**UNITED STATES****SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-K**

 

| **(Mark One)** |                                                                                         |
|----------------|----------------------------------------------------------------------------------------------|
| **ý**     | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(****d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**Forthe fiscal year ended December 31, 2002**

 

**or**

 

| **o** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(****d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|--------------------------------------------------------------------------------------------------|

 

**Forthe transition period from                  to                  **

 

**Commissionfile number: 0-28236**

 

**INVISIONTECHNOLOGIES, INC.**

(Exact name of registrant as specified in itscharter)

 

| **DELAWARE**                                                      |   | **94-3123544**                       |
|-------------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization)   |   | (I.R.S. Employer Identification No.) |
|                                                              |   |                                 |
| **7151 GATEWAY BOULEVARD, NEWARK, CALIFORNIA 94560**              |
| (Address of principal executive offices,  including zip code)     |
|                                                              |   |                                 |
| **(510) 739-2400**                                           |
| (Registrant’s telephone number, including  area code)        |
|                                                              |
| Securities Registered Pursuant to  Section 12(b) of the Act: |
| **NONE**                                                          |
|                                                              |
| Securities Registered Pursuant to  Section 12(g) of the Act: |
| **COMMON STOCK, $.001 PAR VALUE**                                 |

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past90 days. Yes ý    No o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein and will not becontained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of thisForm 10-K or any amendment to this Form 10-K. o

 

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

 

On June 28, 2002, which was the last business day of the registrant’smost recently completed second fiscal quarter, the registrant had 16,675,378shares of common stock outstanding, and the aggregate market value of thevoting stock held by non-affiliates of the registrant was approximately$341,108,082 (based on the closing price of $24.16 on that day). For purposesof this computation, voting stock held by directors and executive officers ofthe registrant and stockholders holding 5% or more of the registrant’soutstanding common stock has been excluded. Such exclusion is not intended, andshall not be deemed, to be an admission that such directors, executive officersand stockholders are affiliates of the registrant.

 

On March 14, 2003, there were 17,112,087 shares ofthe registrant’s common stock outstanding.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Portions of the registrant’s definitive Proxy Statement for its AnnualMeeting of Stockholders to be held in June 2003 are incorporated by referenceinto Part III of this report on Form 10-K.

 

 

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**INVISIONTECHNOLOGIES, INC.TABLE OF CONTENTS**

** **
| **PART I.**                       |
|-----------------------------------|
|                              |   |
| **Item**                          |   |
| 1.                                | Business |
| 2.                                | Properties |
| 3.                                | Legal Proceedings |
| 4.                                | Submission of Matters to a Vote of Security  Holders |
| 4A.                               | Executive Officers of the Registrant |
|                              |   |
| **PART II.**                      |
|                              |   |
| **Item**                          |   |
| 5.                                | Market for Registrant’s Common Equity and  Related Stockholder Matters |
| 6.                                | Selected Financial Data |
| 7.                                | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |
| 7A.                               | Quantitative and Qualitative Disclosures  About Market Risk |
| 8.                                | Financial Statements and Supplementary Data |
| 9.                                | Changes in and Disagreements With  Accountants on Accounting and Financial Disclosure |
|                              |   |
| **PART III.**                     |
|                              |   |
| **Item**                          |   |
| 10.                               | Directors and Executive Officers of the  Registrant |
| 11.                               | Executive Compensation |
| 12.                               | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters |
| 13.                               | Certain Relationships and Related  Transactions |
| 14.                               | Controls and Procedures |
|                              |   |
| **PART IV.**                      |
|                              |   |
| **Item**                          |   |
| 15.                               | Exhibits,  Financial Statement Schedules and Reports on Form 8-K |
|                              |   |
| Signature  Page                   |
| Certification  of Sergio Magistri |
| Certification  of Ross Mulholland |

 

InVision, QScan and Quantum Magnetics, CTX, CTX 1000, CTX 2500, CTX5500 DS, CTX 9000 DSi, WoodVision, *i*-Portal, *i*-Portal 100, QScan QR 160,QR Wand and QRCTX, among others, are trademarks of InVision Technologies, Inc.or one of its subsidiaries in the United States and other countries.  InVision, QScan and Quantum Magnetics, amongothers, are registered trademarks marks of InVision Technologies, Inc. or oneof its subsidiaries in the United States.

 

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**PART I.**

 

**ITEM 1. BUSINESS**

 

*References to “we”, “us” and “our” mean InVision Technologies, Inc. andits wholly-owned subsidiaries, Quantum Magnetics, Inc. and Inovec, Inc.*

 

**Forward LookingStatements**

 

This Annual Report on Form 10-K of InVisionTechnologies, Inc. includes forward-looking statements within the meaningof Section 27A of the Securities Act of 1933, and Section 21E of theSecurities Exchange Act of 1934. We intend these forward-looking statements tobe covered by the safe harbor provisions for forward-looking statementscontained in the Private Securities Litigation Reform Act of 1995, and we areincluding this statement for purposes of complying with these safe harborprovisions. We have based these forward-looking statements on our currentexpectations and projections about future events. These forward-lookingstatements are not guarantees of future performance and are subject to risks,uncertainties and assumptions, including those in the section entitled “RiskFactors” at the end of this Item 1. Actual results may vary materially fromthese forward-looking statements as a result of these and other risks.

 

Words such as “expect,” “anticipate,”“intend,” “plan,” “believe,” “estimate” and variations of these words andsimilar expressions are intended to identify forward-looking statements. Weundertake no obligations to publicly update or revise any forward-lookingstatements, whether as a result of new information, future events or otherwise,unless we are required to do so by law. In light of these risks, uncertaintiesand assumptions, the forward-looking events discussed below might not occur.

 

We were incorporated in Delaware in 1990. We maintain our principaloffices at 7151 Gateway Boulevard, Newark, California 94560, and our telephonenumber is (510) 739-2400. Our web site is located at invision-tech.com.Information contained on our web site does not constitute part of this annualreport.

 

**Introduction**

 

We are the leading provider of Transportation Security Administration,or TSA (formerly Federal Aviation Administration, or FAA) certified explosivesdetection systems, or EDS, used at airports for screening checked passengerbaggage. From inception through December 31, 2002, we shipped 628 EDS units forinstallation at U.S. airports, which we believe represents approximately 60% ofthe total number of FAA/TSA-certified EDS products delivered through December31, 2002 for screening checked baggage at U.S. airports. From inception throughDecember 31, 2002, we shipped 151 EDS units for installation in airportsoutside of the United States. Our EDS products are based on advanced computedtomography, or CT, which is the only technology for explosives detection thathas met the FAA/TSA certification standards. We were the first manufacturer,and are currently one of only two manufacturers, whose EDS products have beencertified by the FAA/TSA for screening checked baggage.

 

We also design, develop and manufacture products used for weaponsdetection and for non-aviation applications, including landmine detection andmaximization of timber industry output. Quantum Magnetics, Inc., or Quantum,uses quadrupole resonance, or QR, and magnetic sensing technologies for theinspection, detection and analysis of explosives, concealed weapons and othermaterials. Our Wood division consists of Inovec, which manufactures systemsusing laser-based technologies to increase sawmill yields, and WoodVision,which is developing our CT technology to increase the value of harvestedtimber.

 

**InVision Strategy**

 

We intend to enhance our leadership position in the EDS business andbroaden our portfolio of products and services, as well as further diversifyour revenue base, through internal growth and strategic acquisitions. We also

 

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intend to leverage our technology platform and core research anddevelopment competency in related fields with similar screening and detectionrequirements. The following elements define our growth strategy:

 

*Capitalize on Increased Worldwide Demand for EDSProducts.    *The Aviation andTransportation Security Act, or the Transportation Security Act, which mandates100% EDS screening of checked baggage at U.S. commercial airports, led tosignificantly increased order volume for our EDS products. During 2002,pursuant to a letter contract dated February 19, 2002 and subsequent deliveryorders, the FAA/TSA ordered a total of 625 of our EDS units for deployment atU.S. airports.  By leveraging our proventrack record and strong relationships with the aviation community, we expect togain a significant share of additional orders placed by the TSA.

 

We believe non-U.S. airports also represent a significant market forour EDS products as the international community has increased its focus onaviation security. Of the approximately 1,400 commercial airports worldwide,more than 950 are located in countries other than the United States. AlthoughFAA/TSA certification is not required for EDS products to be used outside ofthe United States, we believe it is the most stringent commercially-applicablestandard. We believe that our CT-based technology has a good reputationinternationally for high detection rates and reliability. Our EDS products areused by airport authorities in a number of countries, including****France, Israel, Italy and the United Kingdom.We intend to continue to service the heightened security concerns ofgovernments worldwide.

 

*Provide Warranty and Post-Warranty Service.    *Wegenerally provide twelve months of warranty service on all installed EDS products,including provision of spare parts, maintenance and field support.  Provision of post-warranty servicerepresents a recurring revenue opportunity for us.  In 2002, the TSA entered into an agreement with Siemens pursuantto which Siemens has the obligation to service all CTX models owned by the FAAand the TSA in the United States and its territories.  In January 2003, we entered into an agreement with Siemenspursuant to which Siemens subcontracted to us its CTX service obligations tothe FAA and the TSA.  The agreement isretroactive to November 2002 and runs through 2007.  Commencing in January 2003, Siemens has the option to extend theagreement for a one-year term, with four annual options to renew.  Siemens has exercised its option to extendfor 2003. With respect to CTX models purchased by our international customers,owners of approximately 90% of these EDS products in service have, in the past,entered into annual service contracts following their first year of operation.

 

*Increase Aftermarket Revenues.    *Ourinstalled base of EDS products presents additional revenue opportunities forsystem upgrades. We intend to offer upgrades to our installed base of EDSproducts to improve performance characteristics, including heightened detectionperformance and reduced false alarm rates.

 

*Create New Market Opportunities by Leveraging ExistingTechnologies.    *We plan to useour technology to develop new detection products for deployment at aviationsecurity checkpoints other than checked baggage. For example, we intend toextend our leadership in screening checked baggage to screening passengers andcarry-on baggage. In addition, we believe our technology can be utilized fornon-aviation applications. For example, we intend to apply our detection capabilitiesto screen for explosives, weapons and drugs at borders, secure or publicfacilities and for non-aviation modes of transportation including shipping,railroads and trucking.

 

*Pursue Strategic Acquisitions.    *Weintend to complement our internal growth through acquisitions of businesseswith technologies and product and service offerings that add to our existingproduct offerings, or that provide access to new markets, additionaldistribution channels or new capabilities. In aviation security, we believethat opportunities exist to expand our offerings through acquisitions ofspecific product lines. We also evaluate acquisition opportunities that wouldbroaden our product line to address the wider aviation security needs of ourcustomers and end users, such as carry-on baggage, passenger screening andpersonnel monitoring and control.  InFebruary 2003, we entered into a definitive agreement to acquire YXLONInternational Holding GmbH, a privately held company based in Hamburg, Germanythat develops x-ray based diffraction for explosive detection and manufacturesx-ray based non-destructive testing equipment. We expect to close the acquisition by the end of March 2003.

 

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**Products andTechnologies**

 

***Explosives andWeapons Detection Products***

 

We provide explosives and weapons detection products for use at keysecurity checkpoints within airports, including checked baggage, carry-onbaggage and passenger screening. The following table summarizes our aviation securityproducts, as well as their applications and key features:

 
| **Products**     |   | **Status**                                           |   | **Applications**                                            |   | **Key  Features**                                                                                                                                                                    |
|------------------|--------|------------------------------------------------------|--------|-------------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| CTX 9000 DSi     |   | In use;  FAA certified in  1999                      |   | Explosives detection for checked baggage                    |   | •  Utilizes CT technology• Designed for  integration into baggage handling systems, unique, 1-meter-wide gantry  aperture• FAA certified at  542 bags per hour        |
| CTX 5500 DS      |   | In use;  FAA certified in  1998                      |   | Explosives detection for checked baggage                    |   | •  Utilizes CT technology • Can be configured  as integrated or stand-alone system• FAA certified at  362 bags per hour                                               |
| CTX 2500         |   | In use;  FAA certified in  1999                      |   | Explosives detection for checked and carry-on baggage       |   | •  Utilizes CT technology• Designed for  small airports and low-traffic areas• Designed for  stand-alone lobby installation• FAA certified at  128 bags per hour |
| CTX 1000 (ARGUS) |   | In development;  FAA certification  expected in 2003 |   | Explosives detection for checked and carry-on baggage       |   | •  Utilizes CT technology• Designed for  small airports and low-traffic areas• Designed for  stand-alone lobby installation• Compact,  portable, low cost        |
| QScan QR 160     |   | In test markets                                      |   | Explosives detection for carry-on baggage and mail packages |   | •  Utilizes QR technology• Compact,  lightweight design                                                                                                                    |
| *i-*Portal  100  |   | In test markets                                      |   | Weapons detection for personnel screening                   |   | •  Utilizes magnetic sensing technology• Creates image  database of scanned personnel                                                                                      |
| QR Wand          |   | In development                                       |   | Weapons and explosives detection for personnel screening    |   | •  Utilizes QR technology• Non-intrusive detection                                                                                                                         |

* *

*Products Based on CT Technology.    *Webegan developing our CT-based EDS technology in 1990, pioneering ourproprietary combination of x-ray and CT technology with sophisticated imageprocessing capabilities in a two-step process for the detection of explosives.CT technology uses a source of x-rays rotating around an object to createmultiple two-dimensional images, commonly known as “slices,” of the densitydistribution of the object in cross-section. CT technology compares parametersderived from the analysis of the density images to a database of explosives’density characteristics. CT is the only technology to base its detection on thedensity of the object examined. We believe that our EDS products produce higherresolution images than our competitors’ products by displaying more pixels andproviding more useful views of suspicious objects.

 

Our FAA-certified EDS product offering, the CTX Series, consists of theCTX 9000 DSi, CTX 5500 DS and CTX 2500. Our CTX Seriesis designed to provide a family of checked baggage explosives detection systemsfor airports of various sizes and design. For example, we offer variations inthroughput speeds, belt width and aperture size, installation and integrationoptions and price through the different products in the series. We believe thatall of our CTX products feature, in comparison to our competition, an abilityto detect the greatest variety and smallest amount of explosives, a lower falsealarm rate and greater operational reliability. We believe customers favor ourCTX products over competitors’ products because of our experience in installingsystems in airports, our service engineering force and the reliable performanceof our CTX systems.  The followingprovides a more detailed description of our CTX Series:

 

•                             TheCTX 9000 DSi model, certified in 1999, is designed to have significantly higherthroughput and to be more easily integrated into airports’ baggage handlingsystems than other CT-based explosives detection systems. The CTX 9000 DSisystem incorporates features that facilitate integration into airports’ baggagehandling systems. It also has a larger aperture than competing CT-basedproducts that matches the width of conveyor belts in airport baggage handlingsystems, and a compact active curtain that allows the system to provide properx-ray shielding during high throughput operation. The system has anFAA-certified throughput of 542 bags per hour.

 

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•                             TheCTX 5500 DS model was certified in 1998 as an upgraded version of our first EDSproduct, the CTX 5000 model, which was certified in 1994. The CTX 5500 DSsystem can be integrated into baggage handling systems or used as a stand-alonemachine. The system has an FAA-certified throughput of 362 bags per hour.

 

•                             TheCTX 2500 model, also certified in 1999, is a less expensive EDS operating atslower throughputs with a smaller footprint than other CT-based explosivesdetection systems. The CTX 2500 system is designed for use in small airportsand low-traffic stations within larger airports. The system has anFAA-certified throughput of 128 bags per hour.

 

In May 2000, we were selected as one of three participants in anFAA-funded research program known as ARGUS. The FAA asked participants todevelop a smaller EDS, which would be less expensive than existing products,and which could be used to scan carry-on baggage in addition to scanningchecked baggage for low throughput applications in small airports. We arenearing completion of this program and we expect to submit it for TSAcertification by the end of the second quarter of 2003.

 

We continue to incorporate improvements into our CTX Series based uponcustomer requirements, operational airport experience, a need for more advanceddetection capabilities and a number of TSA re-certifications of various models.For example, in December 2001, we introduced High Detection Enhancement,or HDE, an upgrade which improves detection sensitivity in our CTX 5500 DS unitto 25% beyond the current TSA standard for detection. We are developing HDE asan upgrade option for the other systems in our CTX Series and we expect tosubmit it for TSA certification by the end of the second quarter of 2003.

 

*Products Based on QR Technology.    *Weoffer entry point screening systems based on QR technology, developed byQuantum. QR detection is based on molecular structure, while CT detection isbased on density. QR technology has a high detection rate for specificexplosives combined with a low false alarm rate. In particular, QR technologyhas significant detection capabilities to identify components typically foundin the most difficult types of explosives to detect.

 

QR technology is a form of magnetic resonance, similar to medicalmagnetic resonance imaging. The QR detector sends out specially tuned lowfrequency radio waves into the material. The nuclei in the material align andthen as they relax to their previous state, they emit a unique radio waveresponse, which is analyzed and compared to a database of known threats.

 

Our QR systems can be used alone or to complement existing CT or x-rayscreening systems. The current system available for sale is the QScan QR 160system to screen mail, parcels and personal items at secure facilities andcarry-on baggage at airports.

 

As of December 31, 2002, we commenced in-airport testing of a prototypesystem consisting of a QScan system coupled to a CTX system, known as“QRCTX.”  This test system is plannedfor certification testing following further development.  We believe the advantages of such a systeminclude automated resolution of alarms, leading to lower operational cost andmore efficient throughput of checked baggage.

 

In addition to our QScan product, Quantum has developed a prototypeexplosives detection handheld wand based on QR, which can be utilized to detectexplosives carried by or concealed on people, including those that may behidden in shoes. We are currently developing a commercial handheld wand.

 

*Products Based on Passive Magnetic Technology.*    Ourpassive magnetic technology combines weapons detection capabilities with a lowrate of false alarms. It is capable of real time detection and tracking ofconcealed weapons. Unlike conventional weapons detection systems that useactive magnetic technology, our passive magnetic technology can measurevariations in a magnetic field without emitting additional radiation. Wedeveloped the technology with the support of the National Institute of Justice.The market for weapons detection systems includes law enforcement and facilitiessecurity, including airports, schools, courthouses, prisons, governmentbuildings, banks and corporate headquarters. In 1998, four prototypes of ourconcealed weapons detection portals were

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installed and are currently operating at a courthouse in BannockCounty, Idaho. From the commercialization of the first portal systems, nowcalled the *i*-Portal100 system, through December 31, 2002, we have shipped 29 such systems forinstallation in the United States.

 

***Landmine DetectionTechnology***

 

With funding from the Defense Advanced Research Projects Agency and theDepartment of Defense, we developed QR-based landmine detection technology,including a vehicle-mounted prototype and a cart-based prototype with atethered, handheld probe. The probe emits radio frequency magnetic field pulsesat the characteristic QR frequency of the explosive. These pulses stimulatecoherent signals from the explosives in the mine that are picked up by a tunedantenna, amplified in a sensitive receiver and analyzed digitally.

 

Most current landmines possess low metal content, forcing current metaldetection devices to be very sensitive to metal, which creates high false alarmrates and slow clearing times. QR technology does not detect explosives basedon metal content and therefore exhibits much lower false alarm rates and fasterclearing times than metal detectors. In 1999, the prototype successfullydemonstrated 100% detection of antipersonnel and antitank landmines during extensivefield trials at the Army Combat Engineering School test facility at FortLeonard Wood, Missouri. This was the first time that plastic, low metalcontent, TNT landmines had been detected with this level of performance by anysystem in actual field conditions. We believe the current QR prototype systemis able to detect the vast majority of all landmines deployed throughout theworld. We believe QR can operate in almost all soil conditions, includingsaturated soils, as well as through fresh water.  Due to current regulations, our ability to export our landminedetection technology outside of the United States is limited.

 

***Wood Products***

 

*WoodVision.**    *We are developing a log scanning system basedon CT technology to optimize the value of harvested timber. Using a CT-basedsystem to locate hidden defects and undesirable wood properties, such as twist,we can identify high quality logs for sale. We believe sawmills can gain asignificant competitive advantage by using a CT-based system to locate hidden defects,such as knots and cracks, and accordingly adjust the cutting pattern toincrease the quality and quantity of the sawn wood.

 

*Inovec*.*    *Ourcurrent Inovec products include the StereoScan 3-D log scanner optimizer, theYieldMaster headrig carriage optimizer, the LogMaster small log optimizer, theTrimMaster trimmer optimizer, the CantMaster cant optimizer and the WaneMasteredger optimizer. These systems use laser scanners to measure the dimensions oflogs or sawn wood before further sawing. Using proprietary optimizingalgorithms, the systems develop cutting solutions to maximize the volume ofusable wood, and then control the relative positions of the saw and the wood.

 

**Industry Segments**

 

We report our financial information in three segments, based onfinancial information regularly reviewed by our management in deciding how toallocate resources and assess performance. Financial information for eachsegment, including revenues, net income (loss) and total assets, is reported inNote 11 of the consolidated financial statements in this annual report.

 

*EDS.    *The “EDS” segmentdevelops, manufactures, markets and supports explosives detection systems forcivil aviation security based on advanced CT technology. Our products were thefirst automated explosives detection system to be certified by the FAA. Frominception through December 31, 2002 we have shipped 779 systems to the FAAand the TSA, to foreign aviation security agencies and to domestic and foreignairports and airlines. Our EDS product sales accounted for 91.8% of our totalrevenues in 2002, 49.1% of our total revenues in 2001 and 58.8% of our totalrevenues in 2000, and our EDS service revenues accounted for 3.1% of our totalrevenues in 2002, 12.9% of our total revenues in 2001 and 10.5% of our totalrevenues in 2000.  As a result, we aresubstantially dependent on the TSA for the majority of our EDS business.

 

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*Quantum.    *The “Quantum”segment develops for commercialization patented and proprietary technology forinspection, detection and analysis of explosives and other materials. Quantum’sproducts are based on passive magnetic sensing technology and QR technology, aform of magnetic resonance. Quantum receives grants from a variety of U.S. governmentagencies for research and development of military and humanitarian landminedetection, carry-on luggage screening, concealed weapon detection, drugdetection and in-process materials inspection. Our Quantum government contractrevenues accounted for 2.8% of our total revenues in 2002, 22.3% of our totalrevenues in 2001 and 13.4% of our total revenues in 2000.

 

*Wood.    *The “Wood”segment, including our wholly-owned subsidiary, Inovec, develops, manufactures,markets and supports technologies for scanning, optimization and controlsystems for the forest products industry. Our Wood product sales accounted for1.7% of our total revenues in 2002, 13.1% of our total revenues in 2001 and15.0% of our total revenues 2000, and our Wood service revenues accounted for0.4% of our total revenues in 2002, 2.1% of our total revenues in 2001 and 1.9%of our total revenues in 2000.

 

**Customers**

 

*EDS.    *From inceptionthrough December 31, 2002, we shipped 779 EDS units for installation.Substantially all purchases of EDS products for U.S. airports are made by theTSA. Prior to the establishment of the TSA, substantially all purchases of EDSproducts for U.S. airports were made by the FAA.  Of the total EDS units shipped, 628 were shipped to the FAA, theTSA and U.S. airlines for installation at commercial U.S. airports. Forsecurity reasons, the FAA and the TSA will not divulge the deployment scheduleor locations of these systems. To date, most orders from U. S. customers havebeen funded by the TSA, and prior to its inception, the FAA. We had EDS salesto the TSA and the FAA of $356.7 million in 2002, $20.0 million in 2001and $30.8 million in 2000.

 

During 2002, we announced orders from the TSA pursuant to a lettercontract dated February 19, 2002 and subsequent delivery orders for 625complete systems across our full product line. Orders from that agency totaled $512.9 million for the year.  Looking forward, we believe our EDS equipmentsales will be driven primarily by demand for the installation of in-line automatedEDS into the baggage handling systems of airports, which will achieve thehighest level of security, vastly improve passenger convenience and loweroperating costs.  However, the timing ofrevenues is highly dependent on the budget process and the ultimate level offunding commitment.  We continue toremain in active discussions with the TSA regarding the U.S. government’s needsfor additional systems. Additional orders for CTX equipment will depend onvarious factors, including future U.S. government funding appropriations.

 

From inception to December 31, 2002, we shipped 151 CTX Series units tocustomers in Belgium, Canada, Chile,France, Germany, Greece, Hong Kong, Israel, Italy, Japan, Malaysia, theNetherlands, the Philippines, Romania, South Africa, South Korea, Spain,Sweden, Switzerland, Taiwan, Thailand and the United Kingdom. Totalrevenues by geographic location are described in Note 11 to ourconsolidated financial statements in this annual report. Substantially all ofour long-lived assets are located in the United States.

 

We typically bill our customers in three stages, as generally providedin our contracts with our customers:

 

•                             amountsto cover the bill of materials when materials are received from suppliers,typically 30% to 40% of the total system price;

 

•                             anadditional amount upon factory acceptance or shipment, ranging from 30% to 60%;and

 

•                             thebalance upon installation and site acceptance, ranging from 5% to 30%.

 

These payment terms effectively provide the necessary working capitalfor acquisition of materials and funding inventory during the manufacturingcycle. We anticipate that potential future orders from the TSA will continue toprovide payment terms which provide the necessary working capital for us andour suppliers, even if production volumes were to rapidly increase. If futureorders from the TSA contain different payment terms, a major increase inproduction rates may require substantial additional working capital.

 

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*Quantum.    *The U.S.government is Quantum’s primary customer for contract research and developmentbusiness. From the commercialization of the first portal systems, now calledthe *i*-Portal100 system, through December 31, 2002, we have shipped 29 such systems forinstallation in the United States.  Ourprimary customers for our *i*-Portal100 system are the FAA and Milestone Technologies.

 

*Wood.    *Over 633 ofInovec’s laser scanners have been installed in over 300 sawmills worldwide asof December 31, 2002. We are developing and conducting field trials onWoodVision’s CT-based log scanning system, and accordingly we have no sales forWoodVision products.

 

**Sales and Marketing**

 

*EDS.*    We market our EDSproducts both directly through internal sales personnel and indirectly throughauthorized agents, distributors and EDS systems integrators. As of December 31,2002, we employed a total of 20 people, including two contractors, in sales andmarketing. For EDS sales through our authorized representatives and distributors,we are generally directly involved in developing proposal documents andnegotiating contract terms.

 

The selling process often involves a team comprised of individuals fromsales and marketing, engineering, customer service and support, legal and seniormanagement. The team frequently engages in a multi-level sales effort directedtoward a variety of constituents, including government regulators, the localairport operator or authority, systems and conveyor integrators, and individualairlines. We provide our sales representatives with training, promotionalliterature, a multi-media presentation, videos and competitive analysis. Thesales process includes assisting customers to design baggage handling systemconfigurations, including the use of computer modeling, educating customers onthe system and technology, and supporting the implementation and integrationprocess.

 

The combination of the high average selling prices, the time needed forvarious agencies to secure funding for systems, and the negotiation andexecution of actual contracts historically has led to a typical sales cyclelasting from six to twelve months, or more, after initial contact with acustomer. For repeat orders from existing customers, we can sometimes expeditethe sales cycle by utilizing existing contracts and contract extensions andthereby avoid lengthy procurement processes.

 

We believe that customer service and support are critical to oursuccess and we have committed significant resources to these functions. Weprovide a high level of customer support to assist in site planning through ourfield service organization, which provides installation and integration of ourproducts into facilities in addition to field service for maintaining thereliability of our products once installed. We believe that this provides uswith a significant advantage over our competitors. Our service organizationincludes customer service engineers, product application specialists andtechnical support engineers. As of December 31, 2002, we had 136 employeesand 46 consultants employed in customer service and support roles.

 

We generally provide a one-year parts and service warranty with thesale of each of our CTX systems. We offer fee-based service contracts to ourcustomers to provide system maintenance, ongoing technical support,documentation and training. We believe our recurring revenues from servicecontracts will increase as our installed base increases. In January 2003, weentered into an agreement with Siemens pursuant to which Siemens subcontractedto us its CTX service obligations to the FAA and the TSA.  The agreement is retroactive to November2002 and runs through 2007.  Commencingin January 2003, Siemens has the option to extend the agreement for a one-yearterm, with four annual options to renew. Siemens has exercised its option to extend for 2003. With respect to CTXmodels purchased by our international customers, owners of approximately 90% ofthese EDS products in service have, in the past, entered into annual servicecontracts following their first year of operation. The annual maintenance feeper unit under these contracts is typically equivalent to approximately 7% ofthe unit’s selling price.

 

We believe that operator qualification and training in the utilizationof the CTX system is important to the detection of explosives. We offeroperator training and testing with each EDS product sale, and we offerspecialized

 

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training as our customers require. We also offer a stand-alone trainingconsole that simulates a CTX system for sale to our customers to trainoperators to use a CTX system without disrupting the operation of a deployedCTX system.

 

*Quantum.*    We anticipatethat when Quantum’s products are ready for commercial distribution, we willengage our sales force currently selling our EDS products to sell the Quantumproducts as well. Currently, Quantum markets the QScan product through amarketing manager and a direct sales person, working with research anddevelopment employees to prepare and present proposals. Quantum sells the *i*-Portal100 system to customers within the transportation and aviation securitymarkets, including the FAA, and to Milestone Technologies. Sales other than tothe FAA****orother customers in the transportation and aviation security market are made toMilestone Technologies, which then sells the products to end-users.

 

*Wood.*    Inovec marketsits wood products using laser technology both directly through internal salespersonnel and indirectly through authorized agents, distributors and systemsintegrators. As of December 31, 2002, Inovec employed a total offive employees in sales and marketing. For sales through its authorizedrepresentatives and distributors, Inovec generally is directly involved in developingproposal documents and negotiating contract terms. We currently have no salesforce for our WoodVision products.

 

**Research andDevelopment**

 

We continue to make substantial investments to enhance the performance,functionality and reliability of our products. We believe that continued andtimely development of new products and enhancements to existing products isnecessary to maintain our competitive position. Accordingly we devote asignificant portion of our personnel and financial resources to engineering andresearch and development programs. As of December 31, 2002, we had 184employees engaged in research and development and product developmentactivities. We are also using the services of 17 specialized contract employeesand consultants in this area. For the year ended December 31, 2002, we spent$21.2 million on total research and development activities, of which $566,000was funded by the FAA, the TSA and other agencies under development contractsand grants.  For the year endedDecember 31, 2001, we spent $13.7 million on total research anddevelopment activities, of which $5.7 million was funded by the FAA andother agencies under development contracts and grants. For the year endedDecember 31, 2000, we spent $11.9 million on total research anddevelopment activities, of which $872,000 was funded by the FAA and otheragencies under development contracts and grants.

 

**Competition**

 

As a result of the terrorist attacks on September 11, 2001, webelieve that the market for explosives detection systems will becomeincreasingly competitive. We expect competition to increase as other companiesintroduce additional and more competitive products. Several advanced explosivesdetection technologies have been developed to attempt to address the need foreffective explosives detection for checked baggage, including CT technology andother technologies described below:

 

•                             Dualenergy x-ray systems measure the x-ray absorption properties of a bag’scontents at two different x-ray energies using one or two views to determine ifany of the contents have the physical characteristics of explosive materials.

 

•                             Multi-viewx-ray, which is like dual energy x-ray, except that it uses three or more viewsin an effort to approximate cross-sectional data. This method gathers moretwo-dimensional data than conventional single- or double-view dual energy x-raysystems.

 

•                             X-raydiffraction systems use a single energy source to take hundreds of measurementsof the angular scatter patterns of a bag’s contents to determine if any of thecontents have the chemical characteristics of explosive materials.

 

Only explosives detection systems based on CT technology have beencertified by the FAA/TSA. Competitors have attempted to obtain FAA/TSAcertification of systems based on non-CT technology in the past without

 

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success. To meet the increased demand for EDS products, the TSA maychange its certification standards and certify non-CT-based technology or otherCT-based products.

 

We believe that the primary competitive factor, especially in theUnited States, is obtaining FAA/TSA certification. Additional factors areprice, throughput rates, ease of integration into baggage handling systems andthe size of baggage that can be screened. We believe that we compare favorablywith both our CT-based and non-CT-based competitors on these factors. Ourprimary competitors in EDS are:

 

•                             *CT-BasedCompetition*. Our only competitor that has developed a CT-based EDSis L-3 Communications Holdings, Inc. which has obtained FAA certificationfor two of its products, including a product developed for the FAA ARGUSprogram. We, and L-3 and former PerkinElmer, Inc. Detection Systems Group,which was sold during 2002 to L-3 Communications Holdings, Inc., areparticipating in the ARGUS program for the development and certification of asmaller EDS.

 

•                             *Dual EnergyX-Ray and Multi-View Competition*. Competitors such as formerPerkinElmer Detection Systems Group, which was sold during 2002 to L-3Communications Holdings, Inc., and Heimann Systems GmbH, offernon-certified explosives detection systems using dual energy x-ray technology.

 

•                             *X-rayDiffraction Competition*. YXLON International Holding GmbH isdeveloping a stand-alone x-ray diffraction unit, and Heimann Systems GmbHoffers an x-ray diffraction system that can be used in combination with one ofits dual-energy x-ray units.  InFebruary 2003, we entered into a definitive agreement to acquire YXLON.  We expect to close the acquisition by theend of March 2003.

 

The primary competition for our QR technology products in the area ofchecked and carry-on baggage currently includes the large installed base ofconventional x-ray scanners and trace detection systems for commercialaviation. In addition, other companies are developing QR technology in thesemarkets, including QR Sciences Limited (formerly Thorlock International Ltd.).We believe that government requirements to screen carry-on baggage forexplosives are needed to increase demand for our QR technology products. Ifdemand increases, we believe that the competitive factors in these markets willbe government certification, if any, performance, price and ease of use.

 

Our *i*-Portalproduct, which is based on passive magnetic technology, competes with productsthat use active magnetic technology. Products based on active magnetictechnology are the current standard for weapons detection. We believe theprimary competitive factors in this area are price, performance and ease ofuse. We believe we compare favorably with the manufacturers of active magnetictechnology products on performance and ease of use, but our *i*-Portalproduct is generally more expensive.

 

Inovec competes with a number of manufacturers of laser-based scanningsystems. We believe that the competitive factors in this market include ease ofintegration with existing sawmill equipment, reliability, service andadaptation for particular sawmill needs. We believe that we compare favorablywith our competitors on these factors.

 

**Manufacturing**

 

Our manufacturing operations consist primarily of materials management,assembly, test and quality control of complete systems and final systemtesting. Using our designs and specifications, subcontractors assemble somemechanical and electrical sub-components, and in times of peak production, weengage subcontractors to assemble entire CTX systems. We perform all finalassembly and testing of products prior to shipment. Because quality andreliability over the life of our products are vital to customer satisfactionand repeat purchases, we believe our quality assurance program is a keycomponent of our business strategy.

 

We believe that our existing manufacturing facilities will enable us toscale to meet increased production volumes in an efficient manner. We believethat utilization of contract manufacturers will provide the capability toproduce additional EDS units as necessary. We have entered into anagreement with CoorsTek under which

 

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CoorsTekperforms contract manufacturing and assembly services relating to ourCTX 2500 and CTX 5500 DS systems.

 

**Suppliers**

 

*EDS.*    We outsourcecertain materials management processes, and certain manufacturing processes,including mechanical sub-assemblies, sheet metal fabrication, cables andassembled printed circuit boards. We generally purchase major contractedassemblies from single source suppliers. We review our single sourceprocurements on a case by case basis, where feasible, and have qualified secondsources for certain contracted assemblies. We have entered into anagreement with CoorsTek under which CoorsTek performs supply chain managementservices. We have experienced delays in obtaining a few of our singlesource assemblies. We cannot assure you that we will not face further shortagesof one or more of these systems in the future.

 

*Quantum.*    Quantumobtains components for its QScan and landmine detection products from companiesthat specialize in small production requirements. For the *i*-Portal product, Quantum isin the process of establishing relationships with component suppliers that cansupply parts on a commercial scale.

 

*Wood.*    Inovec has along-established supply chain for its products using laser technology, withmultiple sources for some components.

 

**Intellectual Propertyand Proprietary Rights**

 

We seek to protect our intellectual property through various methodssuch as patents and patent applications, trademarks, copyrights, non-disclosureagreements and trade secrets. We cannot assure you that the steps taken by usto protect our proprietary technology will be adequate or that our competitorswill not be able to develop similar, functionally equivalent or superiortechnology.

 

*EDS.*    We have reliedprimarily on copyrights and trade secrets for the protection of our EDStechnology. We have two U. S. patents for automatic concealed object detectionsystems using a pre-scan stage as used in the CTX Series. These patents expirein 2010 and 2011. The patents have not prevented competition from developingCT-based products which do not use a pre-scan stage. The time period for filingforeign counterparts of our two U.S. EDS patents has expired, and we did notseek or obtain patent protection. The absence of foreign counterparts to ourpatents could adversely affect our ability to prevent a competitor from usingtechnology similar to technology used in our CTX Series. We also have a U.S.patent for a mechanical radiation shield for our CTX 9000 DSi model, whichexpires in 2021.  We rely on this technologyto increase the speed of the baggage inspection process.  We have filed other applications in theUnited States and Europe for patents covering other features contained in ourCTX 9000 DSi model.

 

In connection with our formation, in 1990, we entered into a licensingagreement with Imatron, Inc. Under the agreement, as amended and currently ineffect, we have an exclusive, worldwide and fully-paid license to use Imatron’sCT technology in products for the scanning of mail, freight, parcels, baggage andwood, and in compact medical scanners for military field applications. Inexchange, we granted to Imatron under this agreement an exclusive, worldwideand fully-paid license to use, in products for the medical industry, any CTscanning technology that we develop during the term of the agreement. Thelicense agreement expires in 2009. We believe that by the time the licenseexpires in 2009, we will not be using any of the original Imatron technology inour products.

 

*Quantum.*    In the UnitedStates, we rely on licenses, patents, copyrights and trade secrets held by usfor the protection of the proprietary elements of our Quantum products. We havea co-exclusive license to technology covered by three QR patents from the NavalResearch Laboratory to commercialize the QR technology, including landminedetection. The license becomes non-exclusive in 2005 and expires in 2010 and2011.  We rely on this technology forall of our QR-based products. We have also been granted a non-exclusive licenseby International Business Machines Corporation for patented and non-patentedproprietary software and know-how related to

 

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electromagnetic sensing and detection. The license expires in2009.  We have not sold products thatincorporate this licensed software and know-how.

 

*Wood.*    We have a patent application pending coveringa number of new features related to the design and use of our CT-based logscanner. We have a patent, issued in the United States and Canada, for technologyused in Inovec log cutting optimization systems.  The technology uses statistical analysis to compensate for errorsand tolerances in the scanning and log cutting process.  The patent expires in 2011.

 

*Government rights to use our technology.*    Inaccordance with the terms of our development contracts with the FAA, the U.S.government has rights to the use of our proprietary technology developed afterthe award of the contracts and funded by the contracts. The U.S. government mayuse these rights to produce or have produced competing products for it usingsuch technology. In addition, we have granted the TSA a two-yearroyalty-bearing license, commencing in March 2002, to enable othermanufacturers to build EDS products based on our technology for the TSA.

 

**Backlog**

 

We measure our backlog of product revenues as orders for systems andupgrades for which contracts or purchase orders have been signed, but whichhave not yet been shipped. We measure our backlog of service revenues as ordersfor maintenance related to product support for which contracts have beensigned, but maintenance service has not yet been performed. We typically shipour products within three to twelve months after receiving an order. However,such shipments may be affected by delays which occur in the delivery ofcomponents to us or our readiness to accept delivery of components for reasonsof site preparation or otherwise. In some instances, shipments may be made morequickly depending on our ability to build machines to order and our customers’demand for immediate delivery.

 

As of December 31, 2002, our EDS product and service revenuebacklog was approximately $246.6 million, compared to $56.0 millionas of December 31, 2001. As of December 31, 2002, our Inovec productand service revenues backlog was approximately $714,000, compared to $1.2million as of December 31, 2001. We had no WoodVision backlog as ofDecember 31, 2002 and December 31, 2001.

 

We measure our backlog of Quantum government contracts as awards fromgovernment agencies which have been funded, but for which services have not yetbeen performed. As of December 31, 2002, our Quantum government contractsbacklog was approximately $12.4 million, compared to approximately$12.9 million as of December 31, 2001.  Of the $12.4 million of backlog, only $4.3 million is funded.

 

Any failure by us to meet an agreed upon schedule could lead to thecancellation of the related order. Variations in the size, complexity anddelivery requirements of the customer order may result in substantialfluctuations in backlog from period to period. In addition, all orders aresubject to cancellation or delay by the customer and, accordingly, we cannotassure investors that our backlog will eventually result in revenues. For thesereasons, we believe that backlog cannot be considered a meaningful indicator ofour performance on an annual or quarterly basis.

 

**Employees**

 

As of December 31, 2002, we directly employed 609 people, of whom184 were primarily engaged in research and development activities, 35 inmarketing and sales, 139 in customer support and field service, 146 inmanufacturing, 26 in quality assurance and 79 in administration and finance. Inaddition, we utilized the services of 97 full-time consultants and temporaryemployees. The number of our manufacturing personnel was significantly expandedin 2002, in response to increased demand for our CTX products. We believe thatour relationship with our employees is good.

 

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**Available Information**

 

Wefile electronically with the Securities and Exchange Commission our annualreports on From 10-K, quarterly reports on Form 10-Q, current reports on From8-K, and amendments to those reports pursuant to Section 13(a) or 15(d) ofthe Securities Exchange Act of 1934.  Wemake available on our website at http://www.invision-tech.com, free of charge,copies of these reports as soon as reasonably practicable after filing orfurnishing the information to the SEC. You can also request copies of such documents by contacting our InvestorRelations Department at (510) 739-2200 or sending an email toinvestor_relations@invision.iip.com.

 

**Risk Factors**

 

*Many factors, including those described below, could cause actualresults to differ materially from those discussed in any forward-lookingstatements.*

 

**RisksRelated to Our Business**

 

**A number of factorsthat affect our revenues make our future results difficult to predict, andtherefore we may not meet expectations for a particular period.**

 

We believe that our revenues have the potential to vary significantlyfrom time to time. We believe that these variations may result from manyfactors, including:

 

•                             thetiming, size and mix of orders from our major customers, including mostprominently, the TSA, and agencies of other governments;

 

•                             delaysin product shipments caused by the inability of airports to install orintegrate our products in a timely fashion;

 

•                             ourability to expand manufacturing capacity sufficiently to meet any increaseddemand for our products;

 

•                             theavailability and cost of key components;

 

•                             theacceptance and timing of enhancements to our existing products;

 

•                             theintroduction and acceptance of new products offered by us or our competitors;

 

•                             changesin pricing policies by us, our competitors or our suppliers, including possibledecreases in average selling prices of our products caused by customer volumeorders or in response to competitive pressures;

 

•                             legislativeor other government actions leading to fluctuations in demand for aviation securityproducts and services; and

 

•                             oursales mix to domestic and international customers.

 

A significant portion of our quarterly and annual operating expensesare, and will continue to be, relatively fixed in nature. This means thatrevenue fluctuations will cause our quarterly and annual operating results tovary substantially. We also may choose to increase spending to pursue newmarket opportunities, which may negatively affect our financial results.

 

Accordingly, we believe that period-to-period comparisons of ourresults of operations cannot be relied upon as indicators of futureperformance. Because of all of the foregoing factors, our operating resultshave from time to time in the past been, and may again in the future be,different from expectations of public market analysts and

 

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investors. Failure to meet market expectations has in the pastresulted, and may again in the future result, in fluctuations in the tradingprice of our common stock.

 

**We depend upon alimited number of suppliers for components of our EDS products, and if we areunable to obtain parts from these suppliers on a timely basis, then we may notbe able to deliver our EDS products as required.**

 

Key components used in our products, including the power supply,gantry, x-ray tubes and x-ray detectors, have been designed by us to ourspecifications and are currently available only from one or a limited number ofsuppliers. We currently do not have long-term agreements with these suppliers.In addition, some of the suppliers of the key components used in our productsare our competitors, and they may be motivated not to supply us with thecomponents we need.  Our inability todevelop alternative sources for single or sole source components, to findalternative third party manufacturers or sub-assemblers, or to obtainsufficient quantities of these components, could result in delays orinterruptions in product shipments, which could cause current or potentialcustomers to seek other suppliers of EDS products. In view of the high cost ofmany of these components, we strive to avoid excess supplies. Our demands forlarge volumes of these key components may strain the abilities of our suppliersto provide these key components on a timely or expedited basis. In addition, wemay compete with other EDS manufacturers to obtain parts for our EDS products.If our suppliers experience financial, operational, production or qualityassurance difficulties, or our sole source suppliers are acquired or otherwiseinfluenced by our competitors, the supply of components to us would be reducedor interrupted. In the event that a supplier ceases operations, discontinues aproduct or withholds or interrupts supply for any reason, we may be unable toacquire the product from alternative sources within a reasonable period oftime.

 

Rapid increases in production levels could also result in higher costsfor components and other increased manufacturing expenses. These higher costscould reduce our profitability. Furthermore, if production is increasedinefficiently, manufacturing yields could decline, which may also lower ourprofitability.

 

**Governmentalagencies, the primary customers for our EDS and other products, are subject tobudget processes which could limit the demand for these products.**

 

Substantially all of the customers for our EDS products and our otherproducts under development to date have been public agencies or quasi-publicagencies, such as the FAA, the TSA and airport authorities. Public agencies aresubject to budgetary processes and expenditure constraints. In the past, manydomestic and foreign government agencies have experienced budget deficits thathave led to decreased capital expenditures in certain areas.

 

The funding of government programs is subject to legislativeappropriation. Budgetary allocations for explosives detection systems depend,in part, upon governmental policies, which fluctuate from time to time inresponse to political and other factors, including the public’s perception ofthe threat of commercial airline bombings. For example, the terrorist attacksof September 11, 2001 resulted in the passage of the TransportationSecurity Act, mandating a small surcharge on each airline ticket purchase tofund airline security. We cannot assure investors that these funds will be usedto purchase our EDS products. In February 2003, an Omnibus Spending Billcontaining funding for the TSA, including $174.5 million earmarked for securityequipment, was signed into law. As of March 27, 2003, we have received noorders for our EDS products from the TSA as a result of this funding. We cannotassure investors that funds will continue to be appropriated by Congress orallocated by the TSA or other agencies for the purchase of EDS products.

 

**Governmental agencieshave special contracting requirements, which create additional risks.**

 

In contracting with public agencies, we are subject to public agencycontract requirements that vary from jurisdiction to jurisdiction. Future salesto public agencies will depend, in part, on our ability to meet public agencycontract requirements, certain of which may be onerous or even impossible forus to satisfy.

 

Government contracts typically contain termination provisionsunfavorable to us and are subject to audit and modification by the governmentat its sole discretion, which subject us to additional risks. These risksinclude the ability of the U.S. government to unilaterally:

 

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•                             suspendor prevent us for a set period of time from receiving new contracts orextending existing contracts based on violations or suspected violations oflaws or regulations;

 

•                             terminateour existing contracts;

 

•                             reducethe scope and value of our existing contracts;

 

•                             auditand object to our contract-related costs and fees, including allocated indirectcosts;

 

•                             controland potentially prohibit the export of our products; and

 

•                             changecertain terms and conditions in our contracts.

 

The U.S. government can terminate any of its contracts with us eitherfor its convenience or if we default by failing to perform in accordance withthe contract schedule and terms. Termination for convenience provisionsgenerally enable us to recover only our costs incurred or committed, andsettlement expenses and profit on the work completed prior to termination.Termination for default provisions do not permit these recoveries and make usliable for excess costs incurred by the U.S. government in procuringundelivered items from another source. Our contracts with foreign governmentsmay contain similar provisions. Consequently, our backlog is not necessarilyindicative of future revenues. The government’s termination of one or more ofthe contracts for our EDS products or our other products under developmentwould harm our business.

 

In addition, U.S. government contracts are conditioned upon thecontinuing availability of Congressional appropriations. Congress usuallyappropriates funds for a given program on a September 30 fiscal year-endbasis, even though contract performance may take years. Consequently, ourcontracts with the TSA may only be partially funded at the outset, andadditional monies are normally committed to the contract by the TSA only asappropriations are made by Congress for future periods. The government’sfailure to fully fund one or more of the contracts for our EDS products or ourother products under development would harm our business.

 

As a government contractor, we are subject to periodic audits andreviews. Based on the results of its audits, the U.S. government may adjust ourcontract-related costs and fees, including allocated indirect costs. Althoughadjustments arising from government audits and reviews have not seriouslyharmed our business, future audits and reviews could cause adverse effects. Inaddition, under U.S. government purchasing regulations, some of our costs,including most financing costs, amortization of intangible assets, portions ofour research and development costs, and some marketing expenses may not be reimbursableor allowed in our negotiation of fixed-price contracts. Further, as a U.S.government contractor, we are subject to an increased risk of investigations,criminal prosecution, civil fraud, whistleblower lawsuits and other legalactions and liabilities to which purely private sector companies are not.

 

In addition, public agency contracts are frequently awarded only afterformal competitive bidding processes, which are often protracted and typicallycontain provisions that permit cancellation in the event that funds areunavailable to the public agency. We may not be awarded any of the contractsfor which our products are bid. Even if we are awarded contracts, substantialdelays or cancellations of purchases could result from protests initiated bylosing bidders.

 

**Legislative actionscould lead to fluctuations in demand for aviation security products andservices.**

 

In addition to the Congressional budgetary process, other legislationcould be introduced that would impact demand for aviation security products andservices. In response to public pressure, fluctuation in concern on the part ofvoters about aviation security, or for other reasons, the plans for deploymentof EDS to screen baggage could be changed. The budgetary debates and delayscould result in fewer EDS being sold to the TSA and elected officials whosupport the EDS program could fail to maintain their offices, any of whichevents could cause a decrease in the demand for our EDS products.

 

**Our major customer, the TSA, is a newly created agency thathas experienced, and may continue to experience, delays in its operations,which may cause delays in our receiving orders from the TSA. **

** **

                The TSA is a relatively newagency that was created in November 2001 by the Transportation Security Act.  As a result, it has experienced, and maycontinue to experience, delays in fulfilling its mandate as a result of delaysin establishing the necessary infrastructure to operate in an efficient manner.  For example, Congress is still in theprocess of organizing subcommittees for the TSA.  This may result in delays in our receiving orders for our EDSproducts.  Further, the TSA is now apart of the Department of Homeland Security, which was created subsequent tothe creation of the TSA and is therefore in an earlier stage of formation,which may further create delays in our receiving orders as this agency isorganized.

 

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**Future sales of ourEDS products will depend on the ability of airports to secure funding to buildbaggage handling systems and to integrate our EDS units into such systems,which they may not be able to do.**

 

Future sales will depend, in part, on installing our EDS products intoairport lobbies or integrating them into existing baggage handling systems. Ifan airport is not configured for these systems, deployment of our EDS productsmay require changes in the airport infrastructure, such as reinforced airportlobby floors and baggage platforms. If our EDS products cannot easily be installedin airport lobbies or integrated into existing baggage handling systems, we mayexperience reduced sales of our EDS products or these sales may be delayed. Inaddition, installations and integrations are currently partially funded by theTSA in the United States. Recent legislation established a “letter of intent”program under which an airport can present a request to the TSA forreimbursement of costs incurred by the airport in improving baggage handlingsystems to increase security. There can be no assurance that the governmentwill continue to fund installations, integrations and reimbursements at thecurrent level or at all. If there is a reduction in funding, we may experiencereduced sales of our EDS products or these sales may be delayed.

 

We believe that a substantial opportunity exists for our CTX 9000 DSimodel to be integrated into baggage handling systems. If airports determine, inconjunction with governmental authorities, that they will be unable orunwilling to modify or finance such in-line baggage handling systems, thisopportunity may be limited.

 

**As a result of theTransportation Security Act, our EDS products are undergoing substantiallyincreased usage per day, which could cause unforeseen problems with theirability to sustain this increased usage.**

 

As required by the Transportation Security Act, as of December 31,2002, 100% of checked baggage must undergo EDS screening. As a result, our EDSproducts in operation are being used more hours per day than before, whichplaces a burden on them not previously experienced. This has resulted in anincrease in the amount of maintenance required to keep them operating, and mayresult in unforeseen problems. If this were to occur, our customers couldperceive that there are reliability problems with our CTX products, which couldreduce the demand for our products. In addition, our CTX 9000 DSi productis a relatively new model with which we have limited experience in sustainingextensive usage. As a result, our CTX 9000 DSi product may experience maintenanceneeds and increased down time beyond that experienced by our CTX 2500 andCTX 5500 DS products. Further, because the CTX 9000 DSi is designed to beintegrated into an airport’s baggage handling system, it has, in addition tothe detection function and mechanisms, components that integrate it into thebaggage handling system, which also require maintenance and may also contributeto increased maintenance needs and down time. If our CTX 9000 DSi product doesexperience additional maintenance needs beyond that of our CTX 2500 andCTX 5500 DS products, our customers may not purchase this product in favor ofour CTX 2500 and CTX 5500 DS products or the products of our competitors.

 

**If we do not manageeffectively the expansion of our operations, our business may be harmed.**

 

Our workforce has more than doubled since September 11, 2001. Wehave managed the growth, despite stress created by rapid growth on ourmanagement control system and resources, including decision support, accountingmanagement, working capital, information systems and facilities. If we do notcontinue to manage and improve our financial and management controls, reportingsystems and procedures to manage our employees effectively, our business couldbe harmed.

 

**We may not be able togrow our service organization quickly enough to support our EDS units deployedin the field.**

 

We are responsible for supporting the installation of, and providingwarranty service for, our EDS units. With the rapid increase in the number ofunits being shipped, we are expanding our service organization’s capability.EDS units are relatively complex machines, which employ high-speed conveyorsand sophisticated imaging technology. If we are unable to hire and trainsufficient service personnel supported by an expanded logistical system, thereliability of our machines could suffer. If this were to occur, there could bea decrease in demand for our products.

 

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**We may seek to growby acquisition, which subjects us to substantial risks, including the failureto successfully integrate an acquired business.**

 

As part of our growth strategy, we may expand our business by pursuingselected acquisitions of technologies and companies that offer complementaryproducts, services, technologies or market access. Our ability to grow byacquisition depends upon the availability of acquisition candidates atreasonable prices and our ability to obtain acquisition financing on acceptableterms. We may incur costs in connection with our pursuit of acquisitions forwhich we are responsible regardless of whether the acquisitions are actuallyconsummated. Future acquisitions by us could result in potentially dilutiveissuances of equity securities, the incurrence of debt and contingent liabilitiesand amortization expenses related to intangible assets, any of which could harmour business. Acquisitions entail numerous risks, including:

 

•                             difficultiesin the assimilation of acquired operations, technologies and products;

 

•                             diversionof management’s attention from other business concerns;

 

•                             lackofexperience operating in the geographic market or industry sector of acquiredcompanies;

 

•                             exposuretounanticipated contingent liabilities of acquired companies; and

 

•                             potentiallossof key employees of acquired companies.

 

The process of integrating supply and distribution channels, computerand accounting systems and other aspects of operations, while managing a largerentity, would present a significant challenge to our management. We may not beable to successfully integrate any businesses, products, technologies orpersonnel that might be acquired in the future. In such case, we would notfully realize the anticipated benefits of a business combination, and thefailure of such efforts would harm our business.

 

In February 2003, we entered into a definitive agreement to acquireYXLON International Holding GmbH.  YXLONis active in businesses that are new to us, and represents a challenge to ourmanagement.  We expect the acquisitionto close at the end of March 2003. Failure to manage integration of YXLON’s businesses could harm ourbusiness results, and could result in additional expenses and loss of revenueopportunities for YXLON and us.

 

**If our EDS productsfail to detect explosives, we could be exposed to product liability and relatedclaims for which we may not have adequate insurance coverage, and we may losecurrent and potential customers.**

 

Our business exposes us to potential product liability risks, which areinherent in the manufacturing, sale and maintenance of EDS products. Ourmachines are not designed to detect, and FAA/TSA certification does not require100% detection of, any and all explosives contained in scanned baggage. Forthis reason, or if our products malfunction, it is possible that explosivematerial could pass undetected through our products, which would lead toproduct liability claims. There are also many other factors beyond our controlthat could lead to liability claims, such as the reliability and competence ofthe customer’s operators and the training of the operators.

 

If a product liability claim is brought against us, the cost ofdefending the claim would be significant and any adverse determination mayresult in liabilities in excess of our insurance coverage. We currently haveproduct liability and war and terrorism insurance in the amount of$200 million.  However, sinceSeptember 11, 2001, insurance rates have increased dramatically, and wecannot be certain that our current insurance can be maintained, or additionalinsurance coverage could be obtained, on acceptable terms, if at all.

 

In addition, the failure of any EDS product to detect explosives, evenif due to operator error and not to the mechanical failure of an EDS product,could result in public and customer perception that our products do not workeffectively, which may cause potential customers to not place orders andcurrent customers to cancel orders already placed or to not place additionalorders, any of which would harm our business and financial results.

 

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**We substantiallydepend on large orders from a limited number of customers. As a result, ordercancellations from any of our customers or the failure of these customers tocontinue to purchase EDS products could have a material negative impact on ourbusiness and financial results.**

 

In any given fiscal quarter or year, our revenues are derived fromorders of multiple units of our EDS products from a limited number ofcustomers. Through December 31, 2002, substantially all of our orders from U.S.customers have been funded by the FAA and the TSA, which allocate our productsto airports in the U.S. EDS sales to the FAA, and following the formation ofthe TSA, to the TSA, accounted for 85.4% of our revenues in the year endedDecember 31, 2002 and 26.9% of our revenues in the year ended December 31,2001. In the year ended December 31, 2002, ten customers accounted for all ofour EDS units sold during the year, and for the fiscal year 2001, sevencustomers accounted for all of our EDS units sold during the year. The failureof these customers, particularly the U.S. government, to continue to purchaseour EDS products or the cancellation of existing orders would harm ourbusiness.

 

**We have granted aroyalty-bearing license to the U.S. government to have our products produced byother manufacturers and if other manufacturers produce our products, we maylose expected revenue opportunities.**

 

In connection with orders for EDS units, the TSA required that we grantthe TSA a two-year royalty-bearing license, commencing in March 2002, toenable other manufacturers to build for the TSA EDS products based on ourtechnology used in these products. With this license, the TSA may purchase EDSproducts from other manufacturers rather than us, even if we have themanufacturing capacity to build those EDS products. If this happens, theroyalty we receive under the license may not fully compensate us for the lostbusiness opportunity. Further, since licensed manufacturers will be buildingsubstantially the same products as we build, if we fail to timely deliver EDSproducts which the TSA has ordered from us, the TSA may not give us theopportunity to cure the failure to deliver, and it may transfer the order from usto a licensed manufacturer. The TSA has not exercised this license to date.

 

**The U.S. government’sright to use technology developed by us, but funded by the U.S. government,limits our intellectual property rights.**

 

In accordance with Federal Acquisition Regulations included in ourdevelopment contracts with the FAA, the U.S. government has rights to use ourproprietary technologies developed after the award of the development contractand funded by the development contract. The U.S. government may use theserights to produce or have produced for the U.S. government competing productsusing CT technology found in our existing CTX products as well as the futureARGUS model. With respect to Quantum, the U.S. government retains the samerights to the passive magnetic technology found in the *i*-Portal and the QRtechnology found in the QScan product. In the event that the U.S. governmentwere to exercise these rights, our competitive position in supplying the U.S.government with certified CT-based explosives detection systems and/or theQuantum products would be harmed.

 

**The sales cycle forour EDS products is lengthy, and we may expend a significant amount of effortin obtaining sales orders and not receive them.**

 

The sales cycle of our EDS products is often lengthy due to theprotracted approval process that typically accompanies large capitalexpenditures and the time required to manufacture and install our EDS products.Typically, six to twelve months may elapse between a new customer’s initialevaluation of our systems and the execution of a contract. Another three monthsto a year may elapse prior to shipment of our EDS products as the customer siteis prepared and our EDS products are manufactured. In addition, in the U.S.,the creation of the TSA and debate on formation of a Department of HomelandSecurity, as well as budgetary debates in Congress, may result in additionaldelays in the purchase of additional EDS products. During the sales cycle weexpend substantial funds and management resources but recognize no associatedrevenue.

 

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**Our internationalsales subject us to risks that could materially harm our business.**

 

Sales to countries other than the U.S. accounted for 11.7% of ourrevenues in the year ended December 31, 2002 and 32.5% of our revenues for theyear ended December 31, 2001. A number of factors related to ourinternational sales and operations could adversely affect our business,including:

 

•                             changesin U.S. and foreign regulatory requirements;

 

•                             politicalinstability in the countries where we sell products;

 

•                             possibleforeign currency controls;

 

•                             fluctuationsin currency exchange rates;

 

•                             ourability to protect and utilize our intellectual property in foreignjurisdictions;

 

•                             tariffs,embargoes or other barriers;

 

•                             difficultiesin staffing and managing foreign operations;

 

•                             difficultiesin obtaining and managing distributors; and

 

•                             potentiallynegative tax consequences.

 

The sale of some of our products outside the U.S. is subject tocompliance with the U.S. International Traffic in Arms Regulations and ExportAdministration Regulations. Our failure to obtain the requisite licenses, meetregistration standards or comply with other government export regulations, mayaffect our ability to generate revenues from the sale of our products outsidethe U.S., which could harm our business. In particular, our EDS products andour landmine detection equipment are deemed regulated military devices subjectto export restrictions under the U.S. Department of State regulations.Consequently, these regulations may make these products more difficult to sellto a number of countries. Compliance with government regulations may alsosubject us to additional fees and costs. The absence of comparable restrictionson competitors in other countries may adversely affect our competitiveposition.

 

**Because of theincreased demand for our EDS products by the U.S. government, we may lose othercustomers, which could harm our business.**

 

The TSA has been authorized by the U.S. Department of Commerce to placea priority rating on EDS contracts, which would obligate us to timely fulfillthe TSA’s orders and delay any unrated or lower-rated orders. In addition, aspart of any future orders, the TSA may request that we agree to timely fill itsorders prior to fulfilling the needs of any other customers. Accordingly, wemay not be able to fulfill orders for our EDS products from non-U.S. governmentcustomers during this period of increased demand from the U.S. government. Thiscould cause our current and potential non-U.S. government customers to seek EDSproducts from other sources, and could trigger financial penalties under theagreements with such customers. We also may lose our goodwill and relationshipswith these customers, which could harm our ability to make sales in the future.

 

**We may not beselected to provide post-warranty service on our CTX systems.**

 

Once a warranty period on a CTX system has expired, we offer to ourcustomers the opportunity to buy a service contract from us, includingscheduled maintenance, repairs and parts. In January 2003, we entered into anagreement with Siemens pursuant to which Siemens subcontracted to us its CTXservice obligations to the FAA and the TSA. The agreement is retroactive to November 2002 and runs through2007.  Commencing in January 2003,Siemens has the option to extend the agreement for a one-year term, with fourannual options to renew.  Siemens hasexercised its option to extend for 2003. We cannot assure investors thatSiemens will

 

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renew the agreement in subsequent years. In addition, historically, wehave sold service contracts on approximately 90**%** of eligible CTX systems deployed internationally, with arenewal rate near 100%. We may not achieve this rate of service contract salesin the future.

 

**Our future EDSproducts may fail to obtain certification by the TSA.**

 

We plan to continue to develop new models for our family of EDSproducts, including through our current participation in the ARGUS program, anFAA/TSA-sponsored program designed to develop a smaller, low-cost EDS product.However, we cannot be certain that any new product, including the ARGUS system,if completed, will be certified by the TSA. The failure to gain certificationfor a product would harm our ability to sell the product, and recognizeassociated revenues.

 

**Our existing productsmay fail to obtain re-certification by the TSA for changes in the EDS systems.**

 

Our existing EDS products can be required to be re-certified by theTSA. This can happen when a critical component is changed, or we wish to makeother changes to the EDS systems. When this happens, the affected EDS modelrequires re-certification by the TSA. The failure or delay in gaining re-certificationfor an existing EDS product could harm our ability to continue to sell theproduct and recognize associated revenues.

 

**Our inability toadapt to rapid technological change could impair our ability to remaincompetitive.**

 

The EDS industry may undergo significant technological development inresponse to increased demand for aviation security products. A fundamentalshift in technology in our product markets could harm us, because we derivesubstantially all of our revenues from sales of EDS products.

 

We anticipate that we will incur significant expenses in the design andinitial manufacturing and marketing of new products and services. Ourcompetitors may implement new technologies before we are able to, allowing themto provide more effective products at more competitive prices. Futuretechnological developments could:

 

•                             adverselyimpact our competitive position;

 

•                             requirewrite-downsof obsolete technology;

 

•                             requireus to discontinue production of obsolete products before we can recover any orall of our related research, development and commercialization expenses; or

 

•                             requiresignificant capital expenditures beyond those currently contemplated.

 

We cannot assure investors that we will be able to achieve thetechnological advances to remain competitive and profitable, that new productsand services will be developed and manufactured on schedule or on acost-effective basis, that anticipated markets will exist or develop for newproducts or services, or that our existing products and services will notbecome technologically obsolete.

 

**The EDS industry ishighly competitive. Given the anticipated continuing demand for airportsecurity products, competition may increase.**

 

The EDS industry is intensely competitive and we may not compete successfullywith our competitors. As a result of increased demand for security systems,additional companies may enter the EDS industry. Some of our competitors,including L-3 Communications Holdings, Inc. and many of the potential newentrants into the EDS industry, have financial, technical, production and otherresources substantially greater than ours. Our failure to compete successfullycould result in lost sales and could hamper our financial results.

 

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**We depend on keymanagement and personnel and may not be able to retain those employees orrecruit additional qualified personnel.**

 

We believe that our future success will be due, in part, to thecontinued services of our senior management team. We do not have long-termemployment agreements with any of our executive officers. Losing the servicesof one or more members of our management team could negatively affect ourbusiness and our expansion efforts. We do not maintain key person lifeinsurance policies for members of our management. We could be seriously harmedby the loss of any of our executive officers. In addition, in order to manageour growth, we will need to recruit and retain additional skilled personnel,such as advanced engineering professionals. Our failure to recruit qualifiedemployees in a timely manner and retain them could harm our business and ourability to continue to grow.

 

**Natural disasters,including earthquakes, may damage our facilities.**

 

Our corporate and manufacturing facilities in California are locatednear major earthquake faults, which have experienced earthquakes in the past.In the event of a major earthquake or other natural disaster, our facilitiesmay sustain significant damage and our operations could be harmed.

 

**Our business could beharmed if we fail to properly protect our intellectual property.**

 

Our success depends in part on our ability to protect our intellectualproperty. Although we attempt to protect our intellectual property in the U.S.and other countries, there can be no assurance that we will successfullyprotect our technology or that competitors will not be able to develop similartechnology independently. We cannot assure investors that the claims allowedunder any patents held by us will be sufficiently broad to protect ourtechnology against competition from third parties with similar technologies orproducts. In addition, we cannot assure investors that any patents issued to uswill not be challenged, invalidated or circumvented or that the rights grantedunder these patents will provide a competitive advantage to us. Moreover, thelaws of some foreign countries do not protect intellectual property rights tothe same extent as the laws of the U.S., and we could experience variousobstacles and high costs in protecting our intellectual property rights inforeign countries. If we are unable to obtain or maintain these protections, wemay not be able to prevent third parties from using our intellectual property.

 

We also rely on trade secrets, proprietary know-how and continuingtechnological innovation to remain competitive. We have taken measures toprotect our trade secrets and know-how, including the use of confidentialityagreements with our employees. It is possible that these agreements may bebreached and that the available remedies for any breach will not be sufficientto compensate us for damages incurred.

 

**Litigation may benecessary to enforce or defend against claims of intellectual propertyinfringement, which could be expensive and, if we lose, could prevent us fromselling our products.**

 

Litigation may be necessary in the future to enforce our patents andother intellectual property rights, to protect our trade secrets or todetermine the validity and scope of the proprietary rights of others. Anylitigation, regardless of the outcome, could be costly and require significanttime and attention of key members of our management and technical personnel.

 

Our domestic and international competitors, many of whom havesubstantially greater resources and have made substantial investments incompeting technologies, may have patents that will prevent, limit or interferewith our ability to manufacture and sell our products. We have not conducted anindependent review of patents issued to third parties. Because of the perceivedmarket opportunity we face, companies possessing technology rights that theybelieve we might be infringing will now be much more motivated to assertinfringement of their rights. These third parties may assert infringement orinvalidity claims against us and litigation may be necessary to defend againstthese claims. An adverse outcome in the defense of a patent suit could subjectus to significant liabilities to third parties, require disputed rights to belicensed from third parties or require us to cease selling our products. Evensuccessful defenses of patent suits can be costly and time-consuming.

 

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**We have receivedsignificant amounts of funding from government grants and contracts. We cannotassure investors that we will continue to receive this level of funding forfuture product development.**

 

The U.S. government currently plays an important role in funding thedevelopment of EDS technology and sponsoring its deployment in U.S. airports.For the year ended December 31, 2002, we performed reimbursable research anddevelopment for EDS products totaling $886,000 from FAA and TSA grants andcontracts, and for the year ended December 31, 2001, we performedreimbursable research and development for EDS products totaling$8.3 million from FAA grants and contracts. We are also aware that othercompetitors in the EDS market have received FAA and TSA development grants. TheU.S. government also currently funds almost all of the development of Quantumproducts, including QR and passive magnetic sensing. For the year endedDecember 31, 2002, we had contract revenues of $12.1 million from the U.S.government for the development of Quantum products, and for the year endedDecember 31, 2001, we had contract revenues of $16.6 million from theU.S. government for development of Quantum products. We cannot assure investorsthat additional research and development funds from the government will becomeavailable in the future or that we will receive any of these additional funds.If the government fails to continue to sponsor our technology, we would have toexpend more resources on product development, which could adversely affect ourbusiness. In addition, any future grants to our competitors may improve theirability to develop and market advanced detection products and cause ourcustomers to delay any purchase decisions, which could harm our ability tomarket our products.

 

**RisksRelated to Ownership of Our Common Stock**

 

**The price of ourcommon stock may fluctuate significantly.**

 

A number of factors could cause the market price of our common stock tofluctuate significantly, including:

 

•                             terroristattacks or acts of war;

 

•                             legislativeandregulatory developments related to anti-terrorism efforts or aviation security;

 

•                             ourquarterly operating results or those of other explosives detection companies;

 

•                             thepublic’s reaction to our press releases, announcements and our filings with theSecurities and Exchange Commission;

 

•                             changesinearnings estimates or recommendations by research analysts;

 

•                             changesinour relationships with customers; and

 

•                             developmentsaffectingour competitors.

 

The market price of our common stock has fluctuated dramatically sincethe terrorist attacks of September 11, 2001. For example, immediatelyprior September 11, 2001, our common stock closed at $3.11 per share.Since that date, our closing stock price has risen to a high of $48.29 pershare on March 12, 2002. On December 31, 2002, our common stock closed at$26.36 per share. In addition, the stock market has periodically experiencedsignificant price and volume fluctuations that have particularly affected themarket prices of common stock of technology companies. These changes have oftenbeen unrelated to the operating performance of particular companies. Thesebroad market fluctuations may also negatively affect the market price of ourcommon stock.

 

**Delaware law and ourcharter documents may impede or discourage a takeover, which could cause themarket price of our shares to decline.**

 

We are a Delaware corporation and the anti-takeover provisions ofDelaware law impose various impediments on the ability of a third party toacquire control of us, even if a change in control would be beneficial to ourexisting stockholders. Our certificate of incorporation provides for 5,000,000shares of preferred stock which our board of

 

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directors may issue with terms determined by them without stockholderapproval, a classified board of directors serving staggered three-year terms,restrictions on who may call a special meeting of stockholders and aprohibition on stockholder action by written consent. These provisions ofDelaware law and in our charter documents could impede a merger, takeover orother business combination involving us or discourage a potential acquirer frommaking a tender offer for our common stock, which, under certain circumstances,could reduce the market value of our common stock.

 

**We may not pay cashdividends.**

 

We have not declared or paid any cash dividends on our capital stockpreviously, and we have agreed not to pay cash dividends under our current bankline of credit. Historically, we have retained earnings, if any, to support thedevelopment of our business. Payment of future dividends, if any, will be atthe discretion of our board of directors after taking into account variousfactors, including our financial condition, operating results and current andanticipated cash needs.

 

**We may become subjectto costly and time-consuming class action litigation following significantchanges in our stock price.**

 

In the past, following periods of volatility in the market price of acompany’s securities, securities class action litigation has often beeninstituted against such a company. Were such litigation to be commenced againstus, we would incur substantial costs and there would be diversion of ourmanagement’s attention and resources, which could materially harm our business,results of operations and financial condition.

 

**ITEM 2. PROPERTIES**

 

Our principal corporate office and EDS manufacturing facility arelocated in Newark, California, and consists of approximately 112,000 squarefeet under a lease that expires in August 2007. We have an option toextend the lease for five years. We also entered into an amendment to theoriginal Newark agreement to lease a second facility consisting of 18,700square feet.  The lease for the secondfacility expires in September 2004.

 

Quantum’s office and manufacturing facility are located in San Diego,California, in an approximately 33,000 square foot facility under a lease thatoriginally expired in April 2002, and a separate 3,000 square footfacility which expired in May 2002, both of which continue to be occupiedunder a month-to-month lease. In December 2002, Quantum moved some of itsoperations to a new facility in San Diego consisting of approximately 58,400square feet.  The new lease expires inDecember 2012, with a one-time option to extend the lease another tenyears.  Quantum expects to completelymove out of its old facility by the beginning of the second quarter of 2003.

 

Inovec’s office and manufacturing facility are located in Eugene,Oregon, and consist of approximately 10,000 square feet under lease thatexpires in March 2003 and approximately 5,000 square feet in a separatebuilding under a lease that expires in March 2003. Additionally, we leasea facility consisting of approximately 4,000 square feet in Eugene, Oregon forWoodVision and Inovec operations, currently under a one-year lease expiring inAugust 2003. Another lease for a facility consisting of 4,500 square feetexpired in May 2002, but Inovec continues to occupy the facility on amonth-to-month basis.  Negotiations areunderway for a one-year lease.

 

Webelieve our facilities are adequate for our current and near-term needs, andthat we will be able to locate additional facilities as needed.  See Note 8 of the notes to theconsolidated financial statements for more information about our leasecommitments.

 

**ITEM 3. LEGAL PROCEEDINGS**

 

We are involved in routine claims and administrative proceedingsarising in the ordinary course of business. We believe that collectively theseproceedings will not materially harm our business.

 

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**ITEM 4****.****SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

Not applicable.

 

**ITEM 4A**.  **EXECUTIVEOFFICERS OF THE REGISTRANT**

 

The following table shows our executive officers and their positionsand offices as of March 14, 2003. We have included biographies after the table.

 
| **Name**          |   | **Age** |   | **Position**                                            |
|-------------------|--------|---------|--------|---------------------------------------------------------|
| Sergio Magistri   |   | 50      |   | President, Chief Executive Officer and Director         |
| Donald E. Mattson |   | 70      |   | Senior Vice President and Chief Operating Officer       |
| Ross Mulholland   |   | 60      |   | Senior Vice President and Chief Financial Officer       |
| David M. Pillor   |   | 48      |   | Senior Vice President, Sales and Marketing and Director |

 

*Sergio Magistri* has served as our President,Chief Executive Officer and a director since December 1992. FromJune 1991 to November 1992, he was a Project Manager with AGIE,Switzerland, a manufacturer of high precision tooling equipment, responsiblefor all aspects of a family of new products for high precision electro-erosionmachining with sub-micron precision. From 1988 to June 1991, Dr. Magistriwas a consultant to high technology companies. As a consultant,Dr. Magistri was involved in the formation of InVision and the developmentof its business plan and of its technology. From 1983 to 1988,Dr. Magistri held various positions with Imatron, including EngineeringPhysicist and Manager of Advanced Reconstruction Systems, and Director ofComputer Engineering. Dr. Magistri holds a degree in ElectricalEngineering and a doctorate in Biomedical Engineering from the Swiss Instituteof Technology, Zurich, Switzerland.

 

*Donald E. Mattson* has served as our SeniorVice President and Chief Operating Officer since November 2000.Mr. Mattson previously served as our Interim Vice President of Operationsin 1998. In addition to his position with us, from 1992 to 2000,Mr. Mattson was a management consultant and held a number of differentpositions, including, among others, interim management assignments as executiveofficer of Microware Distributors, Inc., a computer distribution company,president of SyDos, a disk drive sub-systems company, and vice president ofoperations of Quantum, a tape drive manufacturing company. Prior to 1992,Mr. Mattson held senior management positions at MicrowareDistributors, Inc., Optical Data, Inc., Media Technology Corporation,Verbatim Corporation, Memorex Corporation and Varian Associates.Mr. Mattson holds a bachelor’s degree in Industrial Management andTechnology and an MBA from the University of California, Berkeley.

 

*Ross Mulholland* has served as our Senior VicePresident and Chief Financial Officer since March 2001. FromJanuary 2000 to March 2001, Mr. Mulholland was Chief FinancialOfficer and Vice President of Operations of TechPlanet, a Silicon Valleyprivate company providing information technology services. In 2001, TechPlanetfiled for bankruptcy protection under Chapter 7. Before that, he was VicePresident and Chief Financial Officer at Silicon Entertainment, atechnology-based specialty retailer, from 1998 to 2000, and Senior VicePresident and Chief Financial Officer for The Nature Company/Discovery ChannelStores, a specialty retailer and direct marketing company, from 1995 to 1997.He has also held senior management positions with several leading nationalretailers, including Dayton-Hudson Corporation. Mr. Mulholland holds abachelor’s degree in Liberal Arts and an MBA from Wayne State University.

 

*David M. Pillor* joined InVision inJuly 1994 as Vice President, Sales and Marketing, and has served as ourSenior Vice President, Sales and Marketing since November 1995 and as adirector since 1999. From 1988 to July 1994, Mr. Pillor held variouspositions including Area Sales Manager, National Sales Manager and VicePresident of Sales of Technomed International, a medical products company.Mr. Pillor holds a bachelor’s degree in Chemistry from the University ofMaryland.

 

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**PART II.**

 

**ITEM5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS**

 

**Market Information**

 

Our common stock has been traded on the Nasdaq National Market underthe symbol “INVN” since May 15, 1997. Prior to that date, our common stockhad been traded on the Nasdaq SmallCap Market under the symbol “INVN” sinceApril 23, 1996. The following table sets forth for the periods indicatedthe high and low sale prices for our common stock, as reported by the NasdaqNational Market.

 
|                             |   | **High** |   | **Low** |   |
|----------------------------------|--------|----------|--------|---------|--------|
| **Year ended December 31, 2002** |   |     |   |    |   |
| First Quarter                    |   | $        | 49.76  |    | $      | 24.70 |   |
| Second Quarter                   |   | $        | 43.40  |    | $      | 17.42 |   |
| Third Quarter                    |   | $        | 37.25  |    | $      | 21.60 |   |
| Fourth Quarter                   |   | $        | 37.50  |    | $      | 22.78 |   |
|                             |   |     |   |    |   |
| **Year ended December 31, 2001** |   |     |   |    |   |
| First Quarter                    |   | $        | 3.38   |    | $      | 1.38 |   |
| Second Quarter                   |   | $        | 4.15   |    | $      | 2.28 |   |
| Third Quarter                    |   | $        | 11.70  |    | $      | 2.94 |   |
| Fourth Quarter                   |   | $        | 47.09  |    | $      | 9.20 |   |

 

On March 14, 2003, the last reported sale price of our commonstock on the Nasdaq National Market was $21.15. As of December 31, 2002,there were 17,008,153 shares of our common stock outstanding held by 260holders of record.

 

**Dividends**

 

We have not declared or paid any cash dividends on our capital stockpreviously, and we have agreed not to pay cash dividends under our current bankline of credit. Historically, we have retained earnings, if any, to support thedevelopment of our business. Payment of future dividends, if any, will be atthe discretion of our board of directors after taking into account variousfactors, including our financial condition, operating results and current andanticipated cash needs.

 

**ITEM 6. SELECTED FINANCIAL DATA**

 

The following selected consolidated financial data is qualified byreference to, and should be read in conjunction with, Item 7, Management’sDiscussion and Analysis of Financial Condition and Results of Operations, andthe consolidated financial statements and notes thereto and the otherinformation contained in this annual report.

 

The selected consolidated balance sheet data as of December 31,2002 and 2001 and the selected consolidated statement of operations data foreach year in the three years ended December 31, 2002, have been derivedfrom our audited consolidated financial statements appearing elsewhere in thisannual report. The selected consolidated balance sheet data as ofDecember 31, 2000, 1999 and 1998 and the consolidated statement ofoperations data for the years ended December 1999 and 1998 have beenderived from our audited consolidated financial statements not included in thisannual report. Historical results are not necessarily indicative of futureresults. Product cost of revenues is net of reimbursable ramp up costs from theTSA of $11.0 million in 2002.  Cost ofrevenues and operating expenses are net of amounts recoverable under contractsand grants with governmental agencies of $866,000 in 2002, $8.3 million in2001, $1.7 million in 2000, $865,000 in 1999 and $3.6 million in1998. We

 

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acquired Inovec, which was accounted for as a purchase effectiveJanuary 1, 2000 and, accordingly, Inovec’s results of operations are onlyincluded in the consolidated statement of operations data for the years endedDecember 31, 2002, 2001 and 2000. 

 
|                                          |   | **Year Ended  December 31,**               |    |
|-----------------------------------------------|--------|--------------------------------------------|---------|
|                                          |   | **2002**                                   |    | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                          |   | **(In  thousands, except per share data)** |    |
| **Consolidated Statement of Operations Data** |   |                                       |    |   |   |   |   |   |   |   |   |
| Revenues:                                     |   |                                       |    |   |   |   |   |   |   |   |   |
| Product revenues                              |   | $                                          | 411,426 |   | $ | 46,536 |   | $ | 58,713 |   | $ | 43,160 |   | $ | 60,854 |   |
| Service revenues                              |   | 15,622                                     |    | 11,239 |   | 9,801 |   | 4,582 |   | 2,430 |   |
| Government contract revenues                  |   | 12,083                                     |    | 16,556 |   | 10,632 |   | 10,694 |   | 7,210 |   |
| Total revenues                                |   | 439,131                                    |    | 74,331 |   | 79,146 |   | 58,436 |   | 70,494 |   |
|                                          |   |                                       |    |   |   |   |   |   |   |   |   |
| Cost of revenues:                             |   |                                       |    |   |   |   |   |   |   |   |   |
| Product costs                                 |   | 234,767                                    |    | 28,782 |   | 39,333 |   | 24,886 |   | 32,701 |   |
| Service costs                                 |   | 10,761                                     |    | 7,162 |   | 6,512 |   | 3,678 |   | 2,245 |   |
| Government contract costs                     |   | 8,708                                      |    | 13,010 |   | 7,849 |   | 7,739 |   | 5,223 |   |
| Total cost of revenues                        |   | 254,236                                    |    | 48,954 |   | 53,694 |   | 36,303 |   | 40,169 |   |
|                                          |   |                                       |    |   |   |   |   |   |   |   |   |
| Gross profit                                  |   | 184,895                                    |    | 25,377 |   | 25,452 |   | 22,133 |   | 30,325 |   |
|                                          |   |                                       |    |   |   |   |   |   |   |   |   |
| Operating expenses:                           |   |                                       |    |   |   |   |   |   |   |   |   |
| Research and development                      |   | 20,622                                     |    | 7,979 |   | 11,039 |   | 10,443 |   | 8,498 |   |
| Selling, general and administrative           |   | 31,744                                     |    | 14,727 |   | 16,551 |   | 11,767 |   | 12,997 |   |
| Total operating expenses                      |   | 52,366                                     |    | 22,706 |   | 27,590 |   | 22,210 |   | 21,495 |   |
|                                          |   |                                       |    |   |   |   |   |   |   |   |   |
| Income (loss) from operations                 |   | 132,529                                    |    | 2,671 |   | (2,138 | ) | (77 | ) | 8,830 |   |
| Interest expense                              |   | (399                                       | )       | (289 | ) | (195 | ) | (227 | ) | (390 | ) |
| Interest and other income, net                |   | 38                                         |    | 570 |   | 527 |   | 754 |   | 697 |   |
| Income (loss) before income taxes             |   | 132,168                                    |    | 2,952 |   | (1,806 | ) | 450 |   | 9,137 |   |
|                                          |   |                                       |    |   |   |   |   |   |   |   |   |
| Provision (benefit) for income taxes          |   | 53,874                                     |    | (4,571 | ) | — |   | 67 |   | 1,096 |   |
|                                          |   |                                       |    |   |   |   |   |   |   |   |   |
| Net income (loss)                             |   | $                                          | 78,294  |   | $ | 7,523 |   | $ | (1,806 | ) | $ | 383 |   | $ | 8,041 |   |
| Net income (loss) per share:                  |   |                                       |    |   |   |   |   |   |   |   |   |
| Basic                                         |   | $                                          | 4.90    |   | $ | 0.58 |   | $ | (0.14 | ) | $ | 0.03 |   | $ | 0.67 |   |
| Diluted                                       |   | $                                          | 4.40    |   | $ | 0.52 |   | $ | (0.14 | ) | $ | 0.03 |   | $ | 0.63 |   |
| Weighted average shares outstanding:          |   |                                       |    |   |   |   |   |   |   |   |   |
| Basic                                         |   | 15,987                                     |    | 12,998 |   | 12,510 |   | 12,133 |   | 12,046 |   |
| Diluted                                       |   | 17,803                                     |    | 14,343 |   | 12,510 |   | 12,751 |   | 12,827 |   |

 
|                                               |   | **December  31,**   |    |
|----------------------------------------------------|--------|---------------------|---------|
|                                               |   | **2002**            |    | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                               |   | **(In  thousands)** |    |
| **Consolidated Balance Sheet Data**                |   |                |    |   |   |   |   |   |   |   |   |
| Cash, cash equivalents and short-term  investments |   | $                   | 159,736 |   | $ | 13,378 |   | $ | 11,908 |   | $ | 24,169 |   | $ | 12,457 |   |
| Working capital                                    |   | $                   | 227,074 |   | $ | 49,634 |   | $ | 37,672 |   | $ | 40,913 |   | $ | 38,911 |   |
| Total assets                                       |   | $                   | 417,787 |   | $ | 89,733 |   | $ | 69,332 |   | $ | 62,987 |   | $ | 63,486 |   |
| Long-term liabilities                              |   | $                   | 653     |   | $ | 680 |   | $ | 1,861 |   | $ | 1,181 |   | $ | 1,565 |   |
| Total stockholders’ equity                    |   | $                   | 236,713 |   | $ | 61,420 |   | $ | 47,504 |   | $ | 47,485 |   | $ | 46,830 |   |

 

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**ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

*For a more complete understanding of our financial condition andresults of operations, and some of the risks that could affect future results,see “Business—Risk Factors” in Item 1. This section should also be read inconjunction with the consolidated financial statements and related notes inItem 8.*

 

**Overview**

 

We are organized under three segments. Our EDS business manufacturesCT-based detection products used by the aviation industry to screen baggage forexplosives. Our wholly-owned subsidiary, Quantum, utilizes QR and magneticsensing technologies for the inspection, detection and analysis of explosives,concealed weapons and other materials. Our Wood division consists of Inovec,which manufactures systems using laser-based technologies to improve sawmillyield, and WoodVision, which is developing our CT and x-ray technology toincrease the value of harvested timber.

 

Our revenues are primarily comprised of:

 

•                             EDSproduct revenues, which include revenues from sales of CTX systems, relatedaccessories and spare parts, and related installation and configuration, andEDS service revenues, which include revenues from maintenance contracts relatedto product support, integration and other services, including those complexintegrations and configurations that are separate from product revenues;

 

•                             Quantumgovernment contract revenues, which include revenues primarily from developmentcontracts utilizing QR and magnetic sensing technologies with governmentagencies and private entities; and

 

•                             Woodproduct revenues from the sales of control and automation systems for timberprocessing equipment and related accessories, installation and configuration,and service revenues from maintenance contracts related to product support,repairs and other services.

 

We market our products and services directly through internal salespersonnel and indirectly through authorized agents, distributors and systemsintegrators. In the United States, we market our products and servicesprimarily through direct sales personnel. Internationally, we use a directsales force and authorized representatives to sell our products. Internationalsales represented 11.7% of total revenues for the year ended December 31,2002, 32.5% of total revenues for the year ended December 31, 2001 and26.2% of total revenues for the year ended December 31, 2000.

 

*EDS.*    In any givenfiscal quarter or year, our EDS product revenues are derived from orders ofmultiple units of our EDS products from a limited number of customers. Forexample, in 2002, ten customers accounted for all of our EDS units sold. Thenumber of our customers does not vary widely from period to period, and we aredependent on multiple orders from this small number of customers for asubstantial portion of our revenues. Therefore, a cancellation or delay of anorder from a customer could have a significant negative impact on ouroperations in a given period. We generated $356.7 million from EDS salesto our largest customer, the FAA and, following the formation of the TSA, theTSA, representing 81.2% of total revenues for the year ended December 31,2002, $20.0 million representing 26.9% of total revenues for the yearended December 31, 2001, and $30.8 million representing 38.9% oftotal revenues for the year ended December 31, 2000. There were no otherEDS customers who accounted for more than 10% of total revenues in the yearsended December 31, 2002, 2001 and 2000.

 

We typically bill our customers in three stages, as generally providedin our contracts with our customers:

 

•                             amountsto cover the bill of materials when materials are received from suppliers,typically 30% to 40% of the total system price;

 

•                             anadditional amount upon factory acceptance or shipment, ranging from 30% to 60%;and

 

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•                             thebalance upon installation and site acceptance, ranging from 5% to 30%.

 

These payment terms effectively provide the necessary working capitalfor acquisition of materials and funding inventory during the manufacturingcycle. We anticipate that potential future orders from the TSA will continue toprovide payment terms which provide the necessary working capital for us andour suppliers, even if production volumes were to rapidly increase. If futureorders from the TSA contain different payment terms, a major increase inproduction rates may require substantial additional working capital.

 

Payment terms for FAA and TSA invoices are net 30 days, whileterms for international invoices vary from amounts due upon receipt of invoiceto 90 days.

 

We consider research and development to be a vital part of ouroperations and continue to dedicate substantial resources to research toenhance the performance, functionality and reliability of our CTX systems, aswell as development of new products. Gross research and development expensesfor EDS were $18.2 million in 2002, $10.7 million in 2001 and$9.5 million in 2000.

 

*Quantum.*    Our Quantumrevenues are substantially derived from development activities funded byvarious U.S. government contract agencies. The government contract revenues arefrom contracts which are typically in the form of cost-plus-fixed-fee orfirm-fixed-price awards. We sold our first QScan product in late 1999 and ourfirst *i*-Portal100 system in 2001, and continue to market these products to customers withinthe aviation and transportation security markets.

 

We also perform independent research and development activities atQuantum which are not directly funded through U.S. government contracts orgrants. Many of these activities explore ways to utilize those technologieswhich are developed or improved under directly funded government contracts.Internal research and development activity levels can fluctuate with the levelof identified internal research and development projects and with the resourcerequirements of funded government contracts and grants.

 

*Wood.*    Our Wood productand service revenues are primarily derived from Inovec’s sales of control and automationsystems for timber processing equipment and related service. We have installedlaser scanners in over 300 sawmills worldwide.

 

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**Results of Operations**

 

The following table sets forth certain income and expenditure itemsfrom our consolidated statements of operations expressed as a percentage oftotal revenues for the periods indicated. 

 
|                                 |   | **Year Ended  December 31,** |   |
|--------------------------------------|--------|------------------------------|--------|
|                                 |   | **2002**                     |   | **2001** |   | **2000** |   |
| Revenues:                            |   |                         |   |   |   |   |   |
| Product revenues                     |   | 93.7                         | %      | 62.6 | % | 74.2 | % |
| Service revenues                     |   | 3.6                          |   | 15.1 |   | 12.4 |   |
| Government contract revenues         |   | 2.7                          |   | 22.3 |   | 13.4 |   |
| Total revenues                       |   | 100.0                        |   | 100.0 |   | 100.0 |   |
|                                 |   |                         |   |   |   |   |   |
| Cost of revenues:                    |   |                         |   |   |   |   |   |
| Product costs                        |   | 53.5                         |   | 38.8 |   | 49.7 |   |
| Service costs                        |   | 2.5                          |   | 9.6 |   | 8.2 |   |
| Government contract costs            |   | 2.0                          |   | 17.5 |   | 9.9 |   |
| Total cost of revenues               |   | 58.0                         |   | 65.9 |   | 67.8 |   |
|                                 |   |                         |   |   |   |   |   |
| Gross margin                         |   | 42.0                         |   | 34.1 |   | 32.2 |   |
|                                 |   |                         |   |   |   |   |   |
| Operating expenses:                  |   |                         |   |   |   |   |   |
| Research and development             |   | 4.7                          |   | 10.7 |   | 13.9 |   |
| Selling, general and administrative  |   | 7.2                          |   | 19.8 |   | 21.0 |   |
|                                 |   |                         |   |   |   |   |   |
| Total operating expenses             |   | 11.9                         |   | 30.5 |   | 34.9 |   |
|                                 |   |                         |   |   |   |   |   |
| Income (loss) from operations        |   | 30.1                         |   | 3.6 |   | (2.7 | ) |
| Interest expense                     |   | (0.1                         | )      | (0.4 | ) | (0.2 | ) |
| Interest and other income, net       |   | —                       |   | 0.8 |   | 0.6 |   |
|                                 |   |                         |   |   |   |   |   |
| Income (loss) before income taxes    |   | 30.0                         |   | 4.0 |   | (2.3 | ) |
| Provision (benefit) for income taxes |   | 12.2                         |   | (6.1 | ) | — |   |
|                                 |   |                         |   |   |   |   |   |
| Net income (loss)                    |   | 17.8                         | %      | 10.1 | % | (2.3 | )% |

 

***Comparison of FiscalYears 2002 and 2001***

 

*Revenues.*    EDS productrevenues were $403.1 million in 2002, an increase of 1,004% from$36.5 million in 2001.  Thisincrease in system sales and related accessories reflects the orders receivedfrom the FAA and the TSA during 2002, as well as international customers inlate 2001 and 2002, resulting from the increased focus on aviation securityfollowing the terrorist attacks of September 11, 2001.  The increase in EDS product revenues isslightly offset by volume discounts. EDS service revenues were $13.7 million in 2002, an increase of 43.4%from $9.6 million in 2001. The increase in service revenues is a result ofsigning an agreement with Siemens, which was retroactive to November 2002, toservice our EDS units owned by the FAA and the TSA in the United States and itsterritories and service contract revenues from international customers for newsupport and maintenance agreements for CTX systems for which warranty periodsexpired during the year.  We anticipatethat service revenues will increase in 2003 compared to 2002 due to theagreement with Siemens and a larger installed base of EDS coming off ofwarranty.  We typically ship against abacklog of orders for our products. As of December 31, 2002, we had inbacklog EDS equipment orders and service agreements of $246.6 million.

 

Quantum’s government contract revenues were $12.1 million in 2002,a decrease of 27.0% from $16.6 million in 2001. During 2002, $7.0 millionof our government contract revenues from the U.S. government were for the

 

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development of landmine technologies, representing 53.1% of Quantumrevenues, compared to 2001, in which $12.6 million of our government contractrevenues from the U.S. government were for the development of landminetechnologies, representing 74.0% of Quantum revenues. As of December 31,2002, we had Quantum government contract backlog of approximately$12.4 million, approximately $6.1 million of which is for the developmentof landmine detection technologies. We anticipate that government contractrevenues for landmine detection technologies will decrease in 2003 compared to2002. This is the result of a reduced need for subcontract support for thelandmines contracts as outsourced milestones are completed. A reduction in suchsupport needs reduces the amounts of revenue recognized in re-billingsubcontract support cost to the government. In addition, Quantum is shiftinginternal resources to develop an upgrade to the CTX family of explosivesdetection systems utilizing QR. This project to combine QR and CT technology ispartially funded by a grant of $1.0 million by the TSA. Quantum’s productrevenues were $1.0 million in 2002, compared to $322,000 in 2001.  Quantum did not have a commercial productuntil 2001.  The increase in Quantum’sproduct revenues in 2002 is primarily due to increased sales of *i*-Portalsystems during a greater span of time compared to the same period in 2001.

 

Wood product revenues were $7.3 million in 2002, a decrease of 24.4%from $9.7 million in 2001. The decrease in Wood product revenues is primarilydue to fewer system and machinery equipment sales, both reflecting softness inthe wood products industry in 2002 compared to 2001. Wood service revenues were$1.7 million in 2002, an increase of 10.1% from $1.5 million in 2001.  The increase in Wood service revenues isprimarily due to increased replacement part sales and increased customerpurchases of spare parts.  As ofDecember 31, 2002, we had in backlog Inovec equipment orders and serviceagreements of $714,000 for laser-based optimization and scanning systems forlumber manufacturing.

 

*Gross Profit.*    Cost ofEDS product revenues primarily consists of purchased materials procured for usein the assembly of our products, as well as manufacturing labor and overhead,installation, training and warranty. Cost of EDS service revenues primarilyconsists of direct labor and materials, and customer support overhead. In anygiven period our gross profit for products and services may be affected byseveral factors, including revenue mix, volume of systems manufactured in agiven period, product configuration, location of the installation andcomplexity of integration into various environments.

 

Gross profit for EDS products was $174.3 million in 2002, anincrease of 1,125% from $14.2 million in 2001. Gross margins for EDSproducts were 43.2% in 2002 and 39.0% in 2001. In addition to significant TSA shipments in 2002, the improvement in EDSproduct gross profit was partially due to amounts reimbursable from the TSA forramp up costs, which consist of consulting expenses, vendor expedite chargesand subcontractor manufacturing set-up costs, totaling $11.0 million.  If this amount were not reimbursable, theseelements of ramp up costs would have been expensed.  The overall improvement in product gross profit was partiallyoffset by $5.3 million in inventory write downs and accrued vendor cancellationfees.  During 2002, in anticipation ofreceiving additional TSA orders for our CTX 5500 DS model, we purchased andmade commitments to purchase large quantities of critical components to buildCTX 5500 DS machines.  These anticipatedTSA orders were largely replaced by orders for our CTX 9000 DSi model and, atyear-end, our CTX 5500 DS raw material inventory levels were in excess of ouranticipated requirements.  Accordingly,we wrote down a portion of our CTX 5500 DS inventory and accrued cancellationfees which taken together totaled $5.3 million during 2002.  The improvement in EDS product gross marginpercentages is primarily due to lower manufacturing overhead per unit,resulting from a larger increase in units produced relative to the increase infixed costs during 2002. 

 

Gross profit for EDS services was $3.9 million in 2002, anincrease of 20.2% from $3.2 million in 2001. Gross margins for EDSservices were 28.2% in 2002 and 33.7% in 2001. The decrease in gross marginpercentages is primarily due to the need to increase EDS customer supportoverhead costs necessary to support an increasing installed base of EDSunits.  Because product sales areinitially covered for support services under warranty, there is approximately a15 to 18 month time lag from shipment to recognizing significant servicecontract revenue tied to the increased sales of EDS products.  However, the EDS product customer is notobligated to purchase support services from us after the warranty period, soadditional service contract revenues are not assured by product sales. Theincreased support costs with no immediate service revenue for recent productsales was the primary reason for lower gross margin for 2002 compared to thatin 2001.

 

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Cost of Quantum government contract revenues primarily consists ofdirect labor, purchased materials, subcontract labor and the applicableoverhead required to support government funded activities. Gross profit forgovernment contracts was $3.4 million in 2002, a 4.8% decrease from$3.5 million in 2001. Gross margins for government contracts were 27.9% in2002 and 21.4% in 2001. The decrease in gross profit is primarily due to lowergovernment contract revenues in 2002 compared to 2001. The improvement in grossmargin percentages for government contracts is primarily due to fewer outsideengineering services being required on a landmines contract, in which relatedservices typically carry a slightly lower margin, in 2002 compared to 2001.

 

Gross profit for Wood products was $2.1 million in 2002, adecrease of 38.0% from $3.4 million in 2001. Gross margins for Woodproducts were 28.4% in 2002 and 34.6% in 2001. The decrease in Wood productsgross profit and gross margin percentages is primarily due to softness in theindustry.  Gross profit for Woodservices was $931,000 in 2002, an increase of 13.8% from $818,000 in 2001.Gross margins for Wood services were 54.6% in 2002 and 52.9% in 2001. Theincrease in gross profit for Wood services is primarily due to higher servicerevenues in 2002 compared to the prior year using the same number of servicepersonnel. The increase in gross margin percentages for Wood services isprimarily due to variations in types ofservices provided in 2002 compared to 2001.

 

*Research and Development.*    Researchand development expenses consist primarily of compensation paid to personnelengaged in research and development activities, amounts paid for outsideservices and costs of materials utilized in the development of hardwareproducts, including prototype units. Research and development expenditures arepartially offset by amounts reimbursed by the FAA, the TSA and other governmentagencies and private entities under research and development contracts andgrants. These services are provided and reimbursed on a cost basis.

 

Gross research and development expenses for EDS were $18.2 millionin 2002, an increase of 70.9% from $10.7 million in 2001. Gross researchand development expenses for EDS as a percentage of EDS revenues were 4.4% in2002 and 23.1% in 2001. Net research and development expenses for EDS were$17.7 million in 2002, an increase of 254.8% compared to $5.0 millionin 2001. Net research and development expenses for EDS as a percentage of EDSrevenues were 4.2% in 2002 and 10.8% in 2001. The increase in gross researchand development expenses for EDS is primarily due to an increased focus onseveral initiatives to support our growth. With the goal of 100% checkedbaggage screening in U.S. airports, we expect that our EDS machines will beoperated at or near capacity for extended periods. We are investing insustaining engineering efforts to ensure that our products achieve high levelsof serviceability and reliability when operated at capacity. We are alsodevoting significant engineering resources to support the rapid expansion ofour manufacturing capacity, and are continuing our development of the ARGUSprogram, an FAA-sponsored program designed to develop a smaller, low-cost EDSproduct to scan checked baggage in small airports and low-traffic stationswithin larger airports, and product enhancements for our existing line of EDSmachines.  We anticipate that we willcommit less engineering resources in 2003 for the ARGUS program since thatprogram is nearing completion.  Theincrease in net research and development expenses for EDS is primarily due toQuantum's development of an upgrade to the CTX family of explosives detectionsystems utilizing QR and less funding received from the ARGUS grant in thecurrent year compared to the prior year. We anticipate that we will continue toincur unfunded costs for the continued development of the ARGUS program overthe next few quarters as we approach the end of the program.  The decrease of gross and net research anddevelopment expenses for EDS as a percentage of revenues is primarily due to asignificant increase in revenues.

 

Research and development expenses for Quantum were $860,000 in 2002, anincrease of 13.3% from $759,000 in 2001. Research and development expenses forQuantum as a percentage of Quantum revenues were 6.5% in 2002 and 4.5% in 2001.The increase in expenses is primarily due to more internal costs incurred for thedevelopment and commercialization of products in 2002 compared to 2001, such asthe *i*-Portal100 system.  The increase of researchand development expenses for Quantum as a percentage of revenues is primarilydue to a decrease in revenues.

 

Research and development expenses for Wood were $2.1 million in2002, a decrease of 7.0% from $2.3 million in 2001. Research anddevelopment expenses for Wood as a percentage of Wood revenues were 23.3% in2002 and

 

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20.1% in 2001. The decrease in expenses is primarily due to a temporaryreallocation of engineering resources to support the rapid growth of the EDSbusiness from Wood development efforts. The increase of research and development expenses for Wood as a percentageof revenues is primarily due to a decrease in revenues.

 

*Selling, general and administrative.*    Selling,general and administrative expenses consist primarily of compensation paid todirect and indirect sales and marketing personnel, administrative personnel,including directors, consultant fees, professional service fees, insurance,travel, selling and distribution costs and other general expenses.

 

Selling, general and administrative expenses for EDS were$24.6 million in 2002, an increase of 186.0% from $8.6 million in2001. Selling, general and administrative expenses for EDS as a percentage ofEDS revenues were 5.9% in 2002 and 18.6% in 2001. Part of the increase inexpenses for EDS was the result of an increase in expenditures to consultants andprofessional fees of $4.5 million, such as investigations relating to potentialacquisitions and investor and public relations, employee headcount of $3.3million, insurance costs of $2.2 million and sales commissions of $2.1 million,all related to the growth of our business compared to the prior year. Thedecrease in selling, general and administrative expenses for EDS as apercentage of revenues is primarily due to the increase in EDS revenues.

 

Selling, general and administrative expenses for Quantum were constantat $2.3 million in 2002 and 2001. Selling, general and administrative expenses for Quantum as a percentageof Quantum revenues were 17.1% in 2002 and 13.8% in 2001. The increase as apercentage of revenues is due to a decrease in total revenue.

 

Selling, general and administrative expenses for Wood were$4.9 million in 2002, an increase of 29.0% from $3.8 million in2001.  Selling, general andadministrative expenses for Wood as a percentage of Wood revenues were 54.2% in2002 and 33.8% in 2001. The net increase in selling, general and administrativeexpenses is primarily due to a $2.1 million impairment write-down of goodwillrelated to the acquisition of Inovec, partially offset by reductions inheadcount and efforts to control expenses. The increase as a percentage of revenue is due to a decrease in totalrevenue and to the $2.1 million impairment write-down.

 

*Interest Expense.*    Interestexpense increased to $399,000 in 2002 from $289,000 in 2001.  The increase in interest expense is primarilydue to increased activities within our financing for insurance premiums, andincreased activities within our lines of credit, such as more standby lettersof credit issued to secure guarantees to customers, in 2002 compared to that in2001.

 

*Interest and Other Income, Net.*    Interestand other income, net was $38,000 in 2002 compared to $570,000 in 2001. The2002 amount consists primarily of interest income on cash, cash equivalents andshort-term investments of $1.9 million, offset by other expenses of $1.9million, primarily consisting of $1.2 million of net foreign exchange lossesprimarily related to foreign exchange contracts entered into in advance ofadopting hedge accounting in May 2002 and a contingent settlement amount of$700,000.  The 2001 amount consistsprimarily of interest income on cash equivalents and short-term investments of$297,000 and other income (net) of $273,000, primarily the reversal of areserve due to a favorable outcome of an international claim, partially offsetby foreign exchange losses.

 

*Provision (Benefit) for Income Taxes.*    Werecorded an income tax provision of $53.9 million in 2002 compared with anincome tax benefit of $4.6 million in 2001.  At December 31, 2002, we had federal and state net operating losscarryforwards of approximately $1.8 million and $321,000, respectively,available to reduce future federal and state taxable income.  Our federal net operating loss carryforwardsbegin to expire in 2010 and our state net operating loss carryforwards expirein 2011.  The tax benefit of the net operating loss carryforwards may be limiteddue to the impact of the Tax Reform Act of 1986.  Events which may cause the tax benefit to belimited include, but are not limited to, a cumulative stock ownership change ofmore than 50% over a three-year period and the timing of utilization of varioustax benefits carried forward.

 

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***Comparison of FiscalYears 2001 and 2000***

 

*Revenues.*    EDS productrevenues were $36.5 million in 2001, a decrease of 21.5% from$46.5 million in 2000. This decrease was primarily attributable todecreased CTX system revenue of approximately $8.6 million, resulting fromfewer CTX systems sold in 2001 compared to 2000, and also due to relatively moreof the newer, lower priced CTX 2500 systems sold to existing customers in 2001compared to 2000. The decrease was also due to a $2.2 million reduction ofrevenues from fewer customer upgrades of the older CTX 5000 systems to thenewer CTX 5500 DS systems. The upgrades were mostly complete at the end of2000. The decrease in EDS product revenues was partially offset by increasedaccessories and spare parts revenues in 2001, as more systems were deployed andoperating in the field in 2001 compared to 2000.

 

EDS service revenues were $9.6 million in 2001, an increase of15.8% from $8.3 million in 2000. The increase in service revenues wasprimarily due to increased service contract revenues from internationalcustomers for new support and maintenance agreements for CTX systems for whichwarranty periods expired during the year. The increase in EDS service revenuewas also due to more non-contract services, such as billed time and materialservices, data reporting and complex integrations, provided on a greaterinstalled base of systems in 2001 compared to 2000. We typically ship against abacklog of orders for our products. As of December 31, 2001, we had inbacklog EDS equipment orders and service agreements of $56.0 million.

 

Quantum’s government contract revenues were $16.6 million in 2001,an increase of 55.7% from $10.6 million in 2000. The increase ingovernment contract revenues was primarily due to an increase in efforts in thedevelopment of landmine and concealed weapons detection technologies, partiallyoffset by decreases in other types of development efforts as those governmentcontracts and grants were completed during the last twelve months. Due toexpanded efforts to develop landmine detection technologies in 2001, Quantumemployed more individuals to work directly on funded projects, as well asincreased subcontract support, compared to the same period in 2000. During2001, $12.6 million of our government contract revenues from the U.S.government were for the development of landmine technologies, representing74.0% of Quantum revenues, compared to 2000, in which $6.0 million of ourgovernment contract revenues from the U.S. government were for the developmentof landmine technologies, representing 54.4% of Quantum revenues. As of December 31,2001, we had Quantum government contract backlog of approximately$12.9 million, primarily for the development of landmine detectiontechnologies. Quantum’s product revenues were $322,000 in 2001, compared to$307,000 in 2000.

 

Wood product revenues were $9.7 million in 2001, a decrease of18.5% from $11.9 million in 2000. The decrease in Wood product revenueswas primarily due to fewer system sales and also due to fewer machineryequipment sales, both reflecting a softness in the wood products industry in 2001compared to 2000. Wood service revenues were constant at $1.5 million foreach of the years ended December 31, 2001 and 2000. As ofDecember 31, 2001, we had in backlog Inovec equipment orders and serviceagreements of $1.2 million for laser-based optimization and scanningsystems for lumber manufacturing.

 

*Gross Profit.*    Gross profit for EDSproducts was $14.2 million in 2001, a decrease of 9.9% from$15.8 million in 2000. Gross margins for EDS products in 2001 were 39.0%and 33.9% in 2000. The decrease in gross profit was primarily due to lower EDSproduct revenues in 2001 compared to 2000. The increase in EDS product grossmargin percentages was primarily due to improvements in the manufacturing costsof the CTX 9000 DSi system, which was first introduced in late 1999, and due tocompetitive pricing factors with international customers in the prior year. Theincrease in gross margin percentages was also due to variations in producttypes and accessories sold in 2001 compared to 2000. The increase in revenuesfrom accessories, which typically carry higher margins, in 2001 added to theimprovement in EDS product margins compared to 2000. Gross profit for EDSservices was $3.2 million in 2001, an increase of 26.3% from$2.6 million in 2000. Gross margins for EDS services were 33.7% in 2001and 30.9% in 2000. The increase in gross profit was primarily due to higher EDSservice revenues in 2001 compared to 2000. The increase in EDS service grossmargin percentages was primarily due to variations in types of service revenue,such as increased billed time and materials services, and continued efforts tomaintain constant overhead costs with a greater installed base of CTX systemsin 2001 compared to 2000. The increase in gross margin percentages for EDS serviceswas also due to revenues recorded in 2001 for services which were performed in2000. The revenues for these services were deferred in the prior year due touncertainty of collection of the receivable at

 

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theend of the year. The revenues for these services were recognized in the currentyear due to the collection of the receivable in 2001.

* *

Gross profit for government contracts was $3.5 million in 2001, a27.4% increase from $2.8 million in 2000. Gross margins for governmentcontracts were 21.4% in 2001 and 26.2% in 2000. The increase in gross profitwas primarily due to higher government contract revenues in 2001 compared to2000, partially offset by decreased margins. The decrease in gross margin percentageswas primarily due to increased outside engineering services utilized on thelandmines contract in 2001 compared to 2000, which services typically carrylower margins.

 

Grossprofit for Wood products was $3.4 million in 2001, a decrease of 6.0% from$3.6 million in 2000. Gross margins for Wood products were 34.6% in 2001and 30.0% in 2000. The decrease in Wood products gross profit was primarily dueto lower revenues in 2001 compared to 2000. The increase in Wood products grossmargin percentages was primarily due to a smaller portion of revenuesattributable to machinery equipment, which typically carry a lower margin thansystem revenues, in 2001 compared to 2000. Gross profit for Wood services was$819,000 in 2001, an increase of 11.6% from $734,000 in 2000. Gross margins forWood services were 52.9% in 2001 and 48.2% in 2000. The increase in grossprofit was primarily due to higher service revenues in 2001 compared to 2000.The increase in Wood service gross margin percentages was primarily due to variationsin types of services provided in 2001 compared to 2000.

 

*Research and Development.*    Grossresearch and development expenses for EDS were $10.7 million in 2001, anincrease of 12.2% from $9.5 million in 2000. Research and developmentcontracts and grants from the FAA and other government agencies and privateentities funded $5.7 million of our gross research and developmentexpenses for EDS in 2001 and $872,000 in 2000. Net research and developmentexpenses for EDS were $5.0 million in 2001, a decrease of 42.3% comparedto $8.6 million in 2000. Net research and development expenses for EDS asa percentage of EDS revenues were 10.8% in 2001 and 15.7% in 2000. The increasein gross research and development expenses for EDS was primarily due to the expandedefforts on the ARGUS program during 2001 compared to 2000. The decrease in netresearch and development expenses was primarily due to the focused efforts onthe ARGUS development, which was funded through research and developmentgrants. As of December 31, 2001, we had in backlog research anddevelopment contracts and grants of $880,000, representing the remainingavailable funding of the ARGUS program.

 

Research and development expenses for Quantum were $759,000 in 2001, anincrease of 55.2% from $489,000 in 2000. Research and development expenses forQuantum as a percentage of Quantum revenues was 4.5% in 2001 and 2000. Theincrease in expenses was primarily due to more internal costs incurred for thedevelopment and commercialization of products in 2001 compared to 2000, such asthe *i*-Portal100 system.

 

Research and development expenses for Wood were $2.3 million in2001, an increase of 17.7% from $1.9 million in 2000. Research anddevelopment expenses for Wood as a percentage of Wood revenues were 20.1% in2001 and 14.3% in 2000. The increase in expenses was primarily due to theincreased efforts during the first half of 2001 for field trials and otherresearch on the development of a log scanning system based on CT technology tooptimize the value of harvested timber. The increase in expenses as a percentage of revenues was due to anincrease in expenses and an 18.5% decrease in Wood product revenues.

 

*Selling, general and administrative.*    Selling, general and administrative expenses for EDS were $8.6 million in2001, a decrease of 11.4% from $9.7 million in 2000. Selling, general andadministrative expenses for EDS as a percentage of EDS revenues were 18.6% in2001 and 17.7% in 2000. The decrease in EDS selling, general and administrativeexpenses was primarily due to our efforts to reduce selling, general andadministrative spending levels in the first part of 2001 compared to 2000,primarily in the areas of employee headcount, travel and entertainment andprofessional services. The decrease was also due to the reimbursement by theFAA of the selling, general and administrative portion of expenses related tothe ARGUS program of $2.1 million in 2001 compared to $400,000 in 2000,due to expanded efforts on the ARGUS development in 2001. These decreases werepartially offset by increased external commission expense for certaininternational sales representatives in 2001 compared to 2000 and also due toincreases in employee headcount, bonuses, consultants, and professional fees,such as investor and public relations, incurred in late 2001 in anticipation ofgreater demand for our EDS products. The decrease in EDS selling, general andadministrative expenses was also partially offset by approximately $373,000 ofnon-recurring

 

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professional fees incurred in the latter part of 2001 related to apossible acquisition which is no longer being pursued.

 

Selling, general and administrative expenses for Quantum were constantat $2.3 million in 2001 and 2000. Selling, general and administrativeexpenses for Quantum as a percentage of Quantum revenues were 13.8% in 2001 and21.1% in 2000. The decrease as a percentage of revenues was due to our effortsto maintain selling, general and administrative spending levels with expandedefforts on government contract projects.

 

Selling, general and administrative expenses for Wood were$3.8 million in 2001, a decrease of 16.4% from $4.6 million in 2000.Selling, general and administrative expenses for Wood as a percentage of Woodrevenues were 33.8% in 2001 and 33.9% in 2000. The decrease in selling, generaland administrative expenses was primarily due to start-up and businessdevelopment costs incurred in 2000 for the newly formed WoodVision division.

 

*Interest Expense.*    Interestexpense increased to $289,000 in 2001 from $195,000 in 2000. Interest expenseresulted primarily from debt financing associated with our working capitallines of credit, equipment term loans, capital leases and financing forinsurance premiums. The increase was primarily due to higher average debtbalances during the year in 2001 compared to 2000, partially offset by lowerinterest rates.

 

*Interest and Other Income, Net.*    Interestand other income, net, was $570,000 in 2001 compared to $527,000 in 2000. The2001 amount consisted primarily of interest income on cash, cash equivalentsand short-term investments of $297,000 and other income (net) of $273,000,primarily the reversal of a reserve due to a favorable outcome of aninternational claim, partially offset by foreign exchange losses. The 2000amount consisted primarily of interest income on cash equivalents andshort-term investments of $917,000, partially offset by other expense of$390,000, primarily net foreign exchange losses. The decrease in interestincome was primarily due to lower average cash balances and lower interestrates on these balances during the year in 2001 compared to 2000.

 

*Provision (Benefit) for Income Taxes.*    Werecorded an income tax benefit of $4.6 million in 2001 compared to noamounts recorded for taxes in 2000. During the fourth quarter of 2001, wedetermined that a deferred tax asset valuation allowance was no longernecessary based on an evaluation of current evidence including, among otherthings, the passage of the Transportation Security Act and its effect on ourestimates of future earnings as well as contracts and customer orders enteredinto during the fourth quarter of 2001. Accordingly, we reversed our deferredtax asset valuation allowance of $5.7 million in the fourth quarter of2001, which more than offset the provision for the 2001 income tax expense. AtDecember 31, 2001, we had federal net operating loss carryforwards ofapproximately $5.0 million and state net operating loss carryforwards of approximately$1.1 million available to reduce future federal and state taxable income.Our federal net operating loss carryforwards begin to expire in 2010 and ourstate net operating loss carryforwards expire in 2011. Our tax creditcarryforwards of $1.3 million expire from 2005 to 2021

 

**Related PartyTransactions**

 

In connection with Messrs. Blum and Turpen joining our board ofdirectors in 2001, each of these directors received a grant to purchase20,000 shares of our common stock, which grants vested over a four-yearperiod. In February 2002, the board of directors amended these grants to causethem to vest over a one-year period. If either Mr. Blum or Mr. Turpenceases to be a director prior to four years from the original date of grant, wewill be required to take a compensation charge equal to the difference betweenthe fair market value of our common stock on the date of the amendment and theexercise price of the option, multiplied by the number of vested shares thatwould not have vested had the option not been amended.

 

In late September 2001, we entered into an agreement withDonald & Co. for investment advisory services related to a potentialacquisition and fundraising activities. We considered other alternatives andchose Donald & Co. to provide these services because time was of theessence and it was able to react quickly to meet our business requirementsbased on its familiarity with our business. Stephen Blum, president ofDonald & Co., is a member of our board of directors. The boardapproved this agreement with Mr. Blum abstaining. Under this agreement,Donald & Co. received a $50,000 cash retainer and a fully-vestedwarrant to purchase 100,000 shares of our

 

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common stock at a price of $9.95 per share, the closing price of ourcommon stock on the day prior to the date of issuance. The board consideredthis fee to be comparable to other alternatives given the circumstances of theengagement. The warrant expires five years from date of issuance. The fairvalue of the warrant was $650,000, which was estimated on the date of grantusing the Black-Scholes option pricing model with the following assumptions: nodividends, risk-free interest rate of 3.94%, volatility of 78% and acontractual life of five years. In September 2002, we issued 100,000 shares ofcommon stock under the warrant. However, in lieu of paying cash for the shares, 34,153 shares valued at$29.13 per share were returned to us to settle the transaction.  Such shares were recorded as treasurystock.  We have allocated one-half ofthe cash retainer and warrant to on-going investment and financial advisoryservices, which was originally recorded in other current assets and thenamortized over the one-year term of the agreement. We recorded amortizationexpense of $262,000 in 2002 and $88,000 in 2001. We have allocated theremaining balance of $350,000 to services provided in connection with ourfollow-on offering in April 2002, which was netted against the proceeds fromthe offering.

 

In August 1996, January 1997 and January 1999, we enteredinto consulting agreements with BGI, Inc., a Virginia-based internationalconsulting firm, to assist us with the marketing of our EDS products to theU.S. government. Under these agreements, we agreed to pay an annual retainer toBGI and a success fee payable 25% in stock or stock options. In November 2000,BGI agreed to convert all of the accrued stock portion of its accumulatedsuccess fees and agreed to cancel an option to purchase 6,586 shares of commonstock in consideration for an agreement by us to issue 20,468 shares of commonstock to BGI. In 2000, we recorded consulting expenses of $108,000 for thiscommon stock. We issued 9,552 shares of common stock in 2001 and we issued theremaining 10,916 shares of common stock in 2002. In March 1998, MorrisBusby, president and a controlling shareholder of BGI, was elected to our boardof directors. Following Ambassador Busby’s election, we continued thisarrangement because we felt that BGI continued to provide needed services to usat comparable market rates. We paid consulting fees to BGI of $120,000 in 2000.This arrangement expired on December 31, 2000.

 

**Noncash Charges**

 

We recorded noncash charges related to grants of stock options havingexercise prices below the fair market value on the date of grant to employeesand directors in the amounts of $136,000 in 2002 and $63,000 in 2000. We didnot record any noncash charges in 2001 related to grants of stock optionshaving exercise prices below the fair value of our common stock on the date ofgrant. We recorded noncash charges related to grants of a warrant to a directorand stock options to a consultant in the amount of $651,000 in 2002 and$148,000 in 2001. No amounts were recorded for grants of warrants or stockoptions to non-employees in 2000. We recorded a noncash charge related to theissuance of common stock to a consultant in the amount of $42,000 in 2002.

 

**Liquidity and CapitalResources**

 

At December 31, 2002, we had $159.7 million in cash and cashequivalents, compared to $11.4 million at December 31, 2001. Workingcapital was $227.1 million at December 31, 2002 compared to$49.6 million at December 31, 2001.

 

Net cash provided by operating activities was $65.4 million in 2002,compared to $519,000 in 2001 and to $9.2 million used in 2000.  The increase in cash flows from operationsin 2002 resulted primarily from an increase in our earnings of approximately$70.8 million, offset by a net decrease resulting from changes in operatingassets and liabilities of approximately $14.9 million. Changes in assets andliabilities reflected long-lead deposits on delivery orders from the TSAresulting in an increase of $81.9 million in deferred revenues, as well as anincrease in accrued liabilities of $50.2 million and an increase in accountspayable of $20.1 million.  However,these increases in operating assets and liabilities were more than offset bycustomer receivables processed in late 2002 that contributed to a $118.4million growth of accounts receivable, and increases in inventory of $37.7million and prepayments of $11.0 million, including long-lead inventorydeposits of $8.4 million.

 

Cash flows from operations in 2001 resulted primarily from an increasein earnings of $9.3 million, which is enhanced by noncash items, such as $3.8million for depreciation and amortization during the year.  Other

 

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contributing factors to the improvement in cash flows from operationswere the timing of payments on accounts payable of $3.0 million and the incometax benefits from employee stock transactions of $2.2 million, partially offsetby increases in inventory of $6.8 million and accounts receivable of $4.9million.

 

Net cash used in operating activities in 2000 resulted primarily froman increase in accounts receivable of $10.6 million.  Other contributing factors to the cash used in operations were anet loss of $1.8 million, a build up increase of $2.2 million in inventory, anda decrease in up-front customer installment payments as of year-end, resultingin a $3.0 million decrease in deferred revenue.  The net use of cash in operating activities was partially offsetby an increase of $4.0 million in accrued liabilities and a $3.8 millionnoncash effect of depreciation and amortization.

 

Net cash used in investing activities was $2.9 million in 2002,compared to $4.2 million in 2001 and to $1.7 million provided by investingactivities in 2000. Net cash used in investing activities in 2002 resulted from$4.7 million in acquisitions of capital equipment and $183,000 for the paymentof an earn-out to the former shareholders of Inovec in accordance with theterms in the purchase agreement, offset by proceeds from the sale of short-terminvestments of $1.9 million.  Net cashused in investing activities in 2001 resulted from $2.0 million for thepurchases of short-term investments, $1.9 million in acquisitions ofcapital equipment, and $267,000 for the payment of an earn-out to the formershareholders of Inovec in accordance with terms in the purchase agreement. Netcash provided by investing activities in 2000 primarily resulted from $5.9million in sales of short-term investments, partially offset by $2.7 million inacquisitions of capital equipment and the cash payment of $1.5 million for thepurchase of Inovec, net of cash acquired.

 

Net cash provided by financing activities was $85.9 million in2002, compared to $3.1 million in 2001 and to $1.1 million in 2000. Netcash provided by financing activities in 2002 primarily resulted from $87.8million in net proceeds from the sale of common stock to the public and underthe employee stock purchase plan and exercises of stock options, partiallyoffset by $1.7 million in repayments of short-term debt, net of proceeds.  Net cash provided by financing activities in2001 was primarily due to $2.5 million in proceeds from sales under theemployee stock purchase plan and exercises of stock options and$1.0 million in proceeds from borrowings of short-term debt, net ofpayments, partially offset by $403,000 in repayments of long-term debt.  Net cash provided by financing activities in2000 was primarily due to $890,000 in proceeds from borrowings of short-termdebt, $669,000 in proceeds from sales under the employee stock purchase planand exercises of stock options, partially offset by $435,000 in repayments oflong-term debt.

 

Effective July 2002, we amended our two line of credit agreements withSilicon Valley Bank.  The firstagreement provides for maximum borrowings in an amount up to $25.0million.  The second agreement ispartially guaranteed by the Export-Import Bank, or EXIM, of the United Statesand provides for maximum borrowings in an amount up to the lower of:  (a) the sum of 70% to 90% of eligible EDSexport accounts receivable plus the lower of: (1) 70% of eligible raw materialsand work-in-process inventory designated for export customers, or (2) 60% ofoutstanding loans under this agreement, or (b) $10.0 million, which we expectwill increase to $15.0 million in 2003 following the approval of the increaseof the guarantee by EXIM.  Borrowingsunder these agreements bear interest at the bank’s prime rate minus 0.5%, whichwas 3.75% at December 31, 2002.  Theagreements expire in July 2004 and require that the EDS segment maintaincertain levels of tangible net worth. We may use proceeds of loans under both lines of credit for generalcorporate purposes.  At December 31,2002, we had no borrowings outstanding under these agreements.  However, at December 31, 2002, we hadoutstanding guarantees to customers through the issuance of letters of creditfor which a partial reserve of $2.0 million is secured by the lines of credit,and foreign exchange contracts for which a 10% reserve of $3.5 million issecured by the lines of credit.  We hadremaining available borrowing capacity under the lines of credit of $29.5million at December 31, 2002 based on eligible EDS accounts receivable andinventories as of that date.

 

We previously borrowed against a committed equipment line of creditagreement with Silicon Valley Bank, which converted into a term loan after drawdown.  Borrowings are secured by theassets purchased or financed.  AtDecember 31, 2002, we had an outstanding $67,000 term loan due June 2003.  The term loan bears interest at the bank’sprime rate plus 1.0%, which was 5.25% at December 31, 2002.

 

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In August 2002, Inovec renewed a line of credit agreement with PacificContinental Bank.  The agreementprovides for a $1.5 million working capital line of credit and is secured byassets of Inovec.  The agreement bearsinterest at the bank’s prime rate plus 1.0%, with an interest rate floor of5.75%.  The agreement expires in August2003 and requires that Inovec maintain certain levels of tangible net worth anddebt/worth ratios.  Inovec may useproceeds from loans under the line of credit for general corporate purposes inits operations.  At December 31,2002, Inovec had no borrowings outstanding under this agreement.

 

**Contractual Obligations and Commitments**

 

The following table depicts our contractual obligations as of December31, 2002 (in thousands): 

 
|                               |   | **Payments  Due by Period** |   |
|------------------------------------|--------|-----------------------------|--------|
| **Contractual Obligations**        |   | **Total**                   |   | **Less than  1 year** |   | **1-3  years** |   | **Thereafter** |   |
| Short-term debt                    |   | $                           | 184    |   | $ | 184 |   | — |   | — |   |
| Long-term debt                     |   | 67                          |   | 67 |   | — |   | — |   |
| Capital lease obligations          |   | 122                         |   | 45 |   | 69 |   | 8 |   |
| Operating leases                   |   | 17,456                      |   | 2,793 |   | 4,666 |   | 9,997 |   |
|                               |   |                        |   |   |   |   |   |   |   |
| Total contractual cash obligations |   | $                           | 17,829 |   | $ | 3,089 |   | $ | 4,735 |   | $ | 10,005 |   |
|                                    |        |                             |        |  |  |  |  |  |  |  |  |  |  |

 

At December 31, 2002, we have commitments of $34.7 million for foreigncurrency forward contracts, which are used to hedge against existingreceivables and orders.  These contractsexpire within one year, when we will need to provide the euro currency from forecastedcustomer receipts to receive $34.7 million. We have no material obligations orcommitments other than the obligations specified in the table above and thecommitments specified in this paragraph.

 

We believe that existing cash, cash equivalents and short-terminvestments, available borrowings under our lines of credits and funds expectedto be generated from operations will be sufficient to finance our workingcapital and capital expenditure requirements for at least the next twelvemonths.  However, if we fail to meetrequired financial covenants in our credit agreements, or our receivables donot support the upper limits of these credit agreements, then we may not beable to have access to further funds under these agreements.  In addition, if we are unable to deliver EDSunits in a timely manner under our recent orders from the TSA or if we fail toadhere to the terms of the licensing agreement with the TSA, the TSA may cancelits orders or not place additional orders. If any of these events occur, our capital resources would besignificantly impaired.

 

**Inflation**

 

The impact of inflation has not been material on our operations, cashflow or liquidity to date.

 

**Critical AccountingPolicies and Estimates**

 

Our discussion and analysis of our financial condition and results ofoperations are based on our consolidated financial statements, which have beenprepared in conformity with accounting principles generally accepted in theUnited States of America. Our preparation of these consolidated financial statementsrequires us to make judgments and estimates that affect the reported amounts ofassets and liabilities, disclosure of contingent assets and liabilities at thedate of the financial statements and the reported amounts of revenues andexpenses during the reporting period. We base our estimates on historicalexperience and on various other assumptions that we believe to be reasonableunder the circumstances. Actual results may differ from such estimates underdifferent assumptions or conditions. The following summarizes our criticalaccounting policies and significant estimates used in preparing ourconsolidated financial statements:

 

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*Revenue Recognition.*    Werecognize revenues when persuasive evidence of an arrangement exists, deliveryhas occurred or services have been rendered, the price is fixed anddeterminable and collectibility is reasonably assured. For sales of EDSproducts to the FAA and the TSA and other domestic customers that have beendemonstrated to meet product specifications prior to shipment, we recognizeproduct revenues at shipment and defer the portion of revenues relating toinstallation and training until these services are performed and accepted bythe customer. The deferred installation and training revenues are based on thefair value of these services and generally represent less than 5% of thesearrangements. Installation is generally completed within a relatively shortperiod of time, typically less than one week. We have a consistent history ofcompleting routine installations and obtaining customer acceptance for domesticand international sales. Some airport installations require more involvedintegration with baggage handling systems and, while not essential to the functionalityof the machine, take longer than most routine installations. Integrationservices are separately priced from products in sales agreements and werecognize service revenues under these agreements as services are performed.

 

Sales of EDS products and services to customers in foreign countrieshave varying contractual terms and are governed, in part, by regulations inforeign jurisdictions; accordingly, we recognize revenue based on the specificfacts and circumstances surrounding each transaction. Revenue recognition onforeign sales is affected by our determination of when legal title and risk ofloss pass to foreign customers as well as by our evaluation of our enforceablerights to unbilled amounts at the balance sheet date for transactions that havebeen recognized as revenues. For foreign sales of EDS products that have beendemonstrated to meet product specifications prior to shipment, where title andrisk of loss pass to the customer at shipment, and where we either have anenforceable claim at the balance sheet date for remaining unbilled amounts orhave the ability to invoice the customer for any unbilled amounts after a fixedperiod of time regardless of whether installation is completed, we recognizeproduct revenue at shipment and defer and recognize the fair value ofinstallation and training revenue, if any, as services are performed. For salesof EDS products to foreign customers where title and risk of loss for such EDSproducts pass upon completion of installation, we recognize product and servicerevenues at the completion of installation and acceptance by the customer. Inother sales of EDS products to foreign customers where a portion of thecontract price is withheld until installation is completed and where we do notbelieve we have an enforceable claim at the balance sheet date through which wecan realize some or all of the withheld amount, we defer and recognize asrevenue the greater of that portion of the contract price or the fair value ofthe installation and training at the completion of installation and acceptanceby the customer.

 

We recognize revenues from Quantum government contracts and from Inovecproduct sales of automation and control systems using thepercentage-of-completion method based on costs incurred to date as a percentageof total estimated costs at completion. We record provisions for estimatedlosses on those contracts that are anticipated to result in losses at thecompletion of the contract. The percentage-of-completion method relies onestimates of total expected contract revenue and costs. We use this method ofrevenue recognition since reasonably dependable estimates of the revenue andcosts applicable to various stages of a contract can be made. Recognizedrevenues and profit are subject to revisions as the contract progresses tocompletion.

* *

*Inventory.*  Ourinventory purchases and commitments are made in order to build inventory tomeet future shipment schedules based on forecasted demand for ourproducts.  The business environment inwhich we operate is subject to rapid changes in customer demand.  We perform a detailed assessment ofinventory by segment each period, which includes a review of, among otherfactors, demand requirements, product life cycle and development plans,component cost trends, product pricing and quality issues.  Based on this analysis, we recordadjustments to inventory for excess, obsolescence or impairment, whenappropriate, to reflect inventory at net realizable value.  Revisions to our inventory adjustments maybe required if actual demand, component costs or product life cycles differfrom our estimates.

* *

*Estimated Cost-down Liability to the TSA.*  Thedelivery orders received from the FAA and TSA beginning in April 2002 aregoverned by a letter contract dated February 19, 2002.  The contract specifies that product priceswill be reduced by an amount equal to 75% of actual bill of materialsavings.  While this contract has notyet been definitized, we have accrued a liability for the estimated amount ofmaterial cost savings to be shared with the TSA.  The estimate was determined by the quantity of product shipmentsto the TSA under the contract extended, for each model, by 75% of the netdecrease in the bill of materials for the production of those unitsshipped.  The estimated liability hasbeen recorded as a reduction of revenues and, once the contract is definitized,the liability will be

 

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adjusted to reflect agreed upon payments to the TSA.  We anticipate that the contract will bedefinitized by the end of the second quarter of 2003.

 

*Accrued Warranty Reserves.*    Weaccrue the estimated cost of product warranties at the time revenues arerecognized. While we engage in extensive product quality programs andprocesses, including actively monitoring and evaluating the quality of ourcomponent suppliers, our warranty obligation is affected by actual warrantycosts, including usage of material and labor and service delivery costsincurred in correcting a product failure. If actual material usage or servicedelivery costs differ from our estimates, revisions to the estimated warrantyliability would be required.

 

*Deferred Tax Asset Valuation Allowance.*    Werecord a valuation allowance to reduce our deferred tax assets when it is morelikely than not, based upon currently available evidence and other factors,that we will not realize some portion or all of our deferred tax assets. Webase our determination of the need for a valuation allowance on an on-goingevaluation of current evidence including, among other things, estimates offuture earnings, the backlog of customer orders and the expected timing ofdeferred tax asset reversals. We charge or credit adjustments to the valuationallowance to income tax expense in the period in which these determinations aremade. If we determine that we would be able to realize our deferred tax assetsin the future in excess of its net recorded amount, an adjustment to thedeferred tax asset would increase income in the period this determination wasmade. Likewise, if we determine that we would not be able to realize all orpart of our net deferred tax assets in the future, we would charge tooperations an adjustment to the deferred tax asset in the period thisdetermination was made.

 

*Valuation of Long-Lived Assets, Including Goodwilland Purchased Intangible Assets*.  We reviewproperty, plant and equipment, goodwill and purchased intangible assets forimpairment whenever events or changes in circumstances indicate the carryingvalue of an asset may not be recoverable. Our asset impairment review assessesthe fair value of the assets based on the future cash flows the assets areexpected to generate. An impairment loss is recognized when estimateddiscounted future cash flows expected to result from the use of the asset plusnet proceeds expected from disposition of the asset, if any, are less than thecarrying value of the asset. This approach uses our estimates of future marketgrowth, forecasted revenue and costs, expected periods the assets will beutilized and appropriate discount rates. Such evaluations of impairment oflong-lived assets, including goodwill and purchased intangible assets are anintegral part of, but not limited to, our strategic reviews of our business andoperations. When an impairment is identified, the carrying amount of the assetis reduced to its estimated fair value. Deterioration of our business in ageographic region or within a business segment in the future could also lead toimpairment adjustments as such issues are identified.

 

**Recently IssuedAccounting Standards**

 

*Accounting for Costs Associated with Exit or Disposal Activities*.  InJune 2002, the Financial Accounting Standards Board issued Statement ofFinancial Accounting Standards No. 146, or SFAS 146, “Accounting for CostsAssociated with Exit or Disposal Activities,” which addresses accounting forrestructuring and similar costs.  SFAS146 supersedes previous accounting guidance, principally Emerging Issues TaskForce, or EITF, Issue No. 94-3.  Weadopted the provisions of SFAS 146 for restructuring activities initiated afterDecember 31, 2002.  SFAS 146 requiresthat the liability for costs associated with an exit or disposal activity berecognized when the liability is incurred. Under EITF Issue No. 94-3, a liability for an exit costs was recognizedat the date of a company’s commitment to an exit plan.  SFAS 146 also establishes that the liabilityshould initially be measured and recorded at fair value.  Accordingly, SFAS 146 may affect the timingof recognizing future restructuring costs as well as the amounts recognized.

 

*Accounting for Stock-Based Compensation*.  In December 2002, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 148, or SFAS 148, “Accounting for Stock-Based Compensation – Transition andDisclosure – an Amendment of FASB Statement No. 123,” which providesalternative methods of transition for a voluntary change to the fair valuebased method of accounting for stock-based employee compensation.  In addition, SFAS 148 amends the disclosurerequirements of SFAS No. 123 to require prominent disclosures in both annualand interim financial statements about the method of accounting for stock-basedemployee compensation and the effect of the method used on reportedresults.  In the fourth quarter of 2002,we adopted the amended disclosure requirements of SFAS 148.

 

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*Accounting and Disclosure Requirements for Guarantees*.  In November 2002, the Financial Accounting Standards Board issued FASBInterpretation No. 45, or FIN 45, “Guarantor’s Accounting and DisclosureRequirement for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers.”  FIN 45 requires that uponissuance of a guarantee, the guarantor must recognize a liability for the fairvalue of the obligation it assumes under that guarantee.  The disclosure provisions of FIN 45 areeffective for financial statements of interim or annual periods that end afterDecember 15, 2002.  The provisions forinitial recognition and measurement are effective on a prospective basis forguarantees that are issued or modified after December 31, 2002, irrespective ofa guarantor’s year-end.  We have not yetdetermined the impact of the adoption of the recognition provisions of FIN 45on our results of operations or financial position.

 

*Revenue Arrangements with Multiple Deliverables*.  In November 2002, the EITF reached a consensus on EITF Issue No. 00-21,or EITF No. 00-21, “Revenue Arrangements with Multiple Deliverables.”  EITF No. 00-21 addresses certain aspects ofthe accounting by a vendor for arrangements under which the vendor will performmultiple revenue generating activities. EITF No. 00-21 will be effective for fiscal periods beginning afterJune 15, 2003.  We have not yetdetermined the impact of the adoption of EITF No. 00-21 on our results ofoperations or financial position.

 

**ITEM 7A. QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

Our international system sales and maintenance contracts are generallydenominated in U.S. dollars. In instances where there are significantinternational system sales contracts denominated in a foreign currency, weenter into forward contracts to mitigate foreign exchange risk. We do not enterinto market risk sensitive instruments for trading purposes. During the yearended December 31, 2002, we entered into foreign exchange forwardcontracts with notional values of approximately $43.6 million to hedgeagainst foreign exchange risk for contracts with international customersdenominated in euros and, at December 31, 2002, had outstanding contractswith notional values totaling $34.7 million with a negative fair value ofapproximately $4.9 million. The following table depicts the maturities of the outstandingcontract amounts:

 
| **Contract Maturity** |   | **Within 3  Months** |   | **4-6  Months** |   | **7-9  Months** |   | **10-12  Months** |   |
|-----------------------|--------|----------------------|--------|-----------------|--------|-----------------|--------|-------------------|--------|
| Amount (in thousands) |   | $                    | 13,884 |            | $      | 18,020          |   | $                 | 2,653  | ** ** | **$** | 99 | ** ** |
|                       |        |                      |        |                 |        |                 |        |                   |        |  |  |  |  |

 

Purchases of raw materials and other inventory components are primarilydenominated in U.S dollars and, when purchased in foreign currencies, aregenerally made on an as needed basis. We have some advance purchase commitmentsin foreign currencies with a few European suppliers. We currently do not hedgeagainst these purchase commitments, as the foreign exchange rate fluctuationshave not had a material adverse impact on these purchases; however, we willcontinue to monitor the foreign exchange rates and may enter into forwardcontracts to mitigate foreign exchange risk as appropriate.

 

Certain costs of providing warranty and maintenance services forsystems sold to foreign countries are denominated in local currencies. To theextent exchange rates fluctuate, it could become more expensive to providethese services. To date, these costs have not been significant; however, weexpect they will increase as our installed base increases.

 

Weare exposed to foreign currency exchange rate risk inherent in our salescommitments, anticipated sales, anticipated purchases and assets andliabilities denominated in currencies other than the U.S. dollar. We transactbusiness in 3 currencies worldwide, of which the most significant to ouroperations is the euro. In some situations, we are a net receiver of foreigncurrencies and therefore benefit from a weaker U.S. dollar and are adverselyaffected by a stronger U.S. dollar relative to those foreign currencies inwhich we transact significant amounts of business. We have performed asensitivity analysis as of December 31, 2002, using a modeling techniquethat measures the change in the fair values arising from a hypothetical 10% and15% adverse movement in the levels of foreign currency exchange rates relativeto the U.S. dollar (that is, strengthening of the U.S. dollar) with all othervariables held constant. The analysis covers all of our foreign exchangeforward contracts offset by the underlying exposures.

 

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Theforeign currency exchange rates used were based on market rates in effect atDecember 31, 2002.  The cashflow impacts of the sensitivity analysis are summarized in the following table:

 
|                                |   |               |   | **Fair Value asof Dec. 31,2002** |   | **Cash flow impact of changein exchange rates** |   |
|-------------------------------------|--------|--------------------|--------|----------------------------------|--------|-------------------------------------------------|--------|
|                                |   | **ContractAmount** |   |                             |   |
| **(in thousands)**                  |   |               |   | **10% Change**                   |   | **15% Change**                                  |   |
|                                |   |               |   |                             |   |                                            |   |   |   |
| Foreign  currency forward contracts |   | $                  | 34,656 |                             | $      | (4,948                                          | )      | $ | 3,973 |   | $ | 5,960 |   |
| Accounts  receivable                |   | 13,216             |   | 14,803                           |   | (1,480                                          | )      | (2,220 | ) |
| Firm  orders*                       |   | 24,123             |   | 27,390                           |   | (2,739                                          | )      | (4,109 | ) |
| Net  accounts payable               |   | (835               | )      | (1,022                           | )      | 102                                             |   | 153 |   |
| total                               |   |               |   |                             |   | $                                               | (144   | ) | $ | (216 | ) |
|                                     |        |                    |        |                                  |        |                                                 |        |  |  |  |  |  |  |

 

----

* Firm orders represent orders for which we have received a signedpurchase order.

 

The cash flow impact of changes in exchange rates at December 31, 2002is not significantly different from the cash flow impact of changes in exchangerates at December 31, 2001.  We do notexpect the impact of changes in interest rates to have a material impact on ouroperations, cash flow or liquidity.  Inaddition, the impact of inflation has not been material on our operations, cashflow or liquidity to date.

 

**ITEM 8. FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

Our consolidated financial statements and notes thereto andsupplementary financial data appear on pages F-1 to F-27 of this annual reportand are incorporated by reference herein.

 

Consistentwith Section 10A(i)(2) of the Securities Exchange Act of 1934, as added bySection 202 of the Sarbanes-Oxley Act of 2002, we are responsible forlisting the non-audit services approved by our Audit Committee to be performedby Deloitte & Touche LLP, our external auditor. Non-audit services aredefined as services other than those provided in connection with an audit or areview of our financial statements. The Audit Committee approved recurringengagements of Deloitte & Touche LLP for the following non-audit services:

 

•                  assurance services, which includes(1) filing work performed in connection with the filing of registrationstatements, and (2) the issuance of various consents;

 

•                  tax services, which includes consultingrelated to (1) federal, state and local tax issues, (2) internationaltax issues, and (3) value added tax issues performed in certain foreigncountries;

 

•                  consulting services, which includes thereview of our business processes; and

 

•                  merger andacquisition services, which includes (1) due diligence services, and(2) consulting related to the structuring of mergers and acquisitions.

 

**ITEM 9. CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

Not applicable.

 

41

----

 

**PART III.**

 

**ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OFTHE REGISTRANT**

 

The information about directors that is required by this item isincorporated by reference to our proxy statement to be delivered tostockholders in connection with our 2003 Annual Meeting of Stockholders in thesection entitled “Proposal 1.” Information about executive officers that isrequired by this item can be found in Item 4A.

 

**ITEM 11. EXECUTIVE COMPENSATION**

 

Information with respect to this item may be found in the sectioncaptioned “Executive Compensation” and “Compensation Committee Interlocks andInsider Participation” appearing in our proxy statement to be delivered tostockholders in connection with our 2003 Annual General Meeting ofStockholders. Such information is incorporated by reference.

 

**ITEM12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATEDSTOCKHOLDER MATTERS**

 

Information with respect to this item may be found in the sectioncaptioned “Security Ownership of Certain Beneficial Owners and Management” and“Stock Option Grants and Exercises” appearing in our proxy statement to bedelivered to stockholders in connection with our 2003 Annual General Meeting ofStockholders. Such information is incorporated by reference.

 

**ITEM 13. CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

 

Information with respect to this item may be found in the sectioncaptioned “Certain Relationships and Related Transactions” appearing in ourproxy statement to be delivered to stockholders in connection with our 2003Annual General Meeting of Stockholders. Such information is incorporated byreference.

 

**ITEM 14. CONTROLS AND PROCEDURES**

 

Within ninety days prior to the date of this Form 10-K, we carried outan evaluation, under the supervision and with the participation of Sergio Magistri,our principal executive officer, and Ross Mulholland, our principal financialofficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures. Based on this evaluation, Messrs. Magistri andMulholland concluded that our disclosure controls and procedures are effectiveat recording, processing, summarizing and reporting, within the time periodsspecified in the SEC’s rules and forms, the information included in ourperiodic SEC reports. It should be noted that a control system, no matter howwell conceived and operated, can provide only reasonable, not absolute,assurance that the objectives of the control system are met. Further, thedesign of a control system must reflect the fact that there are resourceconstraints, and the benefits of controls must be considered relative to theircosts. Additionally, controls can be circumvented by the individual acts ofsome persons, by collusion of two or more people or by management override ofthe control. The design of any system of controls also is based in part uponcertain assumptions about the likelihood of future events, and we cannot assureinvestors that any design will succeed in achieving its stated goals under allpotential future conditions. Because of the inherent limitations in acost-effective control system, misstatements due to error or fraud may occurand not be detected.

 

In addition, there have been no significant changes in our internalcontrols or in other factors that could significantly affect those controlssubsequent to the date of their last evaluation.

 

42

----

 

**PART IV.**

 

**ITEM 15****. EXHIBITS,FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K**

 

**(a)(1) Financial Statements**

 

The consolidated financial statements required by this item aresubmitted in a separate section beginning on page F-1 immediately following thesignature page of this report and are incorporated by reference herein.

 
| Deloitte & Touche LLP, Independent Auditors’ Report                                          |
|------------------------------------------------------------------------------------------------------------|
| Consolidated Balance Sheets as of December 31, 2002 and 2001                                               |
| Consolidated Statements of Operations for the Years Ended December  31, 2002, 2001 and 2000                |
| Consolidated Statements of Cash Flows for the Years Ended December  31, 2002, 2001 and 2000                |
| Consolidated Statements of Stockholders’ Equity for the Years Ended  December 31, 2002, 2001 and 2000 |
| Notes to Consolidated Financial Statements                                                                 |

 

**(a)(2) FinancialStatement Schedule**

 
| II—Valuation and Qualifying Accounts |
|-------------------------------------------|

 

The schedule listed above is set forth immediately following the consolidatedfinancial statements following the signature page of this report and isincorporated by reference herein. Schedules not listed above have been omittedbecause they are not applicable or the required information is shown in theconsolidated financial statements or in the notes thereto.

 

**(a)(3)    Exhibits**

 
| 3.1    |   | Amended and Restated Certificate of Incorporation of the  registrant.(1)                                                                                              |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                  |
| 3.2    |   | Bylaws of the registrant, as amended.(2)                                                                                                                              |
|   |   |                                                                                                                                                                  |
| 3.3    |   | Amendment to Amended and Restated Certificate of Incorporation of the  registrant.(3)                                                                                 |
|   |   |                                                                                                                                                                  |
| 4.1    |   | Reference is made to Exhibits 3.1 through 3.3.                                                                                                                        |
|   |   |                                                                                                                                                                  |
| 10.1   |   | Technology License Agreement, dated September 11, 1990, by and  between the registrant and Imatron, Inc.(4)                                                 |
|   |   |                                                                                                                                                                  |
| 10.2   |   | Registrant’s 2000 Equity Incentive Plan, as amended.(5)(16)                                                                                                      |
|   |   |                                                                                                                                                                  |
| 10.3   |   | Registrant’s 2002 Employee Stock Purchase Plan.(6)(16)                                                                                                           |
|   |   |                                                                                                                                                                  |
| 10.4   |   | Lease, dated as of February 11, 1997, between the registrant and  WHLNF Real Estate L.P.(7)                                                                      |
|   |   |                                                                                                                                                                  |
| 10.5   |   | Purchase Agreement, dated as of December 24, 1996, between the  registrant and the U.S. Federal Aviation Administration.(7)                                      |
|   |   |                                                                                                                                                                  |
| 10.6   |   | Amendment No. 1 to Technology License Agreement between the  registrant and Imatron, Inc. dated July 12, 1999.(8)                                      |
|   |   |                                                                                                                                                                  |
| 10.7   |   | Form of Indemnity Agreement between the registrant and each of Sergio  Magistri, David Pillor, Giovanni Lanzara, Bruno Trezza, Douglas Boyd and  Morris Busby.(8)(16) |
|   |   |                                                                                                                                                                  |
| 10.8   |   | Registrant’s 1991 Equity Incentive Plan.(9)(16)                                                                                                                  |
|   |   |                                                                                                                                                                  |
| 10.9   |   | Registrant’s 2000 Non-Officer Equity Incentive Plan, adopted  February 14, 2000.(9)                                                                         |
|   |   |                                                                                                                                                                  |
| 10.10  |   | Loan and Security Agreement, dated November 8, 2000, between the  registrant and Silicon Valley Bank.(10)                                                        |

 

43

----

 
| 10.11  |   | Loan and Security Agreement (Exim Program), dated November 8,  2000, between the registrant and Silicon Valley Bank.(10)          |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                   |
| 10.12  |   | Form of Indemnity Agreement between the registrant and each of Donald  E. Mattson and Ross Mulholland.(11)(16)                         |
|   |   |                                                                                                                                   |
| 10.13  |   | Amendment to Loan Documents, dated October 12, 2001, between the  registrant and Silicon Valley Bank.(12)                         |
|   |   |                                                                                                                                   |
| 10.14  |   | Amendment to Loan Documents (EXIM Program), dated October 12,  2001, between the registrant and Silicon Valley Bank.(12)          |
|   |   |                                                                                                                                   |
| 10.15  |   | Director Retainer Agreement, dated August 1, 2001, between the  registrant and Louis A. Turpen.(12)                               |
|   |   |                                                                                                                                   |
| 10.16  |   | Director Retainer Agreement, dated May 30, 2001, between the  registrant and Stephen Blum.(12)                                    |
|   |   |                                                                                                                                   |
| 10.17  |   | Warrant to Purchase Common Stock of the registrant, dated  September 26, 2001, to Donald & Co. Securities, Inc.(12) |
|   |   |                                                                                                                                   |
| 10.18  |   | Letter Contract between the registrant and the TSA, dated February  19, 2002.(13)(17)                                                  |
|   |   |                                                                                                                                   |
| 10.19  |   | Delivery Order #2 from the TSA.(13)(17)                                                                                                |
|   |   |                                                                                                                                   |
| 10.20  |   | Delivery Order #3 from the TSA.(13)(17)                                                                                                |
|   |   |                                                                                                                                   |
| 10.21  |   | Amendment to Loan Documents, dated March 4, 2002, between the  registrant and Silicon Valley Bank.(13)                                 |
|   |   |                                                                                                                                   |
| 10.22  |   | Amendment to Loan Documents (EXIM Program), dated March 4, 2002,  between the registrant and Silicon Valley Bank.(13)                  |
|   |   |                                                                                                                                   |
| 10.23  |   | Amended Delivery Order #2 from the TSA.(14)(17)                                                                                        |
|   |   |                                                                                                                                   |
| 10.24  |   | Amended Delivery Order #3 from the TSA.(14)(17)                                                                                        |
|   |   |                                                                                                                                   |
| 10.25  |   | Delivery Order #4 from the TSA.(14)(17)                                                                                                |
|   |   |                                                                                                                                   |
| 10.26  |   | Amendment to Delivery Order #2.(14)                                                                                                    |
|   |   |                                                                                                                                   |
| 10.27  |   | Amendment to Delivery Order #3.(14)                                                                                                    |
|   |   |                                                                                                                                   |
| 10.28  |   | Agreement for Products and Services between the registrant and  CoorsTek, Inc., dated June 10, 2002.(14)(17)                           |
|   |   |                                                                                                                                   |
| 10.29  |   | First Amendment to Lease Agreement, dated December 10, 1997, between  the registrant and WHLNF Real Estate Limited Partnership.(14)    |
|   |   |                                                                                                                                   |
| 10.30  |   | Second Amendment to Lease Agreement, dated July 1, 2002, between the  registrant and DMV SUB 4 LLC.(14)                                |
|   |   |                                                                                                                                   |
| 10.31  |   | Change in Control Equity Acceleration Plan.(15)(16)                                                                                    |
|   |   |                                                                                                                                   |
| 10.32  |   | Senior Management Key Employee Agreement dated as of September 20,  2002 between the registrant and Sergio Magistri.(15)(16)           |
|   |   |                                                                                                                                   |
| 10.33  |   | Senior Management Key Employee Agreement dated as of September 20,  2002 between the registrant and David Pillor.(15)(16)              |
|   |   |                                                                                                                                   |
| 10.34  |   | Senior Management Key Employee Agreement dated as of September 29,  2002 between the registrant and Ross Mulholland.(15)(16)           |
|   |   |                                                                                                                                   |
| 10.35  |   | Senior Management Key Employee  Agreement dated as of September 20, 2002 between the registrant and Don  Mattson.(15)(16)              |
|   |   |                                                                                                                                   |
| 10.36  |   | Amendment to Loan Documents dated as of July 19, 2002 between the  registrant and Silicon Valley Bank.(15)                             |

 

44

----

 
| 10.37  |   | Amendment to Loan Documents (EXIM Program) dated as of July 19, 2002  between the registrant and Silicon Valley Bank.(15)                        |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                             |
| 10.38  |   | Delivery Order DO#5 from the TSA.(15)(17)                                                                                                        |
|   |   |                                                                                                                                             |
| 10.39  |   | Delivery Order DO#6 from the TSA.(15)(17)                                                                                                        |
|   |   |                                                                                                                                             |
| 10.40  |   | Single-Tenant Net Lease Agreement executed on October 4, 2002 between  Carmel Mountain #8 Associates, L.P. and Quantum Magnetics, Inc.           |
|   |   |                                                                                                                                             |
| 10.41  |   | Revision No. 1 to Agreement for Products and Services dated as of  January 24, 2003 between the registrant and CoorsTek, Inc.(17)                |
|   |   |                                                                                                                                             |
| 10.42  |   | Support and Maintenance Agreement executed on January 24, 2003  between the registrant and Siemens Explosive-Detection Field Services,  LLC.(17) |
|   |   |                                                                                                                                             |
| 21.1   |   | Subsidiaries of the registrant.                                                                                                                  |
|   |   |                                                                                                                                             |
| 23.1   |   | Consent of Deloitte & Touche LLP, Independent Auditors.                                                                                 |
|   |   |                                                                                                                                             |
| 99.1   |   | Certificate of Chief Executive Officer and Chief Financial Officer.                                                                              |

 

----

(1)                      Filed as an exhibit to theregistrant’s Registration Statement on Form S-1 (No. 333-05517) andincorporated herein by reference.

 

(2)                      Filed as an exhibit to theregistrant’s Amendment No. 1 to Annual Report on Form 10-K/A for the yearended December 31, 2001 and incorporated herein by reference.

 

(3)                      Filed as an exhibit to the registrant’sAnnual Report on Form 10-K for the year ended December 31, 2001 andincorporated herein by reference.

 

(4)                      Filed as an exhibit to theregistrant’s Registration Statement on Form S-1 (No. 333-380) andincorporated herein by reference.

 

(5)                      Filed as an exhibit to theregistrant’s Registration Statement on Form S-8 (No. 333-103016)filed February 6, 2003 and incorporated herein by reference.

 

(6)                      Filed as an exhibit to theregistrant’s Registration Statement on Form S-8 (No. 333-91154) filedJune 25, 2002 and incorporated herein by reference.

 

(7)                      Filed as an exhibit to theregistrant’s Registration Statement on Form S-1 (No. 333-23413) andincorporated herein by reference.

 

(8)                      Filed as an exhibit to theregistrant’s Annual Report on Form 10-K for the year endedDecember 31, 1999 and incorporated herein by reference.

 

(9)                      Filed as an exhibit to theregistrant’s Registration Statement on Form S-8 (No. 333-56340) filedFebruary 28, 2001 and incorporated herein by reference.

 

(10)                Filed as an exhibit to the registrant’sQuarterly Report on Form 10-Q for the quarterly period endedOctober 1, 2000 and incorporated herein by reference.

 

(11)                Filed as an exhibit to the registrant’sQuarterly Report on Form 10-Q for the quarterly period ended April 1, 2001and incorporated herein by reference.

 

(12)                Filed as an exhibit to registrant’sQuarterly Report on Form 10-Q for the quarterly period endedSeptember 30, 2001 and incorporated herein by reference.

 

(13)                Filed as an exhibit to the registrant’sQuarterly Report on Form 10-Q for the quarterly period endedMarch 31, 2002 and incorporated herein by reference.

 

(14)                Filed as an exhibit to the registrant’sQuarterly Report on Form 10-Q for the quarterly period ended June 30, 2002and incorporated herein by reference.

 

(15)                Filed as an exhibit to the registrant’sQuarterly Report on Form 10-Q for the quarterly period ended September 29,2002 and incorporated herein by reference.

 

45

----

 

(16)                Items that are management contracts orcompensatory plans or arrangements required to be filed as exhibits pursuant toItem 15(c) of Form 10-K.

 

(17)                Confidential treatment has beenrequested for portions of this exhibit.

 

**(b)****                                  Reportson Form 8-K**

 

We did not file any Current Reports on Form 8-K in the quarterended December 31, 2002.

 

**(c)****                                  SeeExhibits listed under Item 15(a)(3).**

 

**(d)****                                  Thefinancial statement schedules required by the Item are listed under Item15(a)(2).**

 

46

----

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has duly caused this AnnualReport on Form 10-K to be signed on its behalf by the undersigned,thereunto duly authorized, on the 27th day of March 2003.

 
|   | **INVISION  TECHNOLOGIES, INC.** |                                  |   |
|--------|---------------------------------------|---------------------------------------|--------|
|   |                                  |                                  |   |   |
|   |                                  |                                  |   |   |
|   | By:                                   | /s/ SERGIO MAGISTRI              |   |   |
|   |                                  | Sergio Magistri                       |   |   |
|   |                                  | President and Chief Executive Officer |   |   |
|        |                                       |                                       |        |  |  |

 

**POWEROF ATTORNEY**

 

Each person whose signature appears below constitutes and appointsSergio Magistri and Ross Mulholland, his true and lawful attorney-in-fact andagent, each acting alone, with full power of substitution and resubstitution,for him and in his name, place and stead, in any and all capacities, to signany or all amendments to the Annual Report on Form 10-K and to file thesame, with all exhibits thereto, and all documents in connection therewith,with the Securities and Exchange Commission, granting unto saidattorney-in-fact and agent, full power and authority to do and perform each andevery act and thing requisite and necessary to be done in and about thepremises, as fully to all intents and purposes as he might or could do inperson, hereby ratifying and confirming all that said attorney-in-fact andagent, or his substitute or substitutes, may lawfully do or cause to be done byvirtue hereof.

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theregistrant in the capacities and on the dates indicated. 

 
| **Signature**            |   | **Title**                                                                                       |   | **Date**       |
|--------------------------|--------|-------------------------------------------------------------------------------------------------|--------|----------------|
|                     |   |                                                                                            |   |           |
| /s/ SERGIO MAGISTRI |   | President, Chief Executive Officer and  Director (Principal Executive Officer)                  |   | March 27, 2003 |
| Sergio Magistri          |   |                                                                                            |   |
|                     |   |                                                                                            |   |           |
| /s/ ROSS MULHOLLAND |   | Senior Vice President and Chief Financial  Officer (Principal Financial and Accounting Officer) |   | March 27, 2003 |
| Ross Mulholland          |   |                                                                                            |   |
|                     |   |                                                                                            |   |           |
|                     |   |                                                                                            |   |           |
| /s/ DAVID M. PILLOR |   | Senior Vice President, Sales and Marketing,  and Director                                       |   | March 27, 2003 |
| David M. Pillor          |   |                                                                                            |   |
|                     |   |                                                                                            |   |           |
|                     |   | Chairman of the Board of Directors                                                              |   |           |
| Giovanni Lanzara         |   |                                                                                            |   |           |
|                     |   |                                                                                            |   |           |
|                     |   |                                                                                            |   |           |
| /s/ STEPHEN BLUM    |   | Director                                                                                        |   | March 27, 2003 |
| Stephen Blum             |   |                                                                                            |   |           |
|                     |   |                                                                                            |   |           |
| /s/ DOUGLAS P. BOYD |   | Director                                                                                        |   | March 27, 2003 |
| Douglas P. Boyd          |   |                                                                                            |   |           |
|                     |   |                                                                                            |   |           |
| /s/ BRUNO TREZZA    |   | Director                                                                                        |   | March 27, 2003 |
| Bruno Trezza             |   |                                                                                            |   |           |

 

47

----

 
| /s/ LOUIS A. TURPEN |   | Director |   | March 27, 2003 |
|--------------------------|--------|----------|--------|----------------|
| Louis A. Turpen          |   |     |   |           |
|                     |   |     |   |           |
| /s/ MORRIS BUSBY    |   | Director |   | March 27, 2003 |
| Morris Busby             |   |     |   |           |

 

48

----

 

# **CERTIFICATION**

 

I, Sergio Magistri, certify that:

 

1.  I have reviewed this annual report on Form 10-K ofInVision Technologies, Inc.;

 

2.  Based on my knowledge, this annual report does notcontain any untrue statement of a material fact or omit to state a materialfact necessary to make the statements made, in light of the circumstances underwhich such statements were made, not misleading with respect to the periodcovered by this annual report;

 

3.  Based on my knowledge, the financial statements, andother financial information included in this annual report, fairly present inall material respects the financial condition, results of operations and cashflows of the registrant as of, and for, the periods presented in this annualreport;

 

4.  The registrant’s other certifying officer and I are responsiblefor establishing and maintaining disclosure controls and procedures (as definedin Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

 

(a)                      designed such disclosure controlsand procedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this annual report isbeing prepared;

 

(b)                     evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and

 

(c)                      presented in this annual reportour conclusions about the effectiveness of the disclosure controls andprocedures based on our evaluation as of the Evaluation Date;

 

5.  The registrant’s other certifying officer and I havedisclosed, based on our most recent evaluation, to the registrant’s auditorsand the audit committee of registrant’s board of directors (or persons performingthe equivalent functions):

 

(a)                      all significant deficiencies inthe design or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and

 

(b)                     any fraud, whether or notmaterial, that involves management or other employees who have a significantrole in the registrant’s internal controls; and

 

6.  The registrant’s other certifying officer and I haveindicated in this annual report whether there were significant changes ininternal controls or in other factors that could significantly affect internalcontrols subsequent to the date of our most recent evaluation, including anycorrective actions with regard to significant deficiencies and materialweaknesses.

 
| Date: March 27, 2003 |                                                                 |
|----------------------|----------------------------------------------------------------------|
|                 |                                                                 |
|                 |                                                                 |
|                 | /s/ Sergio Magistri                                                  |   |
|                 | Sergio Magistri                                                      |
|                 | President and Chief Executive Officer  (Principal Executive Officer) |

 

49

----

 

# **C**ERTIFICATION

 

I, Ross Mulholland, certify that:

 

1.  I have reviewed this annual report on Form 10-K ofInVision Technologies, Inc.;

 

2.  Based on my knowledge, this annual report does notcontain any untrue statement of a material fact or omit to state a materialfact necessary to make the statements made, in light of the circumstances underwhich such statements were made, not misleading with respect to the periodcovered by this annual report;

 

3.  Based on my knowledge, the financial statements, andother financial information included in this annual report, fairly present inall material respects the financial condition, results of operations and cashflows of the registrant as of, and for, the periods presented in this annual report;

 

4.  The registrant’s other certifying officer and I areresponsible for establishing and maintaining disclosure controls and procedures(as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant andhave:

 

(a)                      designed such disclosure controlsand procedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this annual report isbeing prepared;

 

(b)                     evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and

 

(c)                      presented in this annual reportour conclusions about the effectiveness of the disclosure controls andprocedures based on our evaluation as of the Evaluation Date;

 

5.  The registrant’s othercertifying officer and I have disclosed, based on our most recent evaluation,to the registrant’s auditors and the audit committee of registrant’s board ofdirectors (or persons performing the equivalent functions):

 

(a)                      all significant deficiencies inthe design or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and

 

(b)                     any fraud, whether or notmaterial, that involves management or other employees who have a significantrole in the registrant’s internal controls; and

 

6.  The registrant’s other certifying officer and I haveindicated in this annual report whether there were significant changes ininternal controls or in other factors that could significantly affect internalcontrols subsequent to the date of our most recent evaluation, including anycorrective actions with regard to significant deficiencies and materialweaknesses.

 
| Date: March 27, 2003 |                                                   |
|----------------------|--------------------------------------------------------|
|                 |                                                   |
|                 | /s/ Ross Mulholland                                    |   |
|                 | Ross Mulholland                                        |
|                 | Chief Financial Officer  (Principal Financial Officer) |

 

50

----

 

**EXHIBITINDEX**

 
| 3.1    |   | Amended and Restated Certificate of Incorporation of the  registrant.(1)                                                                                              |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                  |
| 3.2    |   | Bylaws of the registrant, as amended.(2)                                                                                                                              |
|   |   |                                                                                                                                                                  |
| 3.3    |   | Amendment to Amended and Restated Certificate of Incorporation of the  registrant.(3)                                                                                 |
|   |   |                                                                                                                                                                  |
| 4.1    |   | Reference is made to Exhibits 3.1 through 3.3.                                                                                                                        |
|   |   |                                                                                                                                                                  |
| 10.1   |   | Technology License Agreement, dated September 11, 1990, by and  between the registrant and Imatron, Inc.(4)                                                 |
|   |   |                                                                                                                                                                  |
| 10.2   |   | Registrant’s 2000 Equity Incentive Plan, as amended.(5)(16)                                                                                                      |
|   |   |                                                                                                                                                                  |
| 10.3   |   | Registrant’s 2002 Employee Stock Purchase Plan.(6)(16)                                                                                                           |
|   |   |                                                                                                                                                                  |
| 10.4   |   | Lease, dated as of February 11, 1997, between the registrant and  WHLNF Real Estate L.P.(7)                                                                      |
|   |   |                                                                                                                                                                  |
| 10.5   |   | Purchase Agreement, dated as of December 24, 1996, between the  registrant and the U.S. Federal Aviation Administration.(7)                                      |
|   |   |                                                                                                                                                                  |
| 10.6   |   | Amendment No. 1 to Technology License Agreement between the  registrant and Imatron, Inc. dated July 12, 1999.(8)                                      |
|   |   |                                                                                                                                                                  |
| 10.7   |   | Form of Indemnity Agreement between the registrant and each of Sergio  Magistri, David Pillor, Giovanni Lanzara, Bruno Trezza, Douglas Boyd and  Morris Busby.(8)(16) |
|   |   |                                                                                                                                                                  |
| 10.8   |   | Registrant’s 1991 Equity Incentive Plan.(9)(16)                                                                                                                  |
|   |   |                                                                                                                                                                  |
| 10.9   |   | Registrant’s 2000 Non-Officer Equity Incentive Plan, adopted  February 14, 2000.(9)                                                                         |
|   |   |                                                                                                                                                                  |
| 10.10  |   | Loan and Security Agreement, dated November 8, 2000, between the  registrant and Silicon Valley Bank.(10)                                                        |
|   |   |                                                                                                                                                                  |
| 10.11  |   | Loan and Security Agreement (Exim Program), dated November 8,  2000, between the registrant and Silicon Valley Bank.(10)                                         |
|   |   |                                                                                                                                                                  |
| 10.12  |   | Form of Indemnity Agreement between the registrant and each of Donald  E. Mattson and Ross Mulholland.(11)(16)                                                        |
|   |   |                                                                                                                                                                  |
| 10.13  |   | Amendment to Loan Documents, dated October 12, 2001, between the  registrant and Silicon Valley Bank.(12)                                                        |
|   |   |                                                                                                                                                                  |
| 10.14  |   | Amendment to Loan Documents (EXIM Program), dated October 12,  2001, between the registrant and Silicon Valley Bank.(12)                                         |
|   |   |                                                                                                                                                                  |
| 10.15  |   | Director Retainer Agreement, dated August 1, 2001, between the  registrant and Louis A. Turpen.(12)                                                              |
|   |   |                                                                                                                                                                  |
| 10.16  |   | Director Retainer Agreement, dated May 30, 2001, between the  registrant and Stephen Blum.(12)                                                                   |
|   |   |                                                                                                                                                                  |
| 10.17  |   | Warrant to Purchase Common Stock of the registrant, dated  September 26, 2001, to Donald & Co. Securities, Inc.(12)                                |
|   |   |                                                                                                                                                                  |
| 10.18  |   | Letter Contract between the registrant and the TSA, dated February  19, 2002.(13)(17)                                                                                 |
|   |   |                                                                                                                                                                  |
| 10.19  |   | Delivery Order #2 from the TSA.(13)(17)                                                                                                                               |
|   |   |                                                                                                                                                                  |
| 10.20  |   | Delivery Order #3 from the TSA.(13)(17)                                                                                                                               |
|   |   |                                                                                                                                                                  |
| 10.21  |   | Amendment to Loan Documents, dated March 4, 2002, between the  registrant and Silicon Valley Bank.(13)                                                                |
|   |   |                                                                                                                                                                  |
| 10.22  |   | Amendment to Loan Documents (EXIM Program), dated March 4, 2002,  between the registrant and Silicon Valley Bank.(13)                                                 |
|   |   |                                                                                                                                                                  |
| 10.23  |   | Amended Delivery Order #2 from the TSA.(14)(17)                                                                                                                       |

 

51

----

 
| 10.24  |   | Amended Delivery Order #3 from the TSA.(14)(17)                                                                                                  |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                             |
| 10.25  |   | Delivery Order #4 from the TSA.(14)(17)                                                                                                          |
|   |   |                                                                                                                                             |
| 10.26  |   | Amendment to Delivery Order #2.(14)                                                                                                              |
|   |   |                                                                                                                                             |
| 10.27  |   | Amendment to Delivery Order #3.(14)                                                                                                              |
|   |   |                                                                                                                                             |
| 10.28  |   | Agreement for Products and Services between the Registrant and  CoorsTek, Inc., dated June 10, 2002.(14)(17)                                     |
|   |   |                                                                                                                                             |
| 10.29  |   | First Amendment to Lease Agreement, dated December 10, 1997, between  the registrant and WHLNF Real Estate Limited Partnership.(14)              |
|   |   |                                                                                                                                             |
| 10.30  |   | Second Amendment to Lease Agreement, dated July 1, 2002, between the  registrant and DMV SUB 4 LLC.(14)                                          |
|   |   |                                                                                                                                             |
| 10.31  |   | Change in Control Equity Acceleration Plan.(15)(16)                                                                                              |
|   |   |                                                                                                                                             |
| 10.32  |   | Senior Management Key Employee Agreement dated as of September 20,  2002 between the registrant and Sergio Magistri.(15)(16)                     |
|   |   |                                                                                                                                             |
| 10.33  |   | Senior Management Key Employee Agreement dated as of September 20,  2002 between the registrant and David Pillor.(15)(16)                        |
|   |   |                                                                                                                                             |
| 10.34  |   | Senior Management Key Employee Agreement dated as of September 29,  2002 between the registrant and Ross Mulholland.(15)(16)                     |
|   |   |                                                                                                                                             |
| 10.35  |   | Senior Management Key Employee  Agreement dated as of September 20, 2002 between the registrant and Don  Mattson.(15)(16)                        |
|   |   |                                                                                                                                             |
| 10.36  |   | Amendment to Loan Documents dated as of July 19, 2002 between the registrant  and Silicon Valley Bank.(15)                                       |
|   |   |                                                                                                                                             |
| 10.37  |   | Amendment to Loan Documents (EXIM Program) dated as of July 19, 2002  between the registrant and Silicon Valley Bank.(15)                        |
|   |   |                                                                                                                                             |
| 10.38  |   | Delivery Order DO#5 from the TSA.(15)(17)                                                                                                        |
|   |   |                                                                                                                                             |
| 10.39  |   | Delivery Order DO#6 from the TSA.(15)(17)                                                                                                        |
|   |   |                                                                                                                                             |
| 10.40  |   | Single-Tenant Net Lease Agreement executed on October 4, 2002 between  Carmel Mountain #8 Associates, L.P. and Quantum Magnetics, Inc.           |
|   |   |                                                                                                                                             |
| 10.41  |   | Revision No. 1 to Agreement for Products and Services dated as of  January 24, 2003 between the registrant and CoorsTek, Inc.(17)                |
|   |   |                                                                                                                                             |
| 10.42  |   | Support and Maintenance Agreement executed on January 24, 2003  between the registrant and Siemens Explosive-Detection Field Services,  LLC.(17) |
|   |   |                                                                                                                                             |
| 21.1   |   | Subsidiaries of the registrant.                                                                                                                  |
|   |   |                                                                                                                                             |
| 23.1   |   | Consent of Deloitte & Touche LLP, Independent Auditors.                                                                                 |
|   |   |                                                                                                                                             |
| 99.1   |   | Certificate of Chief Executive Officer and Chief Financial Officer.                                                                              |

 

----

(1)                      Filed as an exhibit to theregistrant’s Registration Statement on Form S-1 (No. 333-05517) andincorporated herein by reference.

 

(2)                      Filed as an exhibit to theregistrant’s Amendment No. 1 to Annual Report on Form 10-K/A for the yearended December 31, 2001 and incorporated herein by reference.

 

(3)                      Filed as an exhibit to theregistrant’s Annual Report on Form 10-K for the year endedDecember 31, 2001 and incorporated herein by reference.

 

52

----

 

(4)                      Filed as an exhibit to theregistrant’s Registration Statement on Form S-1 (No. 333-380) andincorporated herein by reference.

 

(5)                      Filed as an exhibit to theregistrant’s Registration Statement on Form S-8 (No. 333-103016)filed February 6, 2003 and incorporated herein by reference.

 

(6)                      Filed as an exhibit to theregistrant’s Registration Statement on Form S-8 (No. 333-91154) filedJune 25, 2002 and incorporated herein by reference.

 

(7)                      Filed as an exhibit to theregistrant’s Registration Statement on Form S-1 (No. 333-23413) andincorporated herein by reference.

 

(8)                      Filed as an exhibit to theregistrant’s Annual Report on Form 10-K for the year endedDecember 31, 1999 and incorporated herein by reference.

 

(9)                      Filed as an exhibit to theregistrant’s Registration Statement on Form S-8 (No. 333-56340) filedFebruary 28, 2001 and incorporated herein by reference.

 

(10)                Filed as an exhibit to the registrant’sQuarterly Report on Form 10-Q for the quarterly period endedOctober 1, 2000 and incorporated herein by reference.

 

(11)                Filed as an exhibit to the registrant’sQuarterly Report on Form 10-Q for the quarterly period ended April 1, 2001and incorporated herein by reference.

 

(12)                Filed as an exhibit to registrant’sQuarterly Report on Form 10-Q for the quarterly period endedSeptember 30, 2001 and incorporated herein by reference.

 

(13)                Filed as an exhibit to the registrant’sQuarterly Report on Form 10-Q for the quarterly period endedMarch 31, 2002 and incorporated herein by reference.

 

(14)                Filed as an exhibit to the registrant’sQuarterly Report on Form 10-Q for the quarterly period ended June 30, 2002and incorporated herein by reference.

 

(15)                Filed as an exhibit to the registrant’sQuarterly Report on Form 10-Q for the quarterly period ended September 29,2002 and incorporated herein by reference.

 

(16)                Items that are management contracts orcompensatory plans or arrangements required to be filed as exhibits pursuant toItem 15(c) of Form 10-K.

 

(17)                Confidential treatment has beenrequested for portions of this exhibit.

 

53

----

 

**INDEPENDENT AUDITORS’REPORT**

 

To the Board of Directors and Stockholders ofInVision Technologies, Inc.

 

We have audited the accompanying consolidated balance sheets ofInVision Technologies, Inc. and subsidiaries (the “Company”) as of December 31,2002 and 2001, and the related consolidated statements of operations,stockholders’ equity, and cash flows for each of the three years in the periodended December 31, 2002.  Our auditsalso included the financial statement schedule listed in the Index at Item 15(a)(2).  These financial statements and financialstatement schedule are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial 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 overall financialstatement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly,in all material respects, the financial position of InVision Technologies, Inc.and subsidiaries at December 31, 2002 and 2001, and the results of theiroperations and their cash flows for each of the three years in the period endedDecember 31, 2002, in conformity with accounting principles generally acceptedin the United States of America.  Also,in our opinion, such financial statement schedule, when considered in relationto the basic consolidated financial statements taken as a whole, presentsfairly in all material respects the information set forth therein.

 

As discussed in Note 2 to the financial statements, in 2002 the Companychanged its method of accounting for goodwill and other intangible assets toconform to Statement of Financial Accounting Standards No. 142, “Goodwill andOther Intangible Assets.”

 

 
| /s/ DELOITTE & TOUCHE LLP     |   |   |
|-----------------------------------|--------|--------|
|                              |   |
| San Jose, California              |   |
| February 11, 2003                 |   |
| (February 21, 2003 as to Note 16) |   |

 

F-1

----

 

**InVision Technologies, Inc.Consolidated Balance Sheets(In thousands, except share data)**

 
|                                                                                                                                                                 |   | **December  31,** |    |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|---------|
|                                                                                                                                                                 |   | **2002**          |    | **2001** |   |
|                                                                                                                                                                 |   |              |    |   |   |
| **Assets**                                                                                                                                                           |   |              |    |   |   |
|                                                                                                                                                                 |   |              |    |   |   |
| Current assets:                                                                                                                                                      |   |              |    |   |   |
| Cash and cash equivalents                                                                                                                                            |   | $                 | 159,736 |   | $ | 11,386 |   |
| Short-term investments                                                                                                                                               |   | —            |    | 1,992 |   |
| Accounts receivable, net                                                                                                                                             |   | 146,295           |    | 27,239 |   |
| Inventories                                                                                                                                                          |   | 64,764            |    | 27,104 |   |
| Deferred income taxes                                                                                                                                                |   | 20,889            |    | 4,082 |   |
| Other current assets                                                                                                                                                 |   | 15,811            |    | 5,464 |   |
| Total current assets                                                                                                                                                 |   | 407,495           |    | 77,267 |   |
|                                                                                                                                                                 |   |              |    |   |   |
| Property and equipment, net                                                                                                                                          |   | 7,225             |    | 5,713 |   |
| Deferred income taxes                                                                                                                                                |   | 1,050             |    | 2,237 |   |
| Intangible assets, net                                                                                                                                               |   | 1,603             |    | 4,011 |   |
| Other assets                                                                                                                                                         |   | 414               |    | 505 |   |
| Total assets                                                                                                                                                         |   | $                 | 417,787 |   | $ | 89,733 |   |
|                                                                                                                                                                 |   |              |    |   |   |
| **Liabilities and stockholders’ equity**                                                                                                                        |   |              |    |   |   |
|                                                                                                                                                                 |   |              |    |   |   |
| Current liabilities:                                                                                                                                                 |   |              |    |   |   |
| Accounts payable                                                                                                                                                     |   | $                 | 28,477  |   | $ | 8,375 |   |
| Accrued liabilities                                                                                                                                                  |   | 65,364            |    | 12,822 |   |
| Deferred revenue                                                                                                                                                     |   | 86,284            |    | 4,377 |   |
| Short-term debt                                                                                                                                                      |   | 184               |    | 1,880 |   |
| Current maturities of long-term debt                                                                                                                                 |   | 112               |    | 179 |   |
| Total current liabilities                                                                                                                                            |   | 180,421           |    | 27,633 |   |
|                                                                                                                                                                 |   |              |    |   |   |
| Long-term liabilities                                                                                                                                                |   | 653               |    | 680 |   |
|                                                                                                                                                                 |   |              |    |   |   |
| Commitments and contingencies (Notes 5, 8  and 14)                                                                                                                   |   |              |    |   |   |
|                                                                                                                                                                 |   |              |    |   |   |
| Stockholders’ equity:                                                                                                                                           |   |              |    |   |   |
| Preferred stock, no par value, 5,000,000  shares authorized; no shares issued and outstanding                                                                        |   | —            |    | — |   |
| Common stock, $0.001 par value, 60,000,000  and 20,000,000 shares authorized; 17,243,000 and 13,730,000 shares issued;  17,008,000 and 13,539,000 shares outstanding |   | 17                |    | 14 |   |
| Additional paid-in capital                                                                                                                                           |   | 166,243           |    | 66,011 |   |
| Deferred stock compensation expense                                                                                                                                  |   | (406              | )       | — |   |
| Accumulated other comprehensive loss                                                                                                                                 |   | (1,783            | )       | — |   |
| Retained earnings (accumulated deficit)                                                                                                                              |   | 74,836            |    | (3,458 | ) |
| Treasury stock, at cost (235,000 and 191,000  shares)                                                                                                                |   | (2,194            | )       | (1,147 | ) |
| Total stockholders’ equity                                                                                                                                      |   | 236,713           |    | 61,420 |   |
| Total liabilities and stockholders’ equity                                                                                                                      |   | $                 | 417,787 |   | $ | 89,733 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

F-2

----

 

**InVision Technologies, Inc.Consolidated Statements ofOperations(In thousands, except per share data)**

 
|                                 |   | **Year Ended  December 31,** |    |
|--------------------------------------|--------|------------------------------|---------|
|                                 |   | **2002**                     |    | **2001** |   | **2000** |   |
|                                 |   |                         |    |   |   |   |   |
| Revenues:                            |   |                         |    |   |   |   |   |
| Product revenues                     |   | $                            | 411,426 |   | $ | 46,536 |   | $ | 58,713 |   |
| Service revenues                     |   | 15,622                       |    | 11,239 |   | 9,801 |   |
| Government contract revenues         |   | 12,083                       |    | 16,556 |   | 10,632 |   |
| Total revenues                       |   | 439,131                      |    | 74,331 |   | 79,146 |   |
|                                 |   |                         |    |   |   |   |   |
| Cost of revenues:                    |   |                         |    |   |   |   |   |
| Product costs                        |   | 234,767                      |    | 28,782 |   | 39,333 |   |
| Service costs                        |   | 10,761                       |    | 7,162 |   | 6,512 |   |
| Government contract costs            |   | 8,708                        |    | 13,010 |   | 7,849 |   |
| Total cost of revenues               |   | 254,236                      |    | 48,954 |   | 53,694 |   |
|                                 |   |                         |    |   |   |   |   |
| Gross profit                         |   | 184,895                      |    | 25,377 |   | 25,452 |   |
|                                 |   |                         |    |   |   |   |   |
| Operating expenses:                  |   |                         |    |   |   |   |   |
| Research and development             |   | 20,622                       |    | 7,979 |   | 11,039 |   |
| Selling, general and administrative  |   | 31,744                       |    | 14,727 |   | 16,551 |   |
| Total operating expenses             |   | 52,366                       |    | 22,706 |   | 27,590 |   |
|                                 |   |                         |    |   |   |   |   |
| Income (loss) from operations        |   | 132,529                      |    | 2,671 |   | (2,138 | ) |
| Interest expense                     |   | (399                         | )       | (289 | ) | (195 | ) |
| Interest and other income, net       |   | 38                           |    | 570 |   | 527 |   |
| Income (loss) before income taxes    |   | 132,168                      |    | 2,952 |   | (1,806 | ) |
|                                 |   |                         |    |   |   |   |   |
| Provision (benefit) for income taxes |   | 53,874                       |    | (4,571 | ) | — |   |
|                                 |   |                         |    |   |   |   |   |
| Net income (loss)                    |   | $                            | 78,294  |   | $ | 7,523 |   | $ | (1,806 | ) |
|                                 |   |                         |    |   |   |   |   |
| Net income (loss) per share:         |   |                         |    |   |   |   |   |
| Basic                                |   | $                            | 4.90    |   | $ | 0.58 |   | $ | (0.14 | ) |
| Diluted                              |   | $                            | 4.40    |   | $ | 0.52 |   | $ | (0.14 | ) |
|                                 |   |                         |    |   |   |   |   |
| Weighted average shares outstanding: |   |                         |    |   |   |   |   |
| Basic                                |   | 15,987                       |    | 12,998 |   | 12,510 |   |
| Diluted                              |   | 17,803                       |    | 14,343 |   | 12,510 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

F-3

----

 

**InVisionTechnologies, Inc.Consolidated Statements of Cash Flows(In thousands)**

 
|                                                                                               |   | **Year Ended December 31,** |       |
|----------------------------------------------------------------------------------------------------|--------|-----------------------------|------------|
|                                                                                               |   | **2002**                    |       | **2001** |   | **2000** |   |
| **Cash flows from operating  activities:**                                                         |   |                        | ** ** |   | ** ** |   | ** ** |
| Net income (loss)                                                                                  |   | $                           | 78,294     |   | $ | 7,523 |   | $ | (1,806 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities |   |                        |       |   |   |   |   |
| Depreciation and amortization                                                                      |   | 3,605                       |       | 3,816 |   | 3,754 |   |
| Deferred income taxes                                                                              |   | (14,393                     | )          | (5,822 | ) | (363 | ) |
| Loss on disposal of fixed assets                                                                   |   | 459                         |       | — |   | 107 |   |
| Bad debt expense                                                                                   |   | 170                         |       | 168 |   | 188 |   |
| Income tax benefit from employee stock  transactions                                               |   | 9,185                       |       | 2,160 |   | — |   |
| Stock compensation expense                                                                         |   | 829                         |       | 148 |   | 63 |   |
| Impairment of goodwill                                                                             |   | 2,100                       |       | — |   | — |   |
| Changes in operating assets and liabilities:                                                       |   |                        |       |   |   |   |   |
| Accounts receivable                                                                                |   | (118,415                    | )          | (4,860 | ) | (10,622 | ) |
| Inventories                                                                                        |   | (37,660                     | )          | (6,830 | ) | (2,193 | ) |
| Other assets                                                                                       |   | (10,953                     | )          | (2,568 | ) | 940 |   |
| Accounts payable                                                                                   |   | 20,102                      |       | 3,022 |   | (378 | ) |
| Accrued liabilities                                                                                |   | 50,159                      |       | 1,479 |   | 4,010 |   |
| Deferred revenues                                                                                  |   | 81,907                      |       | 2,239 |   | (3,005 | ) |
| Other liabilities                                                                                  |   | (8                          | )          | 44 |   | 90 |   |
| Net cash provided by (used in) operating  activities                                               |   | 65,381                      |       | 519 |   | (9,215 | ) |
| **Cash flows from investing  activities:**                                                         |   |                        |       |   |   |   |   |
| Purchases of property and equipment                                                                |   | (4,671                      | )          | (1,900 | ) | (2,652 | ) |
| Proceeds from (purchases of) short-term  investments, net                                          |   | 1,939                       |       | (1,992 | ) | 5,887 |   |
| Purchase of subsidiary, net of cash acquired                                                       |   | (183                        | )          | (267 | ) | (1,518 | ) |
| Net cash provided by (used in) investing  activities                                               |   | (2,915                      | )          | (4,159 | ) | 1,717 |   |
| **Cash flows from financing  activities:**                                                         |   |                        |       |   |   |   |   |
| Net proceeds from (repayments of) short-term debt                                                  |   | (1,696                      | )          | 990 |   | 890 |   |
| Repayments of long-term debt                                                                       |   | (195                        | )          | (403 | ) | (435 | ) |
| Proceeds from issuance of common stock, net                                                        |   | 87,775                      |       | 2,531 |   | 669 |   |
| Net cash provided by financing activities                                                          |   | 85,884                      |       | 3,118 |   | 1,124 |   |
| Net change in cash and cash equivalents for the  year                                              |   | 148,350                     |       | (522 | ) | (6,374 | ) |
| Cash and cash equivalents at beginning of year                                                     |   | 11,386                      |       | 11,908 |   | 18,282 |   |
| **Cash and cash equivalents at end  of year**                                                      |   | $                           | 159,736    |   | $ | 11,386 |   | $ | 11,908 |   |
| **Supplemental disclosures of cash  flow information:**                                            |   |                        |       |   |   |   |   |
| Interest paid                                                                                      |   | $                           | 343        |   | $ | 288 |   | $ | 242 |   |
| Income taxes paid, net of refunds                                                                  |   | $                           | 41,282     |   | $ | 116 |   | $ | 187 |   |
| **Supplemental disclosures of  noncash investing and financing activities:**                       |   |                        |       |   |   |   |   |
| Issuance of common stock in connection with  acquisition of subsidiary                             |   | $                           | 1,199      |   | $ | 933 |   | $ | 1,093 |   |
| Liabilities assumed in acquisition of subsidiary                                                   |   | $                           | —     |   | $ | — |   | $ | 2,881 |   |
| Cash and stock payable in connection with  acquisition of subsidiary                               |   | $                           | —     |   | $ | 366 |   | $ | 2,215 |   |
| Warrant issued in connection with investment  advisory services and financing related services     |   | $                           | —     |   | $ | 650 |   | $ | — |   |
| Capital lease obligations incurred for the  purchase of new equipment                              |   | $                           | 111        |   | $ | — |   | $ | 57 |   |
| Issuance of common stock in connection with the  exercise of warrants                              |   | $                           | 995        |   | $ | — |   | $ | — |   |

 

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

 

F-4

----

 

**InVisionTechnologies, Inc.Consolidated Statements ofStockholders’ Equity(In thousands)**

 
|                                                                                              |   |             |       |       |       |                             |       | **Deferred  Stock  Compensation  Expense** |       | **Accumulated  Other  Comprehensive  Loss** |       | **Retained  Earnings  (Accumulated  Deficit)** |       |   |       |   |       | **Total  Stockholders’  Equity** |       |
|---------------------------------------------------------------------------------------------------|--------|------------------|------------|------------|------------|----------------------------------|------------|--------------------------------------------|------------|---------------------------------------------|------------|------------------------------------------------|------------|--------|------------|--------|------------|---------------------------------------|------------|
|                                                                                              |   |             |       |       |       | **Additional  Paid-In  Capital** |       |                                       |       |                                        |       |                                           |       |   |       |
|                                                                                              |   | **Common Stock** |       |       |       |                             |       | **Treasury Stock**                         |       |                                        |
|                                                                                              |   | **Shares**       |       | **Amount** |       |                             |       |                                       |       | **Shares**                                  |       | **Amount**                                     |       |   |
|                                                                                              |   |             | ** ** |       | ** ** |                             | ** ** |                                       | ** ** |                                        | ** ** |                                           | ** ** |   | ** ** |   | ** ** |                                  | ** ** |
| **Balance at January 1, 2000**                                                                    |   | 12,391           |       | $          | 12         |                             | $          | 57,910                                     |       | $                                           | (63        | )                                              | $          | — |       | $      | (9,175     | )                                     | (201       | ) | $ | (1,199 | ) | $ | 47,485 |   |
|                                                                                              |   |             |       |       |       |                             |       |                                       |       |                                        |       |                                           |       |   |       |   |       |                                  |       |
| Net  loss and comprehensive loss                                                                  |   | —           |       | —     |       | —                           |       | —                                     |       | —                                      |       | (1,806                                         | )          | — |       | — |       | (1,806                                | )          |
| Amortization  of deferred stock compensation                                                      |   | —           |       | —     |       | —                           |       | 63                                         |       | —                                      |       | —                                         |       | — |       | — |       | 63                                    |       |
| Exercise  of common stock options                                                                 |   | 63               |       | —     |       | 336                              |       | —                                     |       | —                                      |       | —                                         |       | — |       | — |       | 336                                   |       |
| Shares  issued under the employee stock purchase plan                                             |   | 111              |       | —     |       | 333                              |       | —                                     |       | —                                      |       | —                                         |       | — |       | — |       | 333                                   |       |
| Issuance  of common stock related to an acquisition                                               |   | 249              |       | 1          |       | 1,092                            |       | —                                     |       | —                                      |       | —                                         |       | — |       | — |       | 1,093                                 |       |
| **Balance at December 31, 2000**                                                                  |   | 12,814           |       | 13         |       | 59,671                           |       | —                                     |       | —                                      |       | (10,981                                        | )          | (201   | )          | (1,199 | )          | 47,504                                |       |
|                                                                                              |   |             |       |       |       |                             |       |                                       |       |                                        |       |                                           |       |   |       |   |       |                                  |       |
| Net  income and comprehensive income                                                              |   | —           |       | —     |       | —                           |       | —                                     |       | —                                      |       | 7,523                                          |       | — |       | — |       | 7,523                                 |       |
| Exercise  of common stock options                                                                 |   | 463              |       | 1          |       | 2,266                            |       | —                                     |       | —                                      |       | —                                         |       | — |       | — |       | 2,267                                 |       |
| Shares  issued under the employee stock purchase plan                                             |   | 132              |       | —     |       | 264                              |       | —                                     |       | —                                      |       | —                                         |       | — |       | — |       | 264                                   |       |
| Issuance  of common stock related to an acquisition                                               |   | 321              |       | —     |       | 933                              |       | —                                     |       | —                                      |       | —                                         |       | — |       | — |       | 933                                   |       |
| Issuance  of warrants and options to consultants                                                  |   | —           |       | —     |       | 717                              |       | —                                     |       | —                                      |       | —                                         |       | — |       | — |       | 717                                   |       |
| Issuance  of stock to a consultant                                                                |   | —           |       | —     |       | —                           |       | —                                     |       | —                                      |       | —                                         |       | 10     |       | 52     |       | 52                                    |       |
| Income  tax benefits of employee stock transactions                                               |   | —           |       | —     |       | 2,160                            |       | —                                     |       | —                                      |       | —                                         |       | — |       | — |       | 2,160                                 |       |
| **Balance at December 31, 2001**                                                                  |   | 13,730           |       | 14         |       | 66,011                           |       | —                                     |       | —                                      |       | (3,458                                         | )          | (191   | )          | (1,147 | )          | 61,420                                |       |
|                                                                                              |   |             |       |       |       |                             |       |                                       |       |                                        |       |                                           |       |   |       |   |       |                                  |       |
| Net  income                                                                                       |   | —           |       | —     |       | —                           |       | —                                     |       | —                                      |       | 78,294                                         |       | — |       | — |       | 78,294                                |       |
| Unrealized  loss on cash flow hedges, net of tax                                                  |   | —           |       | —     |       | —                           |       | —                                     |       | (2,274                                      | )          | —                                         |       | — |       | — |       | (2,274                                | )          |
| Less:  reclassification of loss on cash flow  hedges, net of tax                             |   | —           |       | —     |       | —                           |       | —                                     |       | 491                                         |       | —                                         |       | — |       | — |       | 491                                   |       |
| Comprehensive  income                                                                             |   |             |       |       |       |                             |       |                                       |       |                                        |       |                                           |       |   |       |   |       | 76,511                                |       |
| Issuance  of common stock pursuant to secondary public offering, net of issuance costs  of $1,617 |   | 2,500            |       | 2          |       | 84,630                           |       | —                                     |       | —                                      |       | —                                         |       | — |       | — |       | 84,632                                |       |
| Exercise  of common stock options                                                                 |   | 680              |       | 1          |       | 2,055                            |       | —                                     |       | —                                      |       | —                                         |       | — |       | — |       | 2,056                                 |       |
| Deferred  stock compensation                                                                      |   | —           |       | —     |       | 542                              |       | (406                                       | )          | —                                      |       | —                                         |       | — |       | — |       | 136                                   |       |
| Shares  issued under the employee stock purchase plan                                             |   | 172              |       | —     |       | 949                              |       | —                                     |       | —                                      |       | —                                         |       | — |       | — |       | 949                                   |       |
| Issuance  of common stock related to an acquisition                                               |   | 32               |       | —     |       | 1,199                            |       | —                                     |       | —                                      |       | —                                         |       | — |       | — |       | 1,199                                 |       |
| Issuance  of warrants and options to consultants                                                  |   | 100              |       | —     |       | 1,384                            |       | —                                     |       | —                                      |       | —                                         |       | (34    | )          | (995   | )          | 389                                   |       |
| Issuance  of stock to a consultant                                                                |   | 29               |       | —     |       | 288                              |       | —                                     |       | —                                      |       | —                                         |       | (10    | )          | (52    | )          | 236                                   |       |
| Income  tax benefits of employee stock transactions                                               |   | —           |       | —     |       | 9,185                            |       | —                                     |       | —                                      |       | —                                         |       | — |       | — |       | 9,185                                 |       |
| **Balance at December 31, 2002**                                                                  |   | 17,243           |       | $          | 17         |                             | $          | 166,243                                    |       | $                                           | (406       | )                                              | $          | (1,783 | )          | $      | 74,836     |                                  | (235       | ) | $ | (2,194 | ) | $ | 236,713 |   |

 

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

 

F-5

----

 

**INVISIONTECHNOLOGIES, INC.**

 

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1. DESCRIPTIONOF BUSINESS**

 

InVision Technologies, Inc. (the “Company”) was incorporated inDelaware in 1990 and its principal business is to manufacture computedtomography, or CT, based detection products used by the aviation industry toscreen baggage. The Company’s headquarters and principal manufacturingfacilities are located in Newark, California. In 1997, the Company acquiredQuantum Magnetics, Inc. (“Quantum”) as a wholly-owned subsidiary. Quantum is aCalifornia corporation with its headquarters and manufacturing facilitieslocated in San Diego, California. In 2000, the Company acquired Inovec, Inc.(“Inovec”) as a wholly-owned subsidiary. Inovec is a Delaware corporation withits headquarters and manufacturing facilities located in Eugene, Oregon. TheCompany is organized under three segments:

 

*EDS.*    The Companydesigns, manufactures and markets CT-based detection products used by theaviation industry to screen baggage for explosives. The Company’s products werethe first automated explosives detection systems (“EDS”) to be certified by theFederal Aviation Authority (the “FAA”). The Company has sold 779 systems to theFAA and, following the formation of the Transportation Security Administration(the “TSA”), the TSA, to foreign aviation security agencies and to domestic andforeign airports and airlines.

 

*Quantum.*    Quantumdevelops for commercialization patented and proprietary technology forinspection, detection and analysis of explosives and other materials. Quantum’sproducts are based on passive magnetic sensing technology and quadrupoleresonance (“QR”) technology, a form of magnetic resonance. Quantum receivesgrants from a variety of U.S. government agencies for research and developmentof military and humanitarian landmine detection, carry-on luggage screening,concealed weapon detection, drug detection, and in-process materialsinspection.

 

*Wood.*    InFebruary 2000, the Company announced the formation of its WoodVisiondivision (“WoodVision”) to develop the Company’s CT technology to increase thevalue of harvested timber. Previous studies have indicated that CT technologycan be applied to scan a log before it is sawn to determine the optimal cut. Inconnection with the formation of WoodVision, the Company acquired Inovec, whichwas accounted for as a purchase effective January 1, 2000 (see Note 3). Inovec manufactures, marketsand supports yield enhancement equipment for sawmills based on laser scanningand other technologies. Since inception, Inovec has installed over 633 laserscanners and other optimization systems in over 300 sawmills worldwide.

 

**NOTE 2. SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

 

**Basis of Presentation**

 

The consolidated financial statements include the financial statementsof the Company and its wholly-owned subsidiaries. Intercompany accounts andtransactions are eliminated in consolidation.

 

**Financial StatementEstimates**

 

The Company’s preparation of these consolidated financial statements inconformity with accounting principles generally accepted in the United Statesof America requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities, disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. Such estimatesinclude inventory valuation, allowances for potentially uncollectible accountsreceivable, accrued warranty, certain accrued liabilities, valuation allowancesfor deferred tax assets, total estimated costs at completion for contractsaccounted for using the percentage-of-completion method and goodwillimpairment. Actual results could differ from those estimates.

 

F-6

----

 

**Reclassifications**

 

Certain prior year amounts have been reclassified to conform to thecurrent year presentation. These reclassifications did not change previouslyreported total assets, liabilities, stockholders’ equity, operating income(loss) or net income (loss).

 

**Cash and CashEquivalents**

 

The Company considers all highly liquid investments purchased with anoriginal maturity of three months or less to be cash equivalents.

 

**Short-termInvestments**

 

Short-term investments consist primarily of commercial paper withoriginal maturities beyond three months and less than 12 months and areclassified as available-for-sale. Such short-term investments are carried atcost, which approximates fair market value.

 

**Concentration ofCredit Risk**

 

Financial instruments that potentially subject the Company tosignificant concentrations of credit risk consist primarily of cash and cashequivalents, short-term investments and accounts receivable. The Company limitsthe amount of credit exposure of cash balances and short-term investments bymaintaining its accounts in high credit quality financial institutions. Withrespect to accounts receivable, the Company regularly performs evaluations ofits customers’ financial condition and credit worthiness.

 

**Inventories**

 

Inventories are stated at the lower of cost or market.  Cost is determined on a first-in, first-outbasis, and includes materials, labor and overhead.  During the years endedDecember 31, 2002, 2001 and 2000, the Company recorded excess and obsoleteinventory write down expenses of $4.5 million, $429,000 and $293,000,respectively.

 

**Property andEquipment**

 

Property and equipment are recorded at cost. Depreciation andamortization is computed using the straight-line method based upon theestimated useful lives of the assets, which range from two to seven years, orthe lease term of the respective assets, if less than the useful life.

 

**Intangible Assets**

 

TheCompany has patents, licenses, developed technologies and a covenant not tocompete, which are being amortized over their estimated useful lives on astraight-line basis ranging from three to five years.

 

EffectiveJanuary 1, 2002, the Company adopted Statement of Financial AccountingStandards No. 142 (“SFAS 142”),“Goodwill and Other Intangible Assets.” SFAS 142 addresses the initialrecognition and measurement of intangible assets acquired outside of a businesscombination and the accounting for goodwill and other intangible assetssubsequent to their acquisition. SFAS 142 provides that intangible assetswith finite useful lives be amortized and that goodwill and intangible assetswith indefinite lives will not be amortized, but will rather be tested at leastannually for impairment. An impairment loss is recorded when the net book valueof the reporting unit exceeds its estimated fair value.  The Company determines its fair value usingthe discounted future cash flows method.

 

Uponthe adoption of SFAS 142, the Company ceased amortization of the carryingvalues of goodwill of $2.5 million and acquired workforce of $331,000, andreclassified the net carrying amount of acquired workforce to

 

F-7

----

 

goodwill.  The adoption of SFAS 142 resulted in areduction in annual amortization expense of $426,000. In the fourth quarter of2002, the Company performed the annual impairment test required by thestandard, and recorded a $2.1 million impairment of goodwill, relating to theInovec reporting unit.

 

Thefollowing reconciles reported net income and net income per share to theadjusted net income and net income per share as if the Company had followed theamortization provisions of SFAS 142 for the periods presented below (inthousands, except per share data):

 
|                                                              |   | **Year Ended  December 31,** |   |
|-------------------------------------------------------------------|--------|------------------------------|--------|
|                                                              |   | **2002**                     |   | **2001** |   | **2000** |   |
| Net income (loss):                                                |   |                         |   |   |   |   |   |
| As reported                                                       |   | $                            | 78,294 |   | $ | 7,523 |   | $ | (1,806 | ) |
| add:   goodwill amortization expense, net of taxes           |   | —                       |   | 261 |   | 201 |   |
| add:   acquired workforce amortization expense, net of taxes |   | —                       |   | 165 |   | 166 |   |
| As adjusted                                                       |   | $                            | 78,294 |   | $ | 7,949 |   | $ | (1,439 | ) |
|                                                              |   |                         |   |   |   |   |   |
| Basic net income (loss) per share:                                |   |                         |   |   |   |   |   |
| As reported                                                       |   | $                            | 4.90   |   | $ | 0.58 |   | $ | (0.14 | ) |
| As adjusted                                                       |   | $                            | 4.90   |   | $ | 0.61 |   | $ | (0.12 | ) |
|                                                              |   |                         |   |   |   |   |   |
| Diluted net income (loss) per share:                              |   |                         |   |   |   |   |   |
| As reported                                                       |   | $                            | 4.40   |   | $ | 0.52 |   | $ | (0.14 | ) |
| As adjusted                                                       |   | $                            | 4.40   |   | $ | 0.55 |   | $ | (0.12 | ) |

 

**Impairment ofLong-Lived Assets**

 

Effective January 1, 2002, the Company adopted Statement of FinancialAccounting Standards No. 144 (“SFAS 144”), “Accounting for theImpairment or Disposal of Long-Lived Assets.” SFAS 144 removes goodwillfrom its scope and retained the requirements of SFAS 121, “Accounting forthe Impairment of Long-Lived Assets and for Long-Lived Assets to be DisposedOf,” to (1) recognize an impairment loss only if the carrying amount of thelong-lived asset is not recoverable from its undiscounted cash flows and (2)measure an impairment loss as the difference between the carrying amount andthe fair value of the asset. The Company evaluates its long-lived assets forimpairment whenever events or changes in circumstances indicate that thecarrying amount of that asset may not be recoverable.  The adoption of this statement did not have a material impact onthe consolidated financial statements.

 

**Accrued Warranty**

 

Estimatedwarranty costs are recorded on product revenues and adjusted periodically basedon historical and anticipated experience. The Company accrues theestimated cost of product warranties at the time revenues are recognized.Although the Company engages in extensive product quality programs and processes,including actively monitoring and evaluating the quality of componentsuppliers, the warranty obligation is affected by actual warranty costs,including usage of material and labor and service delivery costs incurred incorrecting a product failure.

 

F-8

----

                The following is areconciliation of the changes in the accrued warranty as of and for the yearsended December 31, 2002, 2001 and 2000:

 
|   |   | **Balance at  beginning  of year** |   | **Accruals for  warranties issued** |   | **Reduction for payments made** |   | **Changes in accruals related  to pre-existing  warranties** |   | **Balance at  end of  year** |   |
|--------|--------|------------------------------------|--------|-------------------------------------|--------|---------------------------------|--------|--------------------------------------------------------------|--------|------------------------------|--------|
|   |   |                               |   |                                |   |                            |   |                                                         |   |                         |   |
| 2002   |   | $                                  | 3,175  |                                | $      | 26,428                          |   | $                                                            | (9,887 | )                            | $      | 174 |   | $ | 19,890 |   |
| 2001   |   | $                                  | 4,198  |                                | $      | 2,208                           |   | $                                                            | (3,285 | )                            | $      | 54 |   | $ | 3,175 |   |
| 2000   |   | $                                  | 2,404  |                                | $      | 4,057                           |   | $                                                            | (2,205 | )                            | $      | (58 | ) | $ | 4,198 |   |

 

**Revenue Recognition**

 

Revenues are recognized when persuasive evidence of an arrangementexists, delivery has occurred or services have been rendered, the price isfixed and determinable and collectibility is reasonably assured. For sales ofEDS products to the FAA, the TSA and other domestic customers that have beendemonstrated to meet product specifications prior to shipment, product revenuesare recognized at shipment and the portion of revenues relating to installationand training are deferred until such services are performed and accepted by thecustomer. The deferred installation and training revenues are based on the fairvalue of such services when performed separately for customers. Installation isgenerally not complex and is completed within a relatively short period oftime, typically less than one week. The Company has a consistent history ofcompleting routine installations and obtaining customer acceptance for domesticand international sales. Certain airport installations require more involvedintegration with baggage handling systems and, while not essential to thefunctionality of the machine, take longer than most routine installations. Suchintegration services are separately priced from products in sales agreementsand the Company recognizes service revenues under these agreements as servicesare performed.

 

Sales of EDS products and services to customers in foreign countrieshave varying contractual terms and are governed, in part, by regulations inforeign jurisdictions; accordingly, revenue is recognized based on the specificfacts and circumstances surrounding each transaction. For foreign sales of EDSproducts that have been demonstrated to meet product specifications prior toshipment to customers, where title and risk of loss pass to the customer atshipment, and where the Company either has an enforceable claim at the balancesheet date for remaining unbilled amounts or has the ability to invoice thecustomer for any unbilled amounts after a fixed period of time regardless ofwhether installation is completed, product revenue is recognized at shipmentand the fair value of installation and training revenue, if any, is deferredand recognized as services are performed. For sales of EDS products to certainforeign customers where title and risk of loss for such EDS products pass uponcompletion of installation, product and service revenues are recognized at thecompletion of installation and acceptance by the customer. In certain othersales of EDS products to foreign customers where a portion of the contractprice is withheld until installation is completed and where the Company doesnot believe it has an enforceable claim at the balance sheet date through whichit can realize some or all of the withheld amount, the greater of that portionof the contract price or the fair value of the installation and training isdeferred and recognized as revenue at the completion of installation andacceptance by the customer. Deferred revenues from EDS product sales arise fromadvance payments received from customers for systems not yet delivered.

 

Revenues from separate EDS service maintenance contracts are recognizedratably over the term of the agreements. For other services, service revenuesare recognized as the services are performed. Deferred revenue for EDS servicesarises from advance payments received from customers for services not yetperformed.

 

Revenues from Quantum government contracts and from Inovec productsales of automation and control systems are recognized using thepercentage-of-completion method based on costs incurred to date as a percentageof total estimated costs at completion. Provisions for estimated losses areaccrued on those contracts that are anticipated to result in losses at the completionof the contract. Deferred revenue is recorded as advance payments are receivedfor work not yet performed.

 

F-9

----

 

**Research andDevelopment Costs**

 

Research and development costs are charged to operations as incurred.Contractually reimbursable costs for certain research and developmentactivities are reflected as a reduction to research and development expense inthe period the related costs are incurred.

 

**Stock-BasedCompensation**

 

The Company grants stock options for a fixed number of shares toemployees with an exercise price equal to the fair value of the shares at thedate of grant. The Company accounts for employee stock-based compensation inaccordance with Accounting Principles Board Opinion No. 25 (“APB 25”),“Accounting for Stock Issued to Employees.” The Company accounts forstock-based awards to non-employees in accordance with Statement of FinancialAccounting Standards No. 123 (“SFAS 123”), “Accounting forStock-Based Compensation” and Emerging Issues Task Force Issue No. 96-18,“Accounting for Equity Instruments That Are Issued to Other Than Employees forAcquiring, or in Conjunction with Selling, Goods or Services.”  The Company’s disclosures are in accordancewith Statement of Financial Accounting Standards No. 148 (“SFAS 148”),“Accounting for Stock-Based Compensation and Disclosure—An Amendment of FASBStatement No. 123.”

 

Had compensation cost for options granted and shares issued in 2002,2001 and 2000 under the Company’s stock option plans (the “Equity Plans”) andemployee stock purchase plans (the “Purchase Plans”) been determined based onthe fair value at the grant and issue dates, as prescribed in SFAS 123 andSFAS 148, the Company’s net income (loss) and pro forma net income (loss) pershare would have been as follows (in thousands, except per share data): 

 
|                                                                                        |   | **Year Ended  December 31,** |   |
|---------------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                                        |   | **2002**                     |   | **2001** |   | **2000** |   |
| Net income (loss):                                                                          |   |                         |   |   |   |   |   |
| As reported                                                                                 |   | $                            | 78,294 |   | $ | 7,523 |   | $ | (1,806 | ) |
| add:   stock compensation as reported, net of tax effects                              |   | $                            | 81     |   | — |   | — |   |
| less:   stock compensation determined using the fair value method, net of tax  effects |   | (6,409                       | )      | (1,106 | ) | (1,250 | ) |
| Pro forma                                                                                   |   | $                            | 71,966 |   | $ | 6,417 |   | $ | (3,056 | ) |
|                                                                                        |   |                         |   |   |   |   |   |
| Pro forma net income (loss) per share:                                                      |   |                         |   |   |   |   |   |
| Basic:                                                                                      |   |                         |   |   |   |   |   |
| As reported                                                                                 |   | $                            | 4.90   |   | $ | 0.58 |   | $ | (0.14 | ) |
| Pro forma                                                                                   |   | $                            | 4.50   |   | $ | 0.49 |   | $ | (0.24 | ) |
| Diluted:                                                                                    |   |                         |   |   |   |   |   |
| As reported                                                                                 |   | $                            | 4.40   |   | $ | 0.52 |   | $ | (0.14 | ) |
| Pro forma                                                                                   |   | $                            | 4.05   |   | $ | 0.45 |   | $ | (0.24 | ) |

 

The fair value of each option grant and share granted is estimated onthe date of grant using the Black-Scholes option pricing model with thefollowing assumptions used for grants during the applicable period: 

 
|                                  |   | **2002**  |   | **2001**  |   | **2000**  |   |
|---------------------------------------|--------|-----------|--------|-----------|--------|-----------|--------|
| Option Grants                         |   |      |   |      |   |      |   |
| Average risk free rate of return      |   | 3.50-4.39 | %      | 4.46-4.98 | %      | 6.32-6.68 | %      |
| Weighted average expected option life |   | 4.0 years |   | 4.0 years |   | 3.8 years |   |
| Volatility rate                       |   | 83        | %      | 88        | %      | 66        | %      |
| Dividend yield                        |   | 0         | %      | 0         | %      | 0         | %      |

 

F-10

----

 
|                             |   | **2002**   |   | **2001**   |   | **2000**   | ** ** |
|----------------------------------|--------|------------|--------|------------|--------|------------|------------|
| Shares Granted                   |   |       |   |       |   |       |       |
| Average risk free rate of return |   | 1.25-1.65  | %      | 1.91-5.01  | %      | 5.73-6.36  | %          |
| Weighted average expected life   |   | 3.0 months |   | 3.0 months |   | 3.0 months |       |
| Volatility rate                  |   | 31-33      | %      | 32-125     | %      | 24-134     | %          |
| Dividend yield                   |   | 0          | %      | 0          | %      | 0          | %          |

 

**Income Taxes**

 

The Company accounts for income taxes in accordance with Statement ofFinancial Accounting Standards No. 109, “Accounting for Income Taxes,”which prescribes the use of the asset and liability method whereby deferred taxasset or liability account balances are calculated at the balance sheet dateusing current tax laws and rates in effect. Valuation allowances areestablished when necessary to reduce deferred tax assets when it is more likelythan not that a portion or all of the deferred tax assets will not be realized.

 

**Certain SignificantRisks and Uncertainties**

 

The Company operates in a dynamic and highly competitive industry and,accordingly, can be affected by a variety of factors. For example, managementof the Company believes that changes in any of the following areas could have asignificant negative effect on the Company in terms of its future financialposition, results of operations and cash flows:  dependence upon a limited number of suppliers forcomponent parts; risks associated with budget processes of governmental agencieswhich could limit product demand; legislative actions; the ability of airportsto integrate the Company’s EDS units into their baggage handling systems;unforeseen problems relating to the ability of the Company’s EDS products tosustain increased usage; management of the expansion of the Company’soperations; growth of the service organization; risks associated withintegration of acquired businesses; product liability and related claims ifproducts fail; limited number of customers; the exercise of the royalty-bearinglicense granted to the TSA; limitations on the Company’s intellectual propertyrights; a lengthy sales cycle which could result in not being able to obtainsales orders; risks associated with international sales including, but notlimited to, political instability, changes in regulatory requirements, foreigncurrency risk, tariffs and other barriers, and negative tax consequences; theCompany’s relationships with international customers may be damaged if it isrequired to fulfill TSA orders at the expense of international orders; theselection of another company to provide post-warranty service on the Company’sCTX systems; the Company’s future products or product modifications fail toobtain TSA certification; inability to adapt to rapid technological change;competition in the industry; retaining key management personnel and employees;natural disasters; risks associated with special contracting requirements bygovernmental agencies; failure to properly protect the Company’s intellectual propertyor having to enforce or defend against claims of intellectual propertyinfringement; and the availability of future government funding for productdevelopment.

 

**Comprehensive Income**

 

Statement of Financial Accounting Standards No. 130, “Reporting ComprehensiveIncome” establishes standards for reporting and displaying comprehensive incomeand its components (revenues, expenses, gains and losses) in a full set ofgeneral-purpose financial statements. Such items may include foreign currencytranslation adjustments, unrealized gains/losses from investing and hedgingactivities and other transactions.

 

**Segment Information**

 

Statementof Financial Accounting Standards No. 131, “Disclosures about Segments ofan Enterprise and Related Information,” requires disclosures of segmentinformation under a “management” approach. As discussed in Note 1, the Companyhas three reportable segments based on financial information regularly reviewedby the Company’s chief operating decision maker in deciding how to allocateresources and assess performance.

 

F-11

----

 

**Fair Value ofFinancial Instruments**

 

The Company’s financial instruments include cash and cash equivalents,short-term investments, accounts receivable, accounts payable and accruedliabilities, short-term debt and long-term debt. The carrying values of cashand cash equivalents, short-term investments and accounts receivableapproximate their fair values based on quoted market values or due to theirshort-term maturities. The carrying values of short-term debt and long-termdebt approximate fair value due to their variable interest rates whichapproximate market rates.

 

**Net Income (Loss) PerShare**

 

Basic net income (loss) per share is computed by dividing income (loss)available to common stockholders by the weighted-average shares of common stockoutstanding for the period. Diluted net income (loss) per share reflects theweighted-average shares of common stock outstanding plus the potential effectof dilutive securities or contracts which are convertible to shares of commonstock such as options, warrants, convertible debt and preferred stock (usingthe treasury stock method) and shares issuable in future periods, except incases where the effect would be anti-dilutive.

 

**Derivative Instruments and Hedging Activities**

 

On January 1, 2001, the Company adopted Statement of FinancialAccounting Standards No. 133 (“SFAS 133”), “Accounting for DerivativeInstruments and Hedging Activities.” SFAS 133 requires that every derivativeinstrument, including certain derivative instruments embedded in othercontracts, be recorded on the balance sheet at its fair value. Changes in thefair value of derivatives are recorded each period in current earnings or othercomprehensive income, depending on whether a derivative is designated as partof a hedge transaction and, if it is, the type of hedge transaction.SFAS 133 requires that the Company formally document, designate and assessthe effectiveness of transactions that receive hedge accounting. The Companyadopted SFAS 133 on January 1, 2001 and did not elect hedgeaccounting as defined by SFAS 133. The adoption of this statement did nothave a material impact on the Company’s financial position or results ofoperations.

 

Duringthe year ended December 31, 2002, the Company’s derivatives consisted only offoreign exchange forward contracts.  InMay 2002, the Company designated certain foreign currency forward contracts ascash flow hedges of foreign exchange risk for international sales contracts andbegan applying hedge accounting as defined by SFAS 133.  Accordingly, as of December 31, 2002, theCompany recorded $1,783,000 of other comprehensive loss, net of income taxes of$1,227,000, representing the net change in the fair value of the foreigncurrency forward contracts that were designated as and qualified for hedgeaccounting.  The amounts deferred inother comprehensive loss are reclassified to earnings upon the recognition ofhedged revenue.  During the year endedDecember 31, 2002, the Company also recorded $272,000 as the ineffectivenessunder hedge accounting.  At December 31,2002, some of the changes in fair value of certain forward contracts are offsetby the measurement of associated accounts receivable amounts.  The maturity of foreign exchange forwardcontracts as of December 31, 2002 is consistent with the contractual orexpected timing of the transactions being hedged, principally receipt ofcustomer payments.  These foreignexchange forward contracts all mature within twelve months.  As of December 31, 2002, the Companyanticipates reclassifying the full amount included within other comprehensiveloss to earnings within the next twelve months.

 

TheCompany does not enter into market risk sensitive instruments for trading purposes.The Company had aggregate foreign currency forward contracts with notionalamounts of $34.7 million and $16.9 million at December 31, 2002 and2001, respectively. The fair value of these instruments, included in theconsolidated balance sheets, was a liability balance of $4.9 million and anasset balance of $47,000 at December 31, 2002 and 2001, respectively.

 

F-12

----

 

**Recently Issued Accounting Standards**

 

***Accounting for CostsAssociated with Exit or Disposal Activities***

 

In June 2002, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 146 (“SFAS 146”), “Accounting for CostsAssociated with Exit or Disposal Activities,” which addresses accounting forrestructuring and similar costs.  SFAS146 supersedes previous accounting guidance, principally Emerging Issues TaskForce Issue No. 94-3.  The Company willadopt the provisions of SFAS 146 for restructuring activities initiated afterDecember 31, 2002.  SFAS 146 requiresthat the liability for costs associated with an exit or disposal activity berecognized when the liability is incurred. Under Issue No. 94-3, a liability for an exit costs was recognized atthe date of the Company’s commitment to an exit plan.  SFAS 146 also establishes that the liability should initially bemeasured and recorded at fair value. Accordingly, SFAS 146 may affect the timing of recognizing futurerestructuring costs as well as the amounts recognized.

 

***Accounting for Stock-Based Compensation***

 

InDecember 2002, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No.148 (“SFAS 148”), “Accounting for Stock-Based Compensation – Transition andDisclosure – an Amendment of FASB Statement No. 123,” which providesalternative methods of transition for a voluntary change to the fair valuebased method of accounting for stock-based employee compensation.  In addition, this Statement amends thedisclosure requirements of SFAS No. 123 to require prominent disclosures inboth annual and interim financial statements about the method of accounting forstock-based employee compensation and the effect of the method used on reportedresults.  The amended disclosurerequirements of SFAS No. 123 are effective for years ending after December 15,2002.

 

***Accounting and DisclosureRequirements for Guarantees***

 

InNovember 2002, the Financial Accounting Standards Board issued FASBInterpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and DisclosureRequirement for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers.”  FIN 45 requires that uponissuance of a guarantee, the guarantor must recognize a liability for the fairvalue of the obligation it assumes under that guarantee.  The disclosure provisions of FIN 45 areeffective for financial statements of interim or annual periods that end afterDecember 15, 2002.  The provisions forinitial recognition and measurement are effective on a prospective basis forguarantees that are issued or modified after December 31, 2002, irrespective ofa guarantor’s year-end.  The Company hasnot yet determined the impact of the adoption of the recognition provisions ofFIN 45 on the Company’s results of operations or financial position.

 

***Revenue Arrangements with MultipleDeliverables***

 

InNovember 2002, the EITF reached a consensus on Issue No. 00-21 (“EITF 00-21),“Revenue Arrangements with Multiple Deliverables.”  EITF 00-21 addresses certain aspects of the accounting by avendor for arrangements under which the vendor will perform multiple revenuegenerating activities.  EITF 00-21 willbe effective for fiscal periods beginning after June 15, 2003.  The Company has not yet determined theimpact of the adoption of EITF 00-21 on the Company’s results of operations orfinancial position.

 

**NOTE 3. ACQUISITIONOF INOVEC, INC.**

 

The Company acquired Inovec, a manufacturer of yield enhancementequipment for sawmills, for an initial purchase price of $5.2 million incash and stock, payable over a two-year period.  The acquisition of Inovec was accounted for as a purchaseeffective January 1, 2000.  The Companypaid the purchase price with $2.4 million in cash and $2.8 millionthrough issuance of 506,000 shares of common stock to the former shareholdersof Inovec.

 

In addition, the Company was contingently liable under the purchaseagreement in the event that Inovec achieved certain operating milestones duringthe years ended December 31, 2001 and 2000. Inovec achieved certain

 

F-13

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of these milestones and an additional $366,000 and $533,000 wasrecorded as additional goodwill at December 31, 2001 and 2000,respectively. As a result, the Company paid $267,000 in cash and $266,000through issuance of 91,000 shares of common stock in 2001. The remainingobligation of $366,000 was paid $183,000 in cash and $183,000 through issuanceof 5,000 shares of common stock in April 2002.

 

Thetransaction has been accounted for as a purchase and, accordingly, the resultsof operations of Inovec are included in the consolidated financial statementsfor the years ended December 31, 2002, 2001 and 2000. The Companyallocated the purchase price based on the fair value of assets acquired andliabilities assumed. Portions of the purchase price, including intangibleassets, were identified by independent appraisers utilizing accepted valuationprocedures and techniques. These intangible assets included approximately$1.5 million for developed technologies, $662,000 for the acquiredworkforce, $50,000 for covenants not to compete and the remaining$2.9 million for goodwill. These intangibles are being amortized overtheir estimated useful lives ranging from three to ten years. With the adoptionof SFAS 142, the Company no longer amortizes the carrying values of goodwillof $2.5 million or acquired workforce of $331,000 at January 1, 2002,resulting in a reduction in annual amortization expense of $426,000. In thefourth quarter of 2002, the Company performed the annual impairment testsrequired by the standard, and recorded a $2.1 million impairment of goodwill.

 

**NOTE 4. GOVERNMENTCONTRACTS AND GRANTS**

 

The Company has been awarded various research and development contractsand grants by the FAA, the TSA and other government agencies to share in thecosts of developing and enhancing the Company’s products. During 2002, 2001 and2000, the Company was entitled to reimbursements of $886,000, $8.3 millionand $1.7 million, respectively, under research and development contractsand grants. Such reimbursements for direct costs, overhead and general andadministrative expenses, have been reflected as a reduction to research anddevelopment expense, selling, general and administrative expense, and againstthe manufacturing and customer support overhead pools, in each period presented.Billings under such research and development contracts and grants are submittedto the FAA, the TSA and other government agencies monthly on the basis ofactual costs incurred. At December 31, 2002 and 2001, the relatedreceivable balances from these contracts and grants were $0 and$3.3 million, respectively.

 

In addition, under a letter contract dated February 19, 2002 and asubsequent delivery order, the FAA and, following the formation of the TSA, theTSA agreed to reimburse the Company for certain ramp up costs incurred to meetthe TSA’s product order demand for 2002. Ramp up costs consist of consulting expenses, vendor expedite chargesand subcontract manufacturing set up costs. The Company invoiced $9.3 million in reimbursable expenses to the TSA in2002.  At December 31, 2002, the relatedreceivable balance was $6.5 million, and the Company has approximately $1.6million classified as other current assets which is expected to be invoiced in2003.  If these amounts were notreimbursable, these elements of ramp up costs would have been expensed.

 

**NOTE 5. DEBT**

 

**Lines of Credit**

 

Effective July 2002, the Company amended its two line of creditagreements with Silicon Valley Bank. The first agreement provides for maximum borrowings in an amount up to$25.0 million.  The second agreement ispartially guaranteed by the Export-Import Bank, or EXIM, of the United Statesand provides for maximum borrowings in an amount up to the lower of:  (a) the sum of 70% to 90% of eligible EDSexport accounts receivable plus the lower of: (1) 70% of eligible raw materialsand work-in-process inventory designated for export customers, or (2) 60% ofoutstanding loans under this agreement, or (b) $10.0 million, which the Companyexpects will increase to $15.0 million in 2003 following the approval of theincrease of the guarantee by EXIM. Borrowings under these agreements bear interest at the bank’s prime rateminus 0.5% (3.75% at December 31, 2002). The agreements expire in July 2004 and require that the EDS segment maintaincertain levels of tangible net worth. The Company may use proceeds of loans under both lines of credit forgeneral corporate purposes.  At December31, 2002, the Company had no borrowings outstanding under theseagreements.  However, at December 31,2002, the Company had outstanding guarantees to customers through the issuanceof letters of credit for which a partial reserve of $2.0 million is secured bythe lines of credit, and foreign exchange contracts for which a 10% reserve of

 

F-14

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$3.5 million is secured by the lines of credit.  The Company had remaining availableborrowing capacity under the lines of credit of $29.5 million at December 31,2002 based on eligible EDS accounts receivable and inventories as of that date.

 

As of December 31, 2002, the Company had letters of credit totaling$6.7 million as guarantees primarily to customers for performance and deliverycommitments, and as bid bonds allowing the Company to participate in thesolicitation of sales.  In addition, theCompany has one guarantee to an insurance carrier for premium paymentcommitments.  The guarantees range fromone to thirteen months from December 31, 2002 until expiration.

 

In August 2002, Inovec renewed a line of credit agreement with PacificContinental Bank.  The agreementprovides for a $1.5 million working capital line of credit and is secured byassets of Inovec.  The agreement bearsinterest at the bank’s prime rate plus 1.0% with an interest rate floor of5.75%.  The agreement expires in August2003 and requires that Inovec maintain certain levels of tangible net worth anddebt/worth ratios.  Inovec may useproceeds from loans under the line of credit for general corporate purposes inits operations.  At December 31, 2002,Inovec had no borrowings outstanding under this agreement.

 

## **Short-term Debt**

 

The Company previously borrowed against a committed equipment line ofcredit agreement with Silicon Valley Bank, which converted into a term loanafter draw down.  Borrowings are securedby the assets purchased or financed.  AtDecember 31, 2002, the Company had an outstanding $67,000 term loan due June2003.  The term loan bears interest atthe bank’s prime rate plus 1.0% (5.25% at December 31, 2002).

 

**NOTE 6. STOCKHOLDERS’EQUITY**

 

On February 28, 2002, the Company’s stockholders approved an increasein the number of authorized shares of common stock, previously approved by theboard of directors, from 20,000,000 shares to 60,000,000 shares and the Companyfiled an amendment to its certificate of incorporation effecting this increase.

 

OnMarch 27, 2002, the Company filed an amended Form S-3 Registration Statementunder the Securities Act of 1933 and announced the public offering of 3,000,000shares of its common stock to the public at a price of $36.50 per share.  In this offering, which closed on April 2,2002, the Company sold 2,500,000 shares and received proceeds of $84.6 million,net of issuance costs. A selling stockholder sold another 500,000 shares ofcommon stock in the offering and certain selling stockholders sold 450,000shares to underwriters who exercised their over-allotment option.  The Company did not receive any proceedsfrom the sale of the shares by selling stockholders.

 

In September 2001, the Company entered into an agreement withDonald & Co. for investment advisory and financing related services.The president of Donald & Co. is a member of the board of directors.Under this agreement, Donald & Co. received a $50,000 cash retainerand a fully-vested warrant to purchase 100,000 shares of the Company’s commonstock at a price of $9.95 per share, the closing price of the Company’s commonstock on the day prior to the date of issuance. The warrant expires five yearsfrom date of issuance. The fair value of the warrant was $650,000, which wasestimated on the date of grant using the Black-Scholes option pricing modelwith the following assumptions: no dividends, risk-free interest rate of 3.94%,volatility of 78% and a contractual life of five years. In September 2002, theCompany issued 100,000 shares of common stock under the warrant.  However, in lieu of paying cash for theshares, 34,153 shares valued at $29.13 per share were returned to the Companyto settle the transaction.  Such shareswere recorded as treasury stock. One-half of the cash retainer and warrant, related to on-goinginvestment and financial advisory services, was recorded in other currentassets and was amortized over the one-year term of the agreement. The Companyrecorded amortization expense of $262,000 and $88,000 in 2002 and 2001,respectively. The remaining balance of $350,000, related to services providedin connection with the Company’s follow-on offering in April 2002 was nettedagainst the proceeds from the offering.

 

In October 2001, the Company issued a non-qualified stock optionto a consultant to purchase 15,000 shares of common stock at a price of $14.06per share. The option has a one-year cliff vesting term and expires ten yearsfrom date of issuance. The fair value of the option at the end of the one-yearcliff vesting term as of October 27, 2002 was

 

F-15

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$456,000, which was estimated as of October 27, 2002 using theBlack-Scholes option pricing model with the following assumptions: nodividends, risk-free interest rate of 4.11%, volatility of 86% and acontractual life of nine years. The Company recorded compensation expense overthe vesting period of the option, for which the fair value is adjusted forchanges in the fair value of common stock in subsequent periods. During theyears ended December 31, 2002 and 2001, the Company recorded compensationexpense of $389,000 and $67,000, respectively.

 

From 2000 through 2002, under the terms of the agreement relating tothe acquisition of Inovec, the Company issued 602,000 shares of common stock tothe former shareholders of Inovec.

 

In September 1997, under the terms of the agreement relating tothe acquisition of Quantum, 777,000 shares of common stock were either issuedto Quantum shareholders in exchange for all of the Quantum capital stockoutstanding or reserved for issuance in connection with Quantum common stockoptions outstanding prior to the acquisition which were converted into optionsto purchase InVision common stock.

 

At December 31, 2002, the Company has reserved shares of commonstock for issuance as follows: 

 
| Options outstanding under stock option  plans                                                                 |   | 3,097,454 |   |
|---------------------------------------------------------------------------------------------------------------|--------|-----------|--------|
| Shares reserved for future issuance under  stock option plans                                                 |   | 1,310,353 |   |
| Shares reserved for sale under employee  stock purchase plan                                                  |   | 227,557   |   |
| Shares reserved to be exchanged for Quantum  stock certificates that have not yet been turned in for exchange |   | 1,158     |   |
|                                                                                                          |   |      |   |
| Total                                                                                                         |   | 4,636,522 |   |

 

**NOTE 7. EMPLOYEESTOCK AND BENEFIT PLANS**

 

**Equity Incentive Plans**

 

The Company has several Equity Plans for the officers, employees,consultants and directors of the Company. The Equity Plans provide for thegranting of incentive and non-qualified stock options, stock bonus awards,rights to purchase restricted stock and stock appreciation rights (together“Stock Awards”) for the purchase of up to an aggregate of 6,616,726 shares ofthe Company’s common stock by officers, employees, consultants and directors ofthe Company. The board of directors is responsible for administration of theEquity Plans and also determines the terms of each Stock Award. Options grantedunder the Equity Plans generally vest over a four-year period. In the event ofa change in control transaction, Stock Awards then outstanding shall be continuedor assumed by the surviving entity or similar awards shall be substitutedtherefor. If the surviving entity refuses to do so, then the vesting of or rateof lapse of repurchase rights on such Stock Awards shall accelerate in full tothe date immediately prior to the effective date of such change in controltransaction. With respect to senior vice presidents only, even if the survivingentity continues, assumes or substitutes Stock Awards, the vesting or rate oflapse of repurchase rights on such Stock Awards shall accelerate in fullfollowing the effective date of the change in control transaction. With respectto vice presidents only, even if the surviving entity continues, assumes orsubstitutes Stock Awards, the vesting or rate of lapse of repurchase rights onsuch Stock Awards shall accelerate in full upon an involuntary terminationwithout “cause” or a “constructive termination,” as those terms are defined inthe Company’s Change in Control Equity Acceleration Plan, within a yearfollowing the effective date of the change in control transaction.

 

Non-qualified stock options may be granted at an exercise price pershare of not less than 85% of the fair value per share of common stock on thedate of the grant.  Incentive stockoptions may be granted at an exercise price per share of not less than 100% ofthe fair value per share of common stock on the date of grant (not less than 110% of the fair value in thecase of holders of more than 10% of the Company’s voting stock). Optionsgranted under the Equity Plans generally expire ten years from the date of thegrant (five years for incentive stock options granted to holders of more than10% of the Company’s voting stock). Options granted generally vest 25% one yearafter issuance and 1/48th each month thereafter for three years.

 

F-16

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The activity under the Equity Plans was as follows (in thousands,except per share data):

 
|                                                                       |   | **Year Ended  December 31,** |   |
|----------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                       |   | **2002**                     |   | **2001** |   | **2000** |   |
|                                                                       |   | **Shares**                   |   | **Weighted  Average  Exercise  Price** |   | **Shares** |   | **Weighted  Average  Exercise  Price** |   | **Shares** |   | **Weighted  Average  Exercise  Price** |   |
| Outstanding at beginning of period                                         |   | 2,596                        |   | $ | 3.82 |   | 2,831 |   | $ | 4.07 |   | 1,977 |   | $ | 4.25 |   |
| Granted                                                                    |   | 1,229                        |   | $ | 35.16 |   | 827 |   | $ | 4.02 |   | 1,143 |   | $ | 4.09 |   |
| Exercised                                                                  |   | (665                         | )      | $ | 3.09 |   | (463 | ) | $ | 4.54 |   | (63 | ) | $ | 5.37 |   |
| Canceled (un-vested)                                                       |   | (56                          | )      | $ | 8.11 |   | (414 | ) | $ | 4.38 |   | (158 | ) | $ | 5.13 |   |
| Expired (vested)                                                           |   | (6                           | )      | $ | 4.03 |   | (185 | ) | $ | 5.27 |   | (68 | ) | $ | 6.05 |   |
| Outstanding at end of period                                               |   | 3,098                        |   | $ | 16.51 |   | 2,596 |   | $ | 3.82 |   | 2,831 |   | $ | 4.07 |   |
|                                                                       |   |                         |   |   |   |   |   |   |   |   |   |   |   |
| Options exercisable at period end                                          |   | 1,268                        |   | $ | 6.51 |   | 1,203 |   | $ | 3.52 |   | 1,396 |   | $ | 3.79 |   |
|                                                                       |   |                         |   |   |   |   |   |   |   |   |   |   |   |
| Weighted average grant date fair value of  options granted during the year |   |                         |   | $ | 21.91 |   |   |   | $ | 2.55 |   |   |   | $ | 2.22 |   |

 

Information relating to stock options outstanding under the EquityPlans at December 31, 2002 is as follows (share data in thousands): 

 
|   |   | **Options  Outstanding** |   | **Options  Exercisable**                           |   |
|--------|--------|--------------------------|--------|----------------------------------------------------|--------|
|   |   | **Number  Outstanding**  |   | **Weighted  Average  Remaining  Contractual Life** |   | **Weighted  Average  Exercise Price** |   | **Number  Exercisable** |   | **Weighted  Average  Exercise Price** |   |
|   |   |                     |   |                                               |   |   |   |   |   |   |   |
| $      | 0.55   | -                        | 0.55   |                                               |   | 99 |   | 2.2 |   | $ | 0.55 |   | 99 |   | $ | 0.55 |   |
| $      | 0.97   | -                        | 1.44   |                                               |   | 212 |   | 2.9 |   | $ | 1.11 |   | 209 |   | $ | 1.10 |   |
| $      | 1.81   | -                        | 2.51   |                                               |   | 574 |   | 8.1 |   | $ | 2.27 |   | 192 |   | $ | 2.29 |   |
| $      | 2.75   | -                        | 4.13   |                                               |   | 151 |   | 7.4 |   | $ | 3.70 |   | 76 |   | $ | 3.66 |   |
| $      | 4.16   | -                        | 6.19   |                                               |   | 489 |   | 6.8 |   | $ | 4.69 |   | 325 |   | $ | 4.79 |   |
| $      | 6.50   | -                        | 9.70   |                                               |   | 269 |   | 4.9 |   | $ | 6.94 |   | 263 |   | $ | 6.94 |   |
| $      | 12.35  |                     | 14.89  |                                               |   | 44 |   | 8.8 |   | $ | 14.51 |   | 16 |   | $ | 14.08 |   |
| $      | 19.29  | -                        | 28.66  |                                               |   | 397 |   | 9.4 |   | $ | 24.59 |   | 8 |   | $ | 22.53 |   |
| $      | 29.49  | -                        | 43.52  |                                               |   | 863 |   | 9.2 |   | $ | 39.92 |   | 80 |   | $ | 43.08 |   |
|   |   |                     |   | 3,098                                              |   | 7.5 |   | $ | 16.51 |   | 1,268 |   | $ | 6.51 |   |
|        |        |                          |        |                                                    |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Employee StockPurchase Plans**

 

The Company reserved a total of 849,944 shares of common stock forissuance under the Purchase Plans. As of December 31, 2002, 622,387 shareshave been issued under the Purchase Plans.

 

**Employee 401(k) Plan**

 

The InVision Technologies, Inc. 401(k) Plan (the “401(k) Plan”)was established in 1992 to provide retirement and incidental benefits for itsemployees. As allowed under Section 401(k) of the Internal Revenue Code,the 401(k)

 

F-17

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Plan provides tax-deferred salary deductions for eligible employees.Employees may contribute up to 20% of their annual compensation to the 401(k)Plan, limited to a maximum amount as set periodically by the Internal RevenueService. Beginning in July 1997, the Company began matching employeecontributions at the rate of $0.50 on the dollar up to a maximum of 6% of theemployee’s gross compensation. All matching contributions vest immediately.Company matching contributions to the 401(k) Plan totaled $707,000, $524,000and $395,000 in 2002, 2001 and 2000, respectively.

 

**NOTE 8. COMMITMENTS**

 

The Company leases facilities and equipment under non-cancelable leasesexpiring at various times through 2012. The existing facilities lease for thecorporate facility in Newark, California includes an option to renew for anadditional five years through 2012. Future minimum lease payments under these leasesat December 31, 2002 are as follows (in thousands): 

 
| **Year Ending December 31,**                        |   | **Operating  Leases** |   | **Capital  Leases** |   |
|-----------------------------------------------------|--------|-----------------------|--------|---------------------|--------|
| 2003                                                |   | $                     | 2,793  |                | $      | 55 |   |
| 2004                                                |   | 2,374                 |   | 51                  |   |
| 2005                                                |   | 2,292                 |   | 26                  |   |
| 2006                                                |   | 2,303                 |   | 8                   |   |
| 2007                                                |   | 1,896                 |   | —              |   |
| Years thereafter                                    |   | 5,798                 |   | —              |   |
|                                                |   | $                     | 17,456 |                | 140    |   |
| Less: amount representing interest                  |   |                  |   | (18                 | )      |
| Present value of net minimum lease payments         |   |                  |   | 122                 |   |
| Less: current portion of capital lease  obligations |   |                  |   | (45                 | )      |
| Long-term capital lease obligations                 |   |                  |   | $                   | 77     |   |

 

Rent expense for facilities located in Newark, California; San Diego,California; Eugene, Oregon; France; and in the United Kingdom was $1,903,000,$1,646,000 and $1,529,000, for the years ended December 31, 2002, 2001 and2000, respectively.

 

The leases on the corporate offices and manufacturing facilities inNewark, California and San Diego, California include scheduled base rentincreases over the term of the leases. The total amount of base rent paymentsis being charged to expense on the straight-line method over the term of the leases.  In addition to the base rent payment, theCompany pays a monthly allocation of the building’s operating expenses. AtDecember 31, 2002 and 2001, the Company has recorded deferred rent of$576,000 and $584,000, respectively, to reflect the excess of rent expense overcash payments since inception of the lease as a long-term liability.

 

**NOTE 9. NET INCOME(LOSS) PER SHARE**

 

The following is a reconciliation between the components of the basicand diluted net income (loss) per share calculations for the periods presentedbelow (in thousands, except per share data):

 

F-18

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|                                                                     |   | **Year Ended  December 31,** |   |
|--------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                     |   | **2002**                     |   | **2001** |   | **2000** |   |
|                                                                     |   | **Income**                   |   | **Shares** |   | **Per  Share  Amount** |   | **Income** |   | **Shares** |   | **Per  Share  Amount** |   | **Loss** |   | **Shares** |   | **Per  Share  Amount** |   |
| Basic net income (loss) per share:                                       |   |                         |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) available to common  stockholders                          |   | $                            | 78,294 |   | 15,987 |   | $ | 4.90 |   | $ | 7,523 |   | 12,998 |   | $ | 0.58 |   | $ | (1,806 | ) | 12,510 |   | $ | (0.14 | ) |
| Effect of dilutive securities:                                           |   |                         |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Options and warrants                                                     |   | —                       |   | 1,811 |   | (0.50 | ) | — |   | 1,081 |   | (0.05 | ) | — |   | — |   | — |   |
| Stock payable in connection with  acquisition of subsidiary              |   | —                       |   | 5 |   | — |   | — |   | 264 |   | (0.01 | ) | — |   | — |   | — |   |
|                                                                     |   |                         |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Diluted net income (loss) per share:                                     |   |                         |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) available to common  stockholders plus assumed conversions |   | $                            | 78,294 |   | 17,803 |   | $ | 4.40 |   | $ | 7,523 |   | 14,343 |   | $ | 0.52 |   | $ | (1,806 | ) | 12,510 |   | $ | (0.14 | ) |

 

The computation of diluted net loss per share for the year endedDecember 31, 2000 does not include shares issuable upon exercise ofoptions of 1,046,222 and issuance of common stock related to the acquisition ofInovec payable April 2001 and 2002 based on average share prices prior tothe scheduled payment dates, because their effect would have beenanti-dilutive.

 

**NOTE 10. INCOME TAXES**

 

The provision (benefit) for income taxes for 2002, 2001 and 2000consists of the following (in thousands):

 
|            |   | **Year Ended  December 31,** |   |
|-----------------|--------|------------------------------|--------|
|            |   | **2002**                     |   | **2001** |   | **2000** |   |
| Current:        |   |                         |   |   |   |   |   |
| Federal         |   | $                            | 55,631 |   | $ | 887 |   | $ | 333 |   |
| State           |   | 12,636                       |   | 364 |   | 30 |   |
|            |   | 68,267                       |   | 1,251 |   | 363 |   |
| Deferred:       |   |                         |   |   |   |   |   |
| Federal         |   | (11,921                      | )      | (4,631 | ) | (363 | ) |
| State           |   | (2,472                       | )      | (1,191 | ) | — |   |
|            |   |                         |   |   |   |   |   |
| Total provision |   | $                            | 53,874 |   | $ | (4,571 | ) | $ | — |   |

 

F-19

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The Company’s effective tax rate for 2002, 2001 and 2000 differs fromthe U.S. federal statutory income tax rate as follows:

 
|                              |   | **Year Ended  December 31,** |   |
|-----------------------------------|--------|------------------------------|--------|
|                              |   | **2002**                     |   | **2001** |   | **2000** |   |
|                              |   |                         |   |   |   |   |   |
| U.S. federal statutory rate       |   | 35.0                         | %      | 35.0 | % | (35.0 | )% |
| State taxes, net of federal taxes |   | 5.0                          |   | 1.4 |   | 1.7 |   |
| Non-deductible intangible assets  |   | 0.6                          |   | 10.5 |   | 15.4 |   |
| Change in valuation allowance     |   | —                       |   | (194.1 | ) | 17.6 |   |
| Research and development credit   |   | —                       |   | (4.1 | ) | — |   |
| Other                             |   | 0.2                          |   | (3.5 | ) | 0.3 |   |
| Effective tax rate                |   | 40.8                         | %      | (154.8 | )% | 0.0 | % |

 

Deferred tax assets (liabilities) at December 31, 2002, 2001 and 2000consist of the following (in thousands):

 
|                                            |   | **December  31,** |   |
|-------------------------------------------------|--------|-------------------|--------|
|                                            |   | **2002**          |   | **2001** |   |
| Assets:                                         |   |              |   |   |   |
| Reserves and accruals                           |   | $                 | 20,863 |   | $ | 3,415 |   |
| Net operating loss carryforwards                |   | 649               |   | 1,911 |   |
| Tax credits                                     |   | —            |   | 1,254 |   |
| Other                                           |   | 1,691             |   | 190 |   |
|                                            |   | 23,203            |   | 6,770 |   |
| Liabilities:                                    |   |              |   |   |   |
| Other                                           |   | (1,264            | )      | (451 | ) |
|                                            |   |              |   |   |   |
| Net deferred tax assets                         |   | $                 | 21,939 |   | $ | 6,319 |   |
|                                            |   |              |   |   |   |
| As reported in the consolidated balance  sheet: |   |              |   |   |   |
| Deferred income taxes, current                  |   | $                 | 20,889 |   | $ | 4,082 |   |
| Deferred income taxes, non-current              |   | 1,050             |   | 2,237 |   |
| Net deferred tax assets                         |   | $                 | 21,939 |   | $ | 6,319 |   |

 

At December 31, 2002, the Company had federal and state net operatingloss carryforwards of approximately $1.8 million and $321,000, respectively,available to reduce future federal and state taxable income.  The Company’s federal net operating losscarryforwards begin to expire in 2010 and its state net operating losscarryforwards expire in 2011.  The tax benefit of the net operating losscarryforwards may be limited due to the impact of the Tax Reform Act of 1986.  Events which may cause the tax benefit to belimited include, but are not limited to, a cumulative stock ownership change ofmore than 50% over a three-year period and the timing of utilization of varioustax benefits carried forward.

 

The Company’s income taxes payable have been reduced by the income taxbenefits associated with employee stock transactions.  These benefits were credited directly to stockholders’ equity andamounted to $9.2 million in 2002 and $2.2 million in 2001.

 

**NOTE 11. INDUSTRYSEGMENTS, MAJOR CUSTOMERS AND GEOGRAPHIC INFORMATION**

 

Under the provisions of Statement of Financial Accounting StandardsNo. 131, “Disclosures about Segments of an Enterprise and RelatedInformation,” the Company has three reportable segments based on financialinformation regularly reviewed by the Company’s management in deciding how toallocate resources and assess performance.

 

F-20

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Financial information by business segment is as follows (in thousands):

 
|                         |   | **EDS** |    | **Quantum** |   | **Wood** |   | **Total** |   |
|------------------------------|--------|---------|---------|-------------|--------|----------|--------|-----------|--------|
| **2002**                     |   |    |    |        |   |     |   |      |   |
| Revenues:                    |   |    |    |        |   |     |   |      |   |
| Product revenues             |   | $       | 403,074 |        | $      | 1,008    |   | $         | 7,344  |   | $ | 411,426 |   |
| Service revenues             |   | 13,742  |    | 176         |   | 1,704    |   | 15,622    |   |
| Government contract revenues |   | —  |    | 12,083      |   | —   |   | 12,083    |   |
| Total revenues               |   | $       | 416,816 |        | $      | 13,267   |   | $         | 9,048  |   | $ | 439,131 |   |
|                         |   |    |    |        |   |     |   |      |   |
| Net income (loss)            |   | $       | 81,687  |        | $      | 616      |   | $         | (4,009 | ) | $ | 78,294 |   |
|                         |   |    |    |        |   |     |   |      |   |
| **December 31, 2002**        |   |    |    |        |   |     |   |      |   |
| Total assets                 |   | $       | 407,886 |        | $      | 4,865    |   | $         | 5,036  |   | $ | 417,787 |   |
|                         |   |    |    |        |   |     |   |      |   |
| **2001**                     |   |    |    |        |   |     |   |      |   |
| Revenues:                    |   |    |    |        |   |     |   |      |   |
| Product revenues             |   | $       | 36,505  |        | $      | 322      |   | $         | 9,709  |   | $ | 46,536 |   |
| Service revenues             |   | 9,584   |    | 107         |   | 1,548    |   | 11,239    |   |
| Government contract revenues |   | —  |    | 16,556      |   | —   |   | 16,556    |   |
| Total revenues               |   | $       | 46,089  |        | $      | 16,985   |   | $         | 11,257 |   | $ | 74,331 |   |
|                         |   |    |    |        |   |     |   |      |   |
| Net income (loss)            |   | $       | 8,729   |        | $      | 673      |   | $         | (1,879 | ) | $ | 7,523 |   |
|                         |   |    |    |        |   |     |   |      |   |
| **December 31, 2001**        |   |    |    |        |   |     |   |      |   |
| Total assets                 |   | $       | 76,431  |        | $      | 4,935    |   | $         | 8,367  |   | $ | 89,733 |   |
|                         |   |    |    |        |   |     |   |      |   |
| **2000**                     |   |    |    |        |   |     |   |      |   |
| Revenues:                    |   |    |    |        |   |     |   |      |   |
| Product revenues             |   | $       | 46,499  |        | $      | 307      |   | $         | 11,907 |   | $ | 58,713 |   |
| Service revenues             |   | 8,278   |    | —      |   | 1,523    |   | 9,801     |   |
| Government contract revenues |   | —  |    | 10,632      |   | —   |   | 10,632    |   |
| Total revenues               |   | $       | 54,777  |        | $      | 10,939   |   | $         | 13,430 |   | $ | 79,146 |   |
|                         |   |    |    |        |   |     |   |      |   |
| Net income (loss)            |   | $       | 318     |        | $      | 7        |   | $         | (2,131 | ) | $ | (1,806 | ) |
|                         |   |    |    |        |   |     |   |      |   |
| **December 31, 2000**        |   |    |    |        |   |     |   |      |   |
| Total assets                 |   | $       | 57,261  |        | $      | 4,056    |   | $         | 8,015  |   | $ | 69,332 |   |

 

At December 31, 2002, the Company has accounts receivable fromcustomers located in the United States, Europe, the Middle East, Asia Pacificand other areas of $129.5 million, $16.0 million, $272,000, $331,000and $145,000, respectively. At December 31, 2002, one customer accountedfor 83.4% of total accounts receivable. No other customer accounted for more than 10% of total accountsreceivable in 2002. At December 31, 2001, one customer accounted for 37.5%of total accounts receivable and a second customer accounted for 15.5% of totalaccounts receivable.

 

The only customer that represented 10% or more of total revenues wasthe FAA/TSA with 82%, 29% and 42% for 2002, 2001 and 2000, respectively.

 

F-21

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The Company markets its products both domestically and internationally.Total revenues by geographic region, based on the location of the customerplacing the order, are as follows (in thousands): 

 
|                        |   | **Year Ended  December 31,** |    |
|-----------------------------|--------|------------------------------|---------|
|                        |   | **2002**                     |    | **2001** |   | **2000** |   |
| United States               |   | $                            | 387,810 |   | $ | 50,157 |   | $ | 58,441 |   |
| Europe                      |   | 38,473                       |    | 17,099 |   | 11,939 |   |
| Middle East                 |   | 3,214                        |    | 3,170 |   | 1,773 |   |
| Asia Pacific                |   | 3,483                        |    | 1,099 |   | 5,239 |   |
| Other                       |   | 6,151                        |    | 2,806 |   | 1,754 |   |
| Total all foreign countries |   |                         | 51,321  |   |   | 24,174 |   |   | 20,705 |   |
| Total worldwide revenues    |   | $                            | 439,131 |   | $ | 74,331 |   | $ | 79,146 |   |

 

Substantially all of the Company’s long-lived assets are located in theUnited States.

 

**NOTE 12. RELATEDPARTY TRANSACTIONS**

 

In 2002, 2001 and 2000, the Company recorded professional andconsulting fees of $210,000, $284,000 and $188,000, respectively, ascompensation to the Company’s directors for services provided as members of theboard of directors as well as consulting services rendered to the Company notin connection with their services as directors.

 

In September 2001, the Company entered into an agreement withDonald & Co. for investment advisory and financing related services.The president of Donald & Co. is a member of the board of directors.Under this agreement, Donald & Co. received a $50,000 cash retainerand a fully-vested warrant to purchase 100,000 shares of the Company’s commonstock at a price of $9.95 per share, the closing price of the Company’s commonstock on the day prior to the date of issuance. The warrant expires five yearsfrom date of issuance. The fair value of the warrant was $650,000, which wasestimated on the date of grant using the Black-Scholes option pricing modelwith the following assumptions: no dividends, risk-free interest rate of 3.94%,volatility of 78% and a contractual life of five years. In September 2002, theCompany issued 100,000 shares of common stock under the warrant.  However, in lieu of paying cash for theshares, 34,153 shares valued at $29.13 per share were returned to the Companyto settle the transaction.  Such shareswere recorded as treasury stock. One-half of the cash retainer and warrant, related to on-goinginvestment and financial advisory services, was recorded in other currentassets and was amortized over the one-year term of the agreement. The Companyrecorded amortization expense of $262,000 and $88,000 in 2002 and 2001,respectively. The remaining balance of $350,000, related to services providedin connection with the Company’s follow-on offering in April 2002 was nettedagainst the proceeds from the offering.

 

In August 1996, January 1997 and January 1999, theCompany entered into consulting agreements with BGI, Inc. (“BGI”), aVirginia-based international consulting firm engaged to assist the Company withthe marketing of the Company’s EDS products to the U.S. government. InMarch 1998, Morris Busby, president and a controlling shareholder of BGI,was elected to the Company’s board of directors. The Company paid consultingfees for BGI consulting services of $120,000 in 2000, and recorded additionalconsulting expenses of $108,000 pursuant to an agreement to issue common stock.The agreement expired on December 31, 2000.

 

**NOTE 13. LICENSEAGREEMENTS**

 

In connection with the formation of the Company, the Company obtainedan exclusive, worldwide, and fully-paid license from Imatron, Inc.regarding its patents and know-how related to (1) scanners for inspectionof mail, freight, parcels, baggage and wood products, and (2) compactmedical scanners for military field applications. The license allows theCompany to develop, manufacture and sell systems based on a different type ofCT technology than is currently incorporated in the Company’s CTX Series. TheCompany, in exchange, granted to Imatron an exclusive, worldwide and fully paidlicense under the Company’s then existing or future patents and know-how to

 

F-22

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permit Imatron to utilize such technology in medical scanners otherthan compact medical scanners for military field applications. The licenseexpires in 2009. No royalties have been paid under this license.

 

The Company has granted the TSA a two-year royalty-bearing license,commencing in March 2002, to enable other manufacturers to build EDSproducts based on the Company’s technology for the TSA.  The TSA has not exercised this license todate.

 

In April 1999, Quantum entered into a Technology License Agreementwith International Business Machines Corporation (“IBM”). This agreement is aten-year, non-exclusive, non-transferable, worldwide license for certaindetection technology. A one-time license fee was paid to IBM. Quantum issubject to royalty payments based upon the net sales price of certain productssold or otherwise transferred by IBM. There is no minimum royalty payment. Noroyalties have been paid under this license.

 

In June 1997, Quantum entered into a joint venture to performresearch and development related to certain detection technologies. In exchangefor a 38% ownership interest in the joint venture, Quantum granted a non-exclusive,royalty free, perpetual, transferable sub-license on the SuperconductorTechnology, agreed that the joint venture will be the sole source offabrication and testing of products developed by the joint venture, and agreedto guarantee one-half of a $200,000 working capital loan to the joint venture.In connection with the formation of the joint venture, Quantum sold equipmentto the joint venture in exchange for an eleven-year note receivable of$100,000, bearing interest at 6.7% per annum. In January 1999, Quantumsold sufficient shares to reduce its ownership in the joint venture to 10% andwas released from its obligation to guarantee one-half of the working capitalloan to the joint venture.

 

In March 1995, Quantum executed a ten-year exclusive licenseagreement with a third party. Quantum is subject to royalty payments based on apercentage of the net sales price of certain products made, used or sold.Minimum annual royalties of $20,000 are due beginning in calendar year 1997through the remaining term of the agreement. Quantum did not incur royaltyexpense under this agreement in 1995 or 1996, and paid the minimum royalty of$20,000 in 1997 and 1998. In January 1999, Quantum and the licensor agreedto modify the license by expanding the field of use, increasing the minimumannual royalty to $70,000 and extending the term until January 2009.Quantum paid a one-time fee of $50,000 to obtain such modification andextension and made the minimum annual royalty of $70,000 for each of the years1999 through 2002.

 

In recognition of development costs incurred by QuantumDesign, Inc. (“QD”) prior to the acquisition of Quantum, Quantum agreed topay QD a royalty rate of 4% of net sales of certain products, whether sold byQuantum or any licensee, for a period of six years from the effective date ofthe agreement, April 15, 1994. The agreement also established minimumroyalty payments of $50,000 in years 1997 and 1998, which were applied againstroyalties that become due to QD in the respective fiscal years. This agreementexpired in 2000.

 

**NOTE 14.CONTINGENCIES**

 

The Company may be involved, from time to time, in litigation relatingto claims arising out of its operations in the normal course of business. TheCompany is not currently a party to any legal proceedings, the adverse outcomeof which, in management’s opinion, individually or in aggregate would have amaterial adverse effect on the Company’s business, financial condition, resultsof operations or cash flows.

 

F-23

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**NOTE 15. BALANCE SHEET COMPONENTS**

 
| **(in thousands)**                                     |   | **December  31,** |    |
|--------------------------------------------------------|--------|-------------------|---------|
|                                                   |   | **2002**          |    | **2001** |   |
|                                                   |   |              |    |   |   |
| Accounts receivable, net:                              |   |              |    |   |   |
| Billed                                                 |   | $                 | 89,241  |   | $ | 16,735 |   |
| Unbilled                                               |   | 54,396            |    | 10,693 |   |
| Other receivables                                      |   | 3,042             |    | 166 |   |
| Subtotal                                               |   | 146,679           |    | 27,594 |   |
| Less:   allowance for doubtful accounts           |   | (384              | )       | (355 | ) |
| Total                                                  |   | $                 | 146,295 |   | $ | 27,239 |   |
|                                                   |   |              |    |   |   |
| Inventories:                                           |   |              |    |   |   |
| Raw material and purchased components                  |   | $                 | 22,696  |   | $ | 8,148 |   |
| Field service spare parts                              |   | 16,145            |    | 9,877 |   |
| Work-in-process                                        |   | 21,927            |    | 5,794 |   |
| Finished goods                                         |   | 3,996             |    | 3,285 |   |
| Total                                                  |   | $                 | 64,764  |   | $ | 27,104 |   |
|                                                   |   |              |    |   |   |
| Property and equipment, net:                           |   |              |    |   |   |
| Machinery and equipment                                |   | $                 | 10,864  |   | $ | 6,749 |   |
| Self constructed assets                                |   | 5,670             |    | 5,550 |   |
| Furniture and fixtures                                 |   | 1,383             |    | 1,139 |   |
| Leasehold improvements                                 |   | 3,804             |    | 3,214 |   |
| Subtotal                                               |   | 21,721            |    | 16,652 |   |
| Less:   accumulated depreciation and amortization |   | (14,496           | )       | (10,939 | ) |
| Total                                                  |   | $                 | 7,225   |   | $ | 5,713 |   |
|                                                   |   |              |    |   |   |
| Intangible assets, net:                                |   |              |    |   |   |
| Goodwill                                               |   | $                 | 681     |   | $ | 2,912 |   |
| Developed technologies                                 |   | 1,535             |    | 1,535 |   |
| Acquired workforce                                     |   | —            |    | 662 |   |
| Patents                                                |   | 428               |    | 362 |   |
| Licenses                                               |   | 83                |    | 83 |   |
| Covenant not to compete                                |   | 50                |    | 50 |   |
| Subtotal                                               |   | 2,777             |    | 5,604 |   |
| Less:   accumulated amortization                  |   | (1,174            | )       | (1,593 | ) |
| Total                                                  |   | $                 | 1,603   |   | $ | 4,011 |   |
|                                                   |   |              |    |   |   |
| Accrued liabilities:                                   |   |              |    |   |   |
| Accrued warranty                                       |   | $                 | 19,890  |   | $ | 3,175 |   |
| Accrued employee compensation                          |   | 7,540             |    | 5,499 |   |
| Income taxes                                           |   | 17,919            |    | 210 |   |
| Foreign currency forward contracts                     |   | 4,948             |    | — |   |
| Other                                                  |   | 15,067            |    | 3,938 |   |
| Total                                                  |   | $                 | 65,364  |   | $ | 12,822 |   |

 

F-24

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Unbilled receivables are comprised of those amounts billable tocustomers upon satisfaction of certain activities, such as installation andfinal acceptance, amounts under percentage-of-completion contracts which arenot yet billed at the balance sheet date and other amounts not yet billed dueto timing of invoice preparation.

 

Self-constructed assets are manufactured by the Company for use insystem testing and support, and include the cost of parts and materials and an overheadallocation. The Company depreciates self-constructed assets over theirrespective estimated useful lives, which range from three to five years.

 

During the years ended December 31, 2002, 2001 and 2000, theCompany recorded amortization expense for its intangible assets of $324,000,$794,000 and $682,000, respectively. The carrying value for goodwill as ofDecember 31, 2002 was adjusted to $681,000 to reflect the impairment write downof $2.1 million and to include the $331,000 balance previously classified asacquired workforce.  Expected futureamortization expense for intangibles balances at December 31, 2002 are asfollows:

 
| **(in thousands)**                   |   | **2003** |   | **2004** |   | **2005** |   | **2006** |   | **2007** |   |
|--------------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
| Expected future amortization expense |   | $        | 343    |     | $      | 341      |   | $        | 33     |     | $      | 23 |   | $ | 9 |   |
|                                      |        |          |        |          |        |          |        |          |        |          |        |  |  |  |  |  |

 

At December 31, 2002 and 2001, the Company had $366,000 and$256,000, respectively, of capitalized lease equipment and related accumulatedamortization of $250,000 and $183,000, respectively.

 

The delivery orders received from the FAA and TSA beginning in April2002 are governed by a letter contract dated February 19, 2002.  The contract specifies that product priceswill be reduced by an amount equal to 75% of actual bill of material savings.  While this contract has not yet beendefinitized, the Company has accrued a liability for the estimated amount ofmaterial cost savings to be shared with the TSA.  The estimate was determined by the quantity of product shipmentsto the TSA under the contract extended, for each model, by 75% of the netdecrease in the bill of materials for the production of those unitsshipped.  The estimated liability of$8.3 million at December 31, 2002 has been recorded as a reduction ofrevenues for the year and, once the contract is definitized, the liability willbe adjusted to reflect agreed upon payments to the TSA. The Company anticipatesthat the contract will be definitized by the end of the second quarter of 2003.

 

**NOTE 16. SUBSEQUENTEVENT**

 

OnFebruary 21, 2003 the Company entered into a definitive agreement to acquireYXLON International Holding GmbH for 38.6 million euros.  The transaction would be funded with cash,and is expected to close by the end of March 2003.  The Company would be required to make an additional payment of10.0 million euros if YXLON’s XES 3000 or XES 3500 x-ray diffraction product iscertified for explosives detection by the TSA by December 31, 2003.

 

F-25

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**SELECTED QUARTERLYFINANCIAL DATA (UNAUDITED)**

 
| **Quarter ended 2002**                     |   |         |   |        |   |         |   |        |    |
|--------------------------------------------|--------|--------------|--------|-------------|--------|--------------|--------|-------------|---------|
| **(in thousands, except per share  data)** |   | **March 31** |   | **June 30** |   | **Sept. 29** |   | **Dec. 31** |    |
|                                       |   |         |   |        |   |         |   |        |    |
| Total revenues                             |   | $            | 33,198 |        | $      | 68,426       |   | $           | 117,060 |   | $ | 220,447 |   |
| Gross profit                               |   | 13,424       |   | 28,436      |   | 50,043       |   | 92,992      |    |
| Net income                                 |   | 2,818        |   | 9,606       |   | 21,473       |   | 44,397      |    |
| Basic income per share                     |   | 0.21         |   | 0.58        |   | 1.28         |   | 2.62        |    |
| Diluted income per share                   |   | 0.17         |   | 0.52        |   | 1.17         |   | 2.40        |    |
|                                            |        |              |        |             |        |              |        |             |         |  |  |  |  |

 
| **Quarter ended 2001**                     |   |        |   |       |   |         |   |        |       |
|--------------------------------------------|--------|-------------|--------|------------|--------|--------------|--------|-------------|------------|
| **(in thousands, except per share  data)** |   | **April 1** |   | **July 1** |   | **Sept. 30** |   | **Dec. 31** | ** ** |
|                                       |   |        |   |       |   |         |   |        |       |
| Total revenues                             |   | $           | 17,497 |       | $      | 17,400       |   | $           | 16,404     |   | $ | 23,030 |   |
| Gross profit                               |   | 6,428       |   | 5,337      |   | 5,353        |   | 8,259       |       |
| Net income                                 |   | 89          |   | 144        |   | 447          |   | 6,843       |       |
| Basic income per share                     |   | 0.01        |   | 0.01       |   | 0.03         |   | 0.51        |       |
| Diluted income per share                   |   | 0.01        |   | 0.01       |   | 0.03         |   | 0.43        |       |
|                                            |        |             |        |            |        |              |        |             |            |  |  |  |  |

 

F-26

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**InVisionTechnologies, Inc.Schedule II—Valuation andQualifying AccountsYears Ended December 31, 2002, 2001 and 2000(in thousands)**

 
|                             |   |                                 |   | **Additions**                       |   |                            |   |           |   |
|----------------------------------|--------|--------------------------------------|--------|-------------------------------------|--------|---------------------------------|--------|----------------|--------|
|                             |   | **Balance at  beginning  of period** |   | **Charged to  costs and  expenses** |   | **Charged to  other  accounts** |   | **Deductions** |   | **Balance at  end of  period** |   |
| Allowance  for doubtful accounts |   |                                 |   |                                |   |                            |   |           |   |   |   |
| 2002                             |   | $                                    | 355    |                                | $      | 170                             |   | $              | — |   | $ | 141 |   | $ | 384 |   |
| 2001                             |   | $                                    | 302    |                                | $      | 168                             |   | $              | — |   | $ | 115 |   | $ | 355 |   |
| 2000                             |   | $                                    | 171    |                                | $      | 188                             |   | $              | 101    |   | $ | 158 |   | $ | 302 |   |

 
|             |   | **Balance at  beginning  of year** |   | **Accruals for  warranties issued** |   | **Reduction for payments made** |   | **Changes in accruals related  to pre-existing  warranties** |   | **Balance at  end of  year** |   |
|------------------|--------|------------------------------------|--------|-------------------------------------|--------|---------------------------------|--------|--------------------------------------------------------------|--------|------------------------------|--------|
| Accrued warranty |   |                               |   |                                |   |                            |   |                                                         |   |                         |   |
| 2002             |   | $                                  | 3,175  |                                | $      | 26,428                          |   | $                                                            | (9,887 | )                            | $      | 174 |   | $ | 19,890 |   |
| 2001             |   | $                                  | 4,198  |                                | $      | 2,208                           |   | $                                                            | (3,285 | )                            | $      | 54 |   | $ | 3,175 |   |
| 2000             |   | $                                  | 2,404  |                                | $      | 4,057                           |   | $                                                            | (2,205 | )                            | $      | (58 | ) | $ | 4,198 |   |

 

F-27

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