 3-7 years                  |   | 3,819,757  |      | 3,644,833  |   |
|                                            |   |                       |   |       |      |       |   |
|                                            |   |                       |   | 6,484,854  |      | 6,029,930  |   |
| Less accumulated  depreciation and amortization |   |                       |   | (5,186,885 | )         | (4,664,156 | )      |
|                                            |   |                       |   |       |      |       |   |
|                                            |   |                       |   | $          | 1,297,969 |       | $      | 1,365,774 |   |

 

Leased assets at December 31, 2002 were $280,000 with relatedaccumulated depreciation of $1,333.

 

11

----

 

**(5)****                                 Stockholders’Equity**

 

On May 10, 2002, the Company completed a privateplacement to institutional investors of 3,319,396 shares of its common stock,at a per share price of $5.29, resulting in gross proceeds of approximately$17.6 million.  After offering costs,net proceeds to the Company were approximately $16.5 million.  The shares were sold with theassistance of  U.S. Bancorp PiperJaffray (“Piper Jaffray”).  As theplacement agent, Piper Jaffray received fees of approximately $1.1 million.

 

On December 14, 2001, the Company completed a privateplacement to several institutional investors of 3,195,230 shares of its commonstock, at a per share price of $3.25 , resulting in gross proceeds ofapproximately $10.4 million.  Theinvestors were also issued stock purchase warrants for the right to acquire anaggregate of 584,728 shares of common stock at an exercise price of $3.25 pershare.  These warrants had a fair valueof approximately $2,047,000 at the date of issuance using the Black Scholespricing model.

 

The shares were sold with the assistance of PiperJaffray.  As the placement agent, PiperJaffray received fees of approximately $0.6 million and stock purchase warrantsto acquire an aggregate of 159,762 shares of common stock at $4.90 per share,with a fair value of approximately $532,000 using the Black Scholes model.

 

The rights represented by thesewarrants may be exercised by the holder thereof, in whole or in part, bywritten notice of exercise delivered to the Company and by the surrender ofthese warrants (properly endorsed if required) at the principal office of theCompany and upon payment to it by wire transfer of the purchase price for suchshares.  The Company agrees that theshares so purchased shall be and are deemed to be issued to the holder thereofas the record owner of such shares as of the close of business on the date onwhich these warrants shall have been surrendered and payment made for suchshares as aforesaid.

 

On April 11 and August 16, 2000, the Company completedtwo private placements to five institutional investors for a total of 2,476,375shares of its common stock.  The grossproceeds of the offering were approximately $19.2 million.  The shares were sold with the assistance ofPiper Jaffray.  As the placement agent,Piper Jaffray received fees of approximately $1.2 million.

 

On June 8, 2000, the Company completed a privateplacement of 320,103 shares of its common stock.  The shares were sold to Kimal plc, the Company’s expectedtechnical service partner in the United Kingdom.  The Company received gross proceeds from the offering of$2,500,000, and no commission fees or other selling expenses wereincurred.  The shares of common stockwere sold in reliance on the exemption from registration provided by RegulationS, promulgated by the Securities and Exchange Commission under the SecuritiesAct of 1933.

 

During 2002 and 2000, the Company issued 6,240 and5,000 shares of Common Stock at a fair value of  $35,007 and $30,625 respectively, in exchange for servicesrendered.

 

12

----

 

**(6)****                                 StockOption Plans**

 

The Company established a nonqualified stock optionplan in 1993 (the “1993 Stock Option Plan”) which provides for the granting ofoptions to purchase shares of the Company’s common stock to the employees,scientific advisory board members, other associates, and members of the boardof directors.  In March 1996, theCompany established the 1996 Stock Awards Plan (together with the 1993 StockOption Plan, the “Stock Plans”) to provide incentive awards to directors,employees and other key individuals in the form of stock options, SARs,restricted stock and performance grants. Options vest over various periods as set forth in  agreements relating to a particular option grantand expire as determined by the board on an individual basis, but not to exceed10 years.  At the time the 1996 StockAwards Plan was established, the 1993 Stock Option Plan was terminated, exceptwith respect to options then outstanding. At December 31, 2002, 1,935,642 shares of common stock have beenreserved for issuance under the Stock Plans, including 562,432 shares availablefor future grants under the 1996 Stock Awards Plan.

 

During 2001, the Company issued a total of 3,315non-qualified stock options at a price below fair market value at the time ofthe option awards, resulting in a non-cash compensation charge, recorded inoperating expenses, of approximately $41,000. During 2000, the Company issued a total of 40,451 non-qualified stockoptions at a price below fair market value at the time of the option awards,resulting in a non-cash compensation charge, recorded in operating expenses, ofapproximately $423,000.

 

 

13

----

 

Stock option activity during the periods indicated is as follows:

 
|                          |   | **Number of  shares** |   | **Weighted-average  exercise price** |   |
|-------------------------------|--------|-----------------------|--------|--------------------------------------|--------|
|                          |   |                  |   |                                 |   |
| Balance at  December 31, 1999 |   | 2,023,381             |   | $                                    | 3.7801 |   |
| Granted                       |   | 553,126               |   | 9.2831                               |   |
| Exercised                     |   | (381,662              | )      | 3.2252                               |   |
| Canceled                      |   | (303,520              | )      | 5.9990                               |   |
|                          |   |                  |   |                                 |   |
| Balance at  December 31, 2000 |   | 1,891,325             |   | 5.1477                               |   |
| Granted                       |   | 115,190               |   | 8.9428                               |   |
| Exercised                     |   | (484,784              | )      | 0.4287                               |   |
| Canceled                      |   | (202,815              | )      | 7.8744                               |   |
|                          |   |                  |   |                                 |   |
| Balance at  December 31, 2001 |   | 1,318,916             |   | 6.7943                               |   |
| Granted                       |   | 383,882               |   | 6.0013                               |   |
| Exercised                     |   | (52,098               | )      | 1.6441                               |   |
| Canceled                      |   | (277,490              | )      | 9.5136                               |   |
|                          |   |                  |   |                                 |   |
| Balance at  December 31, 2002 |   | 1,373,210             |   | $                                    | 6.2186 |   |

 

The following table summarizes information about stock optionsoutstanding at December 31, 2002:

 
| **Range of  Exercise Prices** |                                                 | **Number  Outstanding  at 12/31/02** |                                    | **Options  Outstanding** |                                 | **Options  Exercisable** |                                    |
|-------------------------------|------------------------------------------------------|--------------------------------------|-----------------------------------------|--------------------------|--------------------------------------|--------------------------|-----------------------------------------|
| ** **                    | **Weighted-  Average  Remaining  Contractual  Life** | ** **                           | **Weighted-  Average  Exercise  Price** | ** **               | **Number  Exercisable  at 12/31/02** | ** **               | **Weighted-  Average  Exercise  Price** | ** ** |
| $0.1067 to  $1.0000           |                                                 | 24,963                               |                                    | 0.1 years                |                                 | $                        | 0.1594                                  |   | 24,963 |   | $ | 0.1594 |   |
| $4.0000 to  $5.4700           |                                                 | 727,874                              |                                    | 7.0 years                |                                 | $                        | 5.1427                                  |   | 502,324 |   | $ | 5.1923 |   |
| $5.5000 to  $8.5625           |                                                 | 457,798                              |                                    | 7.9 years                |                                 | $                        | 6.7371                                  |   | 230,447 |   | $ | 6.9239 |   |
| $8.6250 to  $10.5000          |                                                 | 128,950                              |                                    | 7.4 years                |                                 | $                        | 9.0538                                  |   | 83,804 |   | $ | 9.1455 |   |
| $11.0000 to  $16.7500         |                                                 | 33,625                               |                                    | 7.1 years                |                                 | $                        | 16.0716                                 |   | 14,625 |   | $ | 15.6303 |   |
| $0.1067 to  $16.7500          |                                                 | 1,373,210                            |                                    |                     |                                 |                     |                                    | 856,163 |   |   |   |

 

14

----

 

**(7)****                                 EmployeeBenefit Plans**

 

In 1995 the Company adopted a tax-qualified employeesavings and retirement plan (the “401(k) Plan”) covering all full-timeemployees.  The 401(k) Plan provides amatch of 100% of the employees’ contributions up to 2% of the employees salary.  Total expense for the years endedDecember 31, 2002, 2001 and 2000 was $62,521, $89,214 and $45,955,respectively.

 

On March 4, 1996, the Company established the 1996Employee Stock Purchase Plan   (the“1996 Stock Purchase Plan”) covering all employees.  The 1996 Stock Purchase Plan allowed employees to purchase Companycommon stock at a 15% discount to market, based on eligible payroll deductions.

 

On April 26, 2001, the Company established the 2001Employee Stock Purchase Plan (the “2001 Stock Purchase Plan”) covering allemployees.  The 2001 Stock Purchase Plansuperceded the Company’s 1996 Stock Purchase Plan.  The 2001 Stock Purchase Plan allows employees to purchase Companycommon stock at a 15% discount to market, based on eligible payroll deductions.  There are four plan periods in each calendaryear, with each such plan period corresponding with a calendar quarter.  Market price is calculated as the fairmarket value of the common stock as of the last trading day of such plan periodless the discount to the market.  Atotal of 250,000 shares of common stock are reserved for issuance under the2001 Stock Purchase Plan.  Total sharesissued based on payroll withholdings for the years ended December 31, 2002,2001 and 2000 were 24,358 (6,645 issued January 2003), 40,441 (7,126 issuedJanuary 2002), and 66,249 (issued January 2001), respectively.  As of December 31, 2002, there are 191,846shares remaining under the 2001 Stock Purchase Plan.

 

**(8)****                                 StockholderRights Plan**

 

On October 28, 1996, the Company adopted a stockholderrights plan and declared a dividend to be made to stockholders of record onNovember 8, 1996 of one preferred share purchase right on each outstandingshare of the Company’s common stock. The stockholder rights plan was adopted to preserve for the stockholdersof the Company the long-term value of the Company in the event of a takeover ofthe Company or the purchase of a significant block of the Company’s commonstock and to protect the Company and its stockholders against coercive takeovertactics.  Prior to the time the rightsbecome exercisable, the rights will be evidenced by the certificatesrepresenting shares of common stock of the Company and will be transferableonly in connection with the transfer of shares of common stock.  If a person acquires 15% of the Company’scommon stock the rights will then be exercisable, and each right will entitlethe holder thereof to purchase for an exercise price of $85.00 (subject toadjustment), shares of the Company’s common stock having a market value oftwice such exercise price, valued as of the date of occurrence of suchtriggering event, subject to the right of the Company to exchange the rightsfor common stock of the Company on a one-for-one basis.  The Company will be entitled to redeem therights at $0.01 per right at any time before public disclosure that a 15%position has been acquired. The rights plan contains an exception forinadvertent acquisitions of more than 15% of the Company's common stock. Therights will expire on October 28, 2006, unless previously redeemed orexercised.

 

15

----

 

**(9)****                                 IncomeTaxes**

 

No Federal or state income taxes have been providedfor in the accompanying financial statements because of net operating lossesincurred to date and the establishment of a valuation allowance equal to theamount of the Company’s deferred tax assets. At December 31, 2002, the Company has net operating loss andresearch and development credit carryforwards for Federal income tax purposesof approximately $111.8 million and $2.9 million, respectively, which expirebetween 2012 and 2022.  Changes in theCompany’s ownership may cause annual limitations on the amount of loss andcredit carryforwards that can be utilized to offset income in the future.

 

The net deferred tax assets are summarized at December 31as follows:

 
|                                           |   | **2002**    |       | **2001**    |   |
|------------------------------------------------|--------|-------------|------------|-------------|--------|
|                                           |   |        |       |        |   |
| Deferred tax  assets:                          |   |        |       |        |   |
| Net operating  loss carryforwards              |   | $           | 46,175,000 |        | $      | 39,989,000 |   |
| Research and  development credit carryforwards |   | 2,870,000   |       | 3,072,000   |   |
| Other                                          |   | 721,000     |       | 416,000     |   |
|                                           |   |        |       |        |   |
| Total deferred  tax assets                     |   | 49,766,000  |       | 43,477,000  |   |
| Less valuation  allowance                      |   | (48,603,000 | )          | (43,477,000 | )      |
|                                           |   |        |       |        |   |
| Net deferred tax  assets                       |   | 1,163,000   |       | —      |   |
| Deferred tax  liability                        |   | (1,163,000  | )          | —      |   |
|                                           |   |        |       |        |   |
| Net deferred  taxes                            |   | $           | —     |        | $      | — |   |

 

Given the Company’s historical losses and uncertaintywith respect to the Company’s ability to generate taxable income, managementhas established a valuation allowance of $48,603,000 at December 31, 2002 and$43,477,000 at December 31, 2001 to reduce the net deferred tax assets tozero.  The valuation allowance increased$5,126,000 and $11,533,000 in 2002 and 2001, respectively.

 

**(10)****                          Commitments**

 

***Purchases***

 

The Company entered into a contract manufacturingagreement with one of its vendors to produce PHD machines. The Company has acontractual obligation through July 31, 2003 to purchase materials and finalassemblies in the amount of $3.8 million that are produced by the vendor.

 

***Leases***

 

During September 1996, the Company entered into a newlease agreement, accounted for as an operating lease, for its offices andlaboratory research facilities. The term of the

 

16

----

 

lease is ten years expiring in September 2006;however, the Company may exercise its option to terminate the lease in 2003 bygiving written notice to the landlord and paying a termination fee ofapproximately $350,000.  The Companyalso leases certain equipment under operating leases.  Included in both research and development expenses and generaland administrative expenses for the years ended December 31, 2002, 2001, and2000 were $654,743, $619,645, and $611,363, respectively, for rent expenseunder operating leases for certain equipment and the Company’s offices andresearch facilities.  The Company hascommitments for future minimum rent payments under these lease agreements, asfollows:

 
| 2003 |   | $       | 419,980 |   |
|------|--------|---------|---------|--------|
| 2004 |   | 432,568 |    |
| 2005 |   | 445,572 |    |
| 2006 |   | 302,950 |    |

 

 

***License Agreements***

 

The Company has been granted licenses to use certaintechnology in the development and sale of its products.  Such license agreements provide for royaltypayments to be made by the Company based on net sales over the life of anyapplication based on the patent rights. Minimum required payments under these agreements are as follows:

 
| 2003                  |   | $       | 215,000 |   |
|-----------------------|--------|---------|---------|--------|
| 2004                  |   | 253,750 |    |
| 2005                  |   | 250,000 |    |
| 2006                  |   | 250,000 |    |
| 2007                  |   | 250,000 |    |
| All subsequent  years |   | 450,000 |    |

 

Total royalty payments for the years endedDecember 31, 2002, 2001, and 2000 were $185,000, $155,000 and $140,000,respectively.

 

**(11)****                          Contingencies**

 

In May 2001, the Company signed an engagement letterwith an investment banking firm to raise funding through the sale of commonstock. A dispute arose as to whether a fee was payable under this letter, andlitigation ensued. In March 2003, the Company and the investment banking firmsettled this litigation.  The Companyagreed to pay $75,000 upon settlement and an additional $75,000 in November2003.  The Company also issued theinvestment banking firm 26,500 shares of its common stock upon settlement andagreed to pay the investment banking firm future advisory fees of up to$160,000 in connection with future financings. An estimated liability was recorded in the Company’s consolidatedfinancial statements as of December 31, 2002 related to the above settlement.

 

17

----

 

In the ordinary course of business, the Company isparty to employment and other legal actions as plaintiff or defendant.  While management cannot determine withcertainty the ultimate outcome of such lawsuits, management believes that theCompany is not involved in any current litigation proceedings which, shouldthere be an unfavorable disposition, either individually or in aggregate, wouldhave a material adverse effect on the Company’s consolidated financialposition, results of operations or liquidity.

 

**(12)****                          SubsequentEvents – Financing Activities**

 

On January 22, 2003, the Company entered into a $15million equity line of credit arrangement with Kingsbridge Capital Limited(“Kingsbridge”). Pursuant to the terms of an Amended and Restated Common StockPurchase Agreement between the Company and Kingsbridge, the Company may sellcommon stock at its sole discretion over a 24-month period on a “when and ifneeded” basis, and Kingsbridge is required under the terms of the agreement topurchase this stock, subject to the satisfaction of certain conditionscontained in the agreement. The Company has no obligation to draw down all orany portion of the commitment.  Aspartial consideration for entering into the equity line arrangement, theCompany issued warrants to Kingsbridge to purchase 200,000 shares of theCompany’s common stock at an exercise price of $5.75 per share.  These warrants had a fair value of  $881,000 using the Black Scholes pricingmodel.

 

The Company has filed a registration statement withthe SEC covering the  equity linearrangement that was declared effective by the SEC on February 14, 2003.  Through March 27, 2003, the Company issued778,474 shares of common stock to Kingsbridge under the equity line arrangementand received $4.5 million.

 

**(13)**                          **Liquidity and Capital Resources**

 

The Company estimates that during fiscal 2003 it willspend between $20 and $24 million for operations, including U.S.commercialization activities of the PHD System.  The Company expects to incur increasingly substantial cashoutlays related to manufacturing scale-up and commercialization of the PHDSystem.

 

It is the Company’s plan to raise the additionalcapital required to fund operations in 2003 and beyond through public orprivate equity or debt financings.  Theadditional capital required for these commercial activities may not beavailable at terms agreeable to the Company or may not be available at all.  In the event the Company cannot raise sufficientcapital for these commercial activities, the Company believes that cash andshort-term investments as of December 31, 2002 are sufficient to finance theCompany’s operations through December 31, 2002, under scaled back commercialplans.

 

18

----