##### Table of Contents



UNITED
    STATES SECURITIES AND EXCHANGE COMMISSIONWashington, D.C.
    20549
  Form 10-K
  (Mark One)þ

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended
    December 31, 2006oro

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period
    from          to          .   Commission file number
    000-27687
 BSQUARE CORPORATION
 (Exact name of registrant as
    specified in its charter)
  Washington

91-1650880(State or other jurisdiction
    of
    incorporation or organization)

(I.R.S. Employer
    Identification No.)   110
    110th Avenue
    NE, Suite 200, Bellevue, Washington 98004 (Address
    of principal executive offices)
  (425) 519-5900
    (Registrants telephone number, including area
    code)
  Securities registered pursuant to Section 12(b) of the
    Act:
   Title of Each Class

Name of Each Exchange on Which RegisteredCommon Stock, no par value

The NASDAQ Stock Market LLC
    (NASDAQ Global Market)   Securities registered pursuant to Section 12(g) of the
    Act:
 None
  o þ
  o þ
  þ o
  Regulation S-K Form 10-K Form 10-K. o
  Rule 12b-2  o o þ
  Rule 12b-2).  Yes o þ
      DOCUMENTS
    INCORPORATED BY REFERENCE
  Form 10-K.




---



##### 



BSQUARE
    CORPORATION
  FORM 10-K
  TABLE OF
    CONTENTS
  PagePART IItem 1


Business


3Item 1A


Risk
    Factors


14Item 2


Properties


24Item 3


Legal
    Proceedings


24Item 4


Submission of
    Matters to a Vote of Security Holders


26PART IIItem 5


Market for
    Registrants Common Equity, Related Stockholder Matters and
    Issuer Purchases of Equity Securities


26Item 6


Selected Financial
    Data


27Item 7


Managements
    Discussion and Analysis of Financial Condition and Results of
    Operations


28Item 7A


Quantitative and
    Qualitative Disclosures About Market Risk


39Item 8


Financial
    Statements and Supplementary Data


41Item 9


Changes in and
    Disagreements with Accountants on Accounting and Financial
    Disclosure


67Item 9A


Controls and
    Procedures


67PART IIIItem 10


Directors,
    Executive Officers and Corporate Governance


67Item 11


Executive
    Compensation


67Item 12


Security Ownership
    of Certain Beneficial Owners and Management and Related
    Stockholder Matters


67Item 13


Certain
    Relationships and Related Transactions, and Director
    Independence


68Item 14


Principal
    Accounting Fees and Services


68PART IVItem 15


Exhibits, Financial
    Statement Schedules


68Signatures





69EXHIBIT 10.22(A)EXHIBIT 21.1EXHIBIT 23.1(A)EXHIBIT 23.1(B)EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2   2




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PART I Item 1.  Business.



FORWARD-LOOKING
    STATEMENTS



This Annual Report on
    Form 10-K
    and the documents incorporated herein by reference contain
    forward-looking statements within the meaning of
    Section 27A of the Securities Act of 1933 and
    Section 21E of the Securities Exchange Act of 1934 based on
    current expectations, estimates and projections about our
    industry and our managements beliefs and assumptions. When
    used in this
    Form 10-K
    and elsewhere, the words believes,
    plans, estimates, intends,
    anticipates, seeks and
    expects and similar expressions are intended to
    identify forward-looking statements. These forward-looking
    statements include, but are not limited to, statements about our
    plans, objectives, expectations and intentions and other
    statements that are not historical facts. These forward-looking
    statements are not guarantees of future performance and are
    subject to certain risks and uncertainties that are difficult to
    predict. Accordingly, actual results may differ materially from
    those anticipated or expressed in such statements as a result of
    a variety of factors, including those set forth under
    Item 1A, Risk Factors. Such forward-looking
    statements include, but are not limited to, statements with
    respect to the following: 
    The development of the smart device market and our ability to
    address its opportunities and challenges;
    The adoption of Windows CE, Windows XP Embedded, Pocket PC and
    Smartphone as operating systems of choice for many smart device
    hardware and software applications vendors;
    Our business plan and our strategy for implementing our plan;
    Our ability to expand our strategic relationships with hardware
    and software vendors;
    Our ability to maintain our relationship with Microsoft
    Corporation (Microsoft);
    Our ability to address challenges and opportunities in the
    international marketplace;
    Our ability to develop our technology and expand our proprietary
    software and service offerings; and
    Our anticipated working capital needs and capital expenditure
    requirements, including our ability to meet our anticipated cash
    needs.   3




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BUSINESS
  Overview
  Form 10-K, ® ® point-of-sale tm .
      th (425) 519-5900.
  Industry
    Background
  easy-to-use,
        
    Growing demand by business professionals and high-end consumers
    for converged mobile devices that combine telephony, data (such
    as email and internet browsing), multimedia and location
    awareness is driving new sophisticated smart device designs by
    our OEM customers;
    The ubiquity of cellular and WLAN wireless networks is driving
    rapid adoption of smart devices that leverage broadband and
    high-speed wireless data networks, including Internet Protocol
    (IP) set-top boxes, 4




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##### Table of Contents



voice-over-IP
    (VoIP) phones, residential gateways, and home networking
    solutions linking smart devices with PCs;  
    The baseline expectation for device functionality continues to
    grow. Users of smart devices expect to be able to access email
    and the Internet and synchronize their devices with corporate
    data sources. Microsoft operating systems are already well
    positioned to leverage this trend with built-in synchronization
    capabilities, access to Exchange email servers, and similar
    functionality;
    Security is becoming an increasingly important concern as
    devices are able to access networks and store sensitive
    information locally such as email, spreadsheets and other
    documents. Users are demanding that these types of information
    be protected in the same ways they are protected on the
    desktop; and
    Higher bandwidth networks coupled with the larger displays and
    increased processing power found on new devices means that more
    multi-media content will be available to devices 
    increasing demand for digital rights management, content
    management and related technologies.  Software
    and Service Solutions for Smart Device Makers
    
    A large North American OEM continued to engage us to assist in
    the development and testing of mobile office phones;
    Palm, Inc. continued to engage us to provide engineering
    services for its series of Windows Mobile Smartphone devices;
    A silicon vendor engaged us to develop drivers for several of
    its silicon solutions and to include its components on our
    proprietary hardware reference designs;
    A silicon vendor engaged us to assist in the development of a
    series of board support packages (BSPs) in support of various
    processors;
    Several large Asian OEMs engaged us to assist in the development
    of new lines of Windows Mobile-based handheld devices;
    A large North American silicon vendor engaged us to assist in
    developing several Windows Mobile BSPs in support of its new
    line of processors focused on the handset market; and
    Over 75 OEMs and silicon vendors  including Symbol
    Technologies, Hewlett-Packard Company (HP), ASUStek Computer,
    Hand Held Products and Lite-On Technology
    Corporation  licensed our SDIO Now! technology
    in 2006 for integration into their smart devices.    Third-Party
    Software Products
    
    We are a Microsoft authorized Value-Added Provider (VAP) of
    Windows Embedded operating systems (OS) and toolkits for Windows
    CE, Windows XP/NT Embedded, Windows XP Professional with
    Embedded Restrictions, Windows Server with Embedded
    Restrictions, Windows XP Embedded for Point of Sale and
    Microsoft Classic operating systems with Embedded
    restrictions, including DOS and Windows 98/2000/ 5




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ME/NT. The majority of our software revenue in 2006 was earned
    through the resale of Microsoft Embedded operating
    systems; and  
    We
    sub-license
    and resell other third-party software such as the Esmertec Jeode
    Java Virtual Machine (JVM) under our
    JEM-CEtm
    brand name and Datalight Inc.s FlashFX and Reliance
    products.  Proprietary
    Software Products
    
    SDIO Hx  SDIO (Secure Digital Input Output) is an
    industry standard format that allows very small form-factor
    peripheral and memory cards to be used with smart devices. Our
    SDIO solutions have become the industry standard software
    development kit used by OEMs, ODMs and peripheral vendors who
    are creating SDIO solutions for smart devices running Microsoft
    Windows CE and Windows Mobile operating systems. There are
    currently over 100 licensees of our SDIO technology.    Wi-Fi/memory
    
    Media+ Portable Media Player  Media+ is a digital
    media-management and player software solution based on
    Microsoft®
    Windows®
    CE 5.0 that enables OEMs to quickly enter the growing market for
    PMP players, a new product category that enables consumers to
    enjoy movies and video clips, view family photos, and listen to
    music on a single mobile device.
    Our DevkitIDP line of Marvell
    XScale®
    Technology-based development platforms accelerate time to market
    for OEMs building Windows CE 5.0, Windows CE 6.0 and Windows
    Mobile 5.0 embedded devices. We currently ship DevkitIDP 255,
    acquired from Vibren Technologies, Inc. (Vibren) in August 2005.
    The DevkitIDP 255 is based on the Marvel PXA255 Embedded
    Processor. In 2006, we launched the DevkitIDP 270 based on a new
    generation Marvell PXA270 embedded processor, as well as
    DevKitIDP 320 based on the new Marvell 320 PROCESSORS.. We
    intend on introducing additional development platforms in the
    future which may be based on other silicon vendors processor
    families. Our DevkitIDP products uniquely offer a wide variety
    of peripheral chips and multiple expansion slots, which provides
    developers valuable flexibility in the early stages of
    development when device functionality is being validated. The
    DevkitIDP product layout is optimized so developers can quickly
    access hardware test points which shortens debug time.
    Our SchemaBSP tool, acquired from Vibren, reduces customer
    development efforts. SchemaBSP offers a revolutionary three-step
    process that, when used in conjunction with Microsoft Platform
    Builder, reduces Windows CE board bring up time by up to 40%.
    Once an BSP is created with SchemaBSP, the architecture of the
    tool enables code reuse across multiple product lines, easy BSP
    updates when new hardware features are added to a design, and
    quick migration to new OS versions of Windows CE.
    Universal serial bus (USB) interfaces. 6




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Year Ended December 31,2006


2005


2004Software revenue:Third-party software

$
30,317


$
28,561


$
25,663BSQUARE proprietary software


2,617



2,649



2,701Total software revenue

$
32,934


$
31,210


$
28,364Software revenue as a percentage
    of total revenue


66
%


73
%


73
%Third-party software revenue as a
    percentage of total software revenue


92
%


92
%


90
%     Engineering
    Service Offerings
    
    Device solution strategy consulting;
    Software and hardware design and development services;
    Platform development systems integration;
    Application, middleware and multimedia software development;
    Quality assurance and testing services;
    Hardware design, prototype and product development services;
    Customer technical support; and
    Platform development and quality assurance training.      Year Ended December 31,2006


2005


2004Total service revenue

$
16,881


$
11,713


$
10,556Service revenue as a percentage of
    total revenue


34
%


27
%


27
%   Strategy
    
    Enhance our proprietary software product portfolio to generate
    additional revenue, particularly higher margin revenue, through
    which will have the added benefit of increasing opportunities to
    sell additional engineering services and third-party software
    products to our customers. During 2006, we increased our level
    of research and development in conjunction with the SDIO Hx
    version releases mentioned previously as well as through the
    development of our DevKitIDP references designs. We are
    continuing to execute and 7




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evolve our product strategy and expect to continue to invest in
    new product development initiatives during 2007;  
    Provide our North American customers of Windows Embedded
    operating systems with additional product offerings as they
    become available from Microsoft. For example, in 2006, Microsoft
    made available to its authorized distributors the Window
    Embedded Point CE 6.0 operating system, which is targeted at the
    general device market;
    Expand our engineering service offerings by adding new packaged
    engineering services, engineering capabilities, training and
    custom consulting offerings; for example, we were funded by
    Microsoft to develop the Windows CE 6.0 training curriculum and
    plan to deliver the first training course to customers early in
    2007;
    Leverage the significant number of customers gained through our
    resale of Microsoft Embedded operating systems by selling these
    customers additional software and service offerings. In each
    quarter, we typically sell Microsoft Embedded operating systems
    to over 400 unique customers. Today, more of these customers
    purchase service or software offerings other than the core
    Microsoft Embedded operating systems than in the past; and
    Increase the percentage of sales derived from our international
    customers, particularly by focusing on growing sales in the
    Asia-Pacific region.    Relationship
    with Microsoft and Impact on our Smart Device Solutions
    Business
    
    We are one of Microsofts largest distributors of embedded
    operating systems worldwide;
    We are a Windows Embedded Gold-level Systems Integrator;
    We were the Microsoft Systems Integrator of the Year for 2006;
    We are a developer and provider of Microsoft Official Curriculum
    Training for Windows CE and Windows XP Embedded;
    We are a leading systems integrator for Microsofts Windows
    Mobile for Smartphone and Pocket PC-based device development
    projects;
    We are a Preferred Provider of Visual Tools to Microsoft;
    We are a Gold-level member of Microsofts Third-Party Tools
    Provider Program;
    We are an authorized Microsoft Windows CE for Automotive
    Solutions Integrator; and
    We have been engaged by Microsoft on various service engagements.    
    We gain early access to new Microsoft embedded software and
    other technologies;
    We are able to leverage co-marketing resources from Microsoft,
    including market development funds, to support our own marketing
    and sales efforts;
    We participate in Microsoft-sponsored trade shows, seminars, and
    other events;
    We receive sales leads from Microsoft that enable us to sell our
    smart device software and service solutions; 8




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
    We receive certain rebates based upon certain predefined
    objectives and our Microsoft Embedded operating systems sales
    volume; and
    We participate in Windows Embedded and Windows Mobile design
    reviews, enabling early access to product roadmap information
    wherein we provide important technical and customer feedback.    Customers
    Sales and
    Marketing
      Research
    and Development
    Competition
  :
  
    Our current and potential customers internal research and
    development departments, which may seek to develop their own
    proprietary products and solutions that compete with our
    proprietary software products and engineering services;
    North American engineering service firms such as Intrinsyc,
    Vanteon and Teleca;
    Off-shore development companies such as WiPro, particularly
    those focused on the North American marketplace
    ODMs, particularly those in Taiwan who are adding software
    development capabilities to their offerings;
    Contract manufacturers who are adding software development
    capabilities to their offerings; and
    Microsoft Embedded operating system distributors such as Arrow
    and Avnet. Larger customers of Microsoft Embedded operating
    systems are typically knowledgeable of the competing
    distributors in the North American market and,
    consequently, will often put large orders out to bid amongst the
    distributors, which can create margin pressure and make it
    difficult to maintain long-term relationships with these
    customers. The gross profit 9




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margin on sales of Microsoft Embedded Windows licenses is
    relatively low, historically about 14% on average. There can be
    no assurance that gross profit on future sales will not decline
    given these competitive pressures.    International
    Operations
      Personnel
      December 31,2006


2005


2004Professional Engineering Services


109



68



59Research and Product Development


12



9



7Sales, Marketing and Administrative


49



47



48Total


170



124



114     Intellectual
    Property and Other Proprietary Rights
   10




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Available
    Information
  1-800-SEC-0330. http://www.sec.gov
  www.bsquare.com. Form 10-K, Form 10-Q Form 8-K
  Directors
    and Executive Officers
    Name

Age

PositionsDonald B. Bibeault


65


Chairman of the BoardBrian T. Crowley


46


President and Chief Executive
    Officer, DirectorElwood D. Howse, Jr.


67


DirectorElliott H. Jurgensen, Jr.


62


DirectorScot E. Land


53


DirectorWilliam D. Savoy


42


DirectorKendra A. VanderMeulen


55


DirectorCarey E. Butler


52


Vice President, Professional
    Engineering ServicesScott C. Mahan


42


Vice President, Finance; Chief
    Financial Officer; Secretary and TreasurerLarry C. Stapleton


44


Vice President, North American
    Sales    11




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12




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13




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Item 1A.
    Risk
    Factors.  Form 10-K
  Microsoft-Related
    Risk Factors
    If we
    do not maintain our OEM Distribution Agreement with Microsoft,
    our revenue would decrease and our business would be adversely
    affected.
  and/or
  Microsoft
    has audited our records under our OEM Distribution Agreement in
    the past and will do so again in the future, and any negative
    audit results could result in additional charges
    and/or the
    termination of the ODA.
   14




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If we
    do not maintain our favorable relationship with Microsoft, we
    will have difficulty marketing and selling our software and
    services and may not receive developer releases of Windows
    Embedded operating systems and Windows Mobile targeted
    platforms. As a result, our revenue and operating results could
    suffer.
  and/or
  Unexpected
    delays or announcement of delays by Microsoft of Windows
    Embedded operating systems and Windows Mobile targeted platforms
    product releases could adversely affect our revenue and
    operating results.
  and/or
  If
    Microsoft adds features to its Windows operating system or
    develops products that directly compete with products and
    services we provide, our revenue and operating results could be
    negatively impacted.
     15




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If the
    market for Windows Embedded operating systems and Windows Mobile
    targeted platforms fails to develop further, develops more
    slowly than expected, or declines, our business and operating
    results may be materially harmed.
    
    Microsofts development and support of the Windows Embedded
    and Windows Mobile markets. As the developer and primary
    promoter of Windows CE, Windows XP Embedded and Windows Mobile,
    if Microsoft were to decide to discontinue or lessen its support
    of these operating systems and platforms, potential customers
    could select competing operating systems, which could reduce the
    demand for our Windows Embedded and Windows Mobile software
    products and engineering services which is our primary focus
    today;
    The ability of the Microsoft Windows Embedded operating systems
    and Windows Mobile software to compete against existing and
    emerging operating systems for the smart device market,
    including: VxWorks and pSOS from WindRiver Systems Inc.; Symbian
    and Palm OS from PalmSource, Inc.; JavaOS from Sun Microsystems,
    Inc.; and other proprietary operating systems. In particular, in
    the market for handheld devices, Windows Mobile faces intense
    competition from the Linux operating system. In the market for
    converged devices, Windows Mobile faces intense competition from
    the Symbian operating system. Windows Embedded operating systems
    and the Windows Mobile for Smartphone may be unsuccessful in
    capturing a significant share of these two segments of the smart
    device market, or in maintaining its market share therein;
    The acceptance by OEMs and consumers of the mix of features and
    functions offered by Windows Embedded operating systems and
    Windows Mobile targeted platforms; and
    The willingness of software developers to continue to develop
    and expand the applications that run on Windows Embedded
    operating systems and Windows Mobile targeted platforms. To the
    extent that software developers write applications for competing
    operating systems that are more attractive to smart device users
    than those available on Windows Embedded operating systems and
    Windows Mobile targeted platforms, potential purchasers could
    select competing operating systems over Windows Embedded
    operating systems and Windows Mobile targeted platforms.  General
    Business-Related Risk Factors
  Our
    marketplace is extremely competitive, which may result in price
    reductions, lower gross profit margins and loss of market
    share.
    
    Our current and potential customers internal research and
    development departments, which may seek to develop their own
    proprietary products and solutions that compete with our
    proprietary software products and engineering services;
    North American engineering service firms such as Intrinsyc,
    Vanteon and Teleca; 16




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
    Off-shore development companies such as WiPro, particularly
    those focused on the North American marketplace;
    ODMs, particularly those in Taiwan who are adding software
    development capabilities to their offerings;
    Contract manufacturers who are adding software development
    capabilities to their offerings; and
    Microsoft Embedded operating system distributors such as Arrow
    and Avnet. Larger customers of Microsoft Embedded operating
    systems are typically knowledgeable of the competing
    distributors in the North American market and,
    consequently, will often put large orders out to bid amongst the
    distributors, which can create margin pressure and make it
    difficult to maintain long-term relationships with these
    customers. The gross profit margin on sales of Microsoft
    Embedded Windows licenses is relatively low, historically about
    14% on average. There can be no assurance that gross profit on
    future sales will not decline given these competitive pressures.    Our
    ability to maintain or grow the portion of our software revenue
    attributable to our own proprietary software products is
    contingent on our ability to bring to market competitive, unique
    offerings that keep pace with technological changes and needs.
    If we are not successful in doing so, our business would be
    harmed.
    We may
    experience delays in our efforts to develop new products and
    services, and these delays could cause us to miss market
    opportunities which could negatively impact our revenue and
    operating results.
   17




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If the
    market for smart devices develops more slowly than we expect, or
    declines, our revenue may not develop as anticipated, if at all,
    and our business would be harmed.
    
    The development of content and applications for smart devices;
    The willingness of large numbers of businesses and consumers to
    use devices such as smartphones, PDAs and handheld industrial
    data collectors to perform functions historically carried out
    manually, or by traditional PCs, including inputting and sharing
    data, communicating among users and connecting to the
    Internet; and
    The evolution of industry standards or the necessary
    infrastructure that facilitate the distribution of content over
    the Internet to these devices via wired and wireless
    telecommunications systems, satellite or cable.  The
    success and profitability of our engineering service offerings
    are contingent on our ability to differentiate our offerings
    adequately in the marketplace, which is, in turn, contingent on
    our ability to retain our engineering personnel and defend our
    billing rate structure against those of our competitors,
    including those using lower-cost offshore resources. If we are
    unable to do so successfully, our business could be
    harmed.
  and/or
  The
    success and profitability of our service engagements are
    contingent upon our ability to scope and bid engagements and
    deliver our services profitably. If we are unable to do so, our
    service revenue service gross profit margin and operating
    results could be negatively impacted.
    We
    have entered into engineering service agreements in which we
    have agreed to perform our engineering service work at
    relatively low rates per hour in exchange for royalties,
    sometimes guaranteed, in the future. There is no guarantee that
    these arrangements will culminate as anticipated.
   18




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Cooperation
    and support from silicon vendors is critical for the success of
    our hardware reference designs. Such cooperation cannot be
    assured.
    The
    long sales cycle of our products and services makes our revenue
    susceptible to fluctuations.
    
    Customers budgetary constraints and internal acceptance
    review procedures;
    The timing of budget cycles; and
    The timing of customers competitive evaluation processes.    Erosion
    of the financial condition of our customers could adversely
    affect our business.
  and/or
  We may
    be subject to product liability claims that could result in
    significant costs.
    Past
    acquisitions have proven difficult to integrate, and future
    acquisitions, if any, could disrupt our business, dilute
    shareholder value and adversely affect our operating
    results.
  and/or
 19




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day-to-day
  Intellectual
    Property-Related Risk Factors
  Our
    software and service offerings could infringe the intellectual
    property rights of third parties, which could expose us to
    additional costs and litigation and could adversely affect our
    ability to sell our products and services or cause shipment
    delays or stoppages.
   20




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If we
    fail to adequately protect our intellectual property rights,
    competitors may be able to use our technology or trademarks,
    which could weaken our competitive position, reduce our revenue
    and increase our costs.
    and/or
    Our
    software or hardware products or the third-party hardware or
    software integrated with our products may suffer from defects or
    errors that could impair our ability to sell our products and
    services.
   21




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If we
    are unable to license key software from third parties, our
    business could be harmed.
    Governace
    and Contract-Related Risk Factors
  It
    might be difficult for a third-party to acquire us even if doing
    so would be beneficial to our shareholders.
    We
    will incur substantial costs to comply with the requirements of
    the Sarbanes-Oxley Act of 2002.
  Form 10-K
  Non-compliance
    with our lease agreement could have a material adverse impact on
    our financial position.
   22




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Decreased
    effectiveness of equity compensation could adversely affect our
    ability to attract and retain employees, and required changes in
    accounting for equity compensation could adversely affect
    earnings.
    International
    Operations-Related Risk Factors
  Our
    international operations expose us to greater intellectual
    property, management, collections, regulatory and other
    risks.
    
    Greater difficulty in protecting intellectual property due to
    less stringent foreign intellectual property laws and
    enforcement policies;
    Longer collection cycles than we typically experience in the
    North America;
    Unfavorable changes in regulatory practices and tariffs;
    Complex
    and/or
    adverse tax laws
    and/or
    changes thereto. Additionally, we may be subject to income,
    withholding and other taxes for which we may realize no current
    benefit despite the existence of significant net operating
    losses and tax credits in the U.S.;
    Loss or reduction of withholding tax exemptions;
    The impact of fluctuating exchange rates between the
    U.S. dollar and foreign currencies; and
    General economic and political conditions in international
    markets which may differ from those in the U.S.    As we
    increase the amount of software development conducted in
    non-U.S. locations,
    potential delays and quality issues may impact our ability to
    timely deliver our software and services, potentially impacting
    our revenue and profitability.
  non-U.S. locations, non-U.S. locations non-U.S. locations.
 23




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As our
    customers seek more cost-effective locations to develop and
    manufacture their smart devices, particularly overseas
    locations, our ability to continue to sell these customers our
    products and services could be limited, which could negatively
    impact our revenue and operating results.
    Item 2.
    Properties.      Item 3.
    Legal
    Proceedings.  IPO
    Litigation
        en banc.
 24




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en banc
        Customer
    Litigation
     25




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Item 4.
    Submission
    of Matters to a Vote of Security Holders.   PART II  Item 5.
    Market
    for Registrants Common Equity, Related Stockholder Matters
    and Issuer Purchases of Equity Securities.  Market
    Information
  1-for-4
  High


LowYear Ended December 31,
    2006:First Quarter

$
3.99


$
2.77Second Quarter

$
3.04


$
1.87Third Quarter

$
2.50


$
1.93Fourth Quarter

$
3.00


$
1.93Year Ended December 31,
    2005:First Quarter

$
6.00


$
1.84Second Quarter

$
2.32


$
1.52Third Quarter

$
3.04


$
1.84Fourth Quarter

$
4.06


$
1.90   Holders
    Dividends
   26




---



##### Table of Contents



Item 6.
    Selected
    Financial Data.    Year Ended December 31,2006


2005


2004


2003


2002(In thousands, except per share data)Consolidated Statements of
    Operations Data:Revenue

$
49,815


$
42,923


$
38,920


$
37,542


$
37,506Cost of revenue(1)


37,828



33,039



29,870



31,141



30,795Gross profit


11,987



9,884



9,050



6,401



6,711Operating expenses:Selling, general and
    administrative(1)


10,046



9,504



9,176



12,609



19,230Research and development(1)


2,820



1,950



855



1,768



10,747Acquired in-process research and
    development


















1,698Amortization of intangible assets














50



847Impairment of goodwill and other
    intangible assets














453



6,472Restructuring and other related
    charges (credits)










40



(2,960
)


16,249Total operating expenses


12,866



11,454



10,071



11,920



55,243Loss from operations


(879
)


(1,570
)


(1,021
)


(5,519
)


(48,532
)Interest and other income (expense)


442



287



237



1,059



(1,900
)Loss from continuing operations
    before income taxes


(437
)


(1,283
)


(784
)


(4,460
)


(50,432
)Income tax provision


(29
)


(14
)


(11
)


(75
)


(1,696
)Loss from continuing operations


(466
)


(1,297
)


(795
)


(4,535
)


(52,128
)Loss from discontinued operations










(6,256
)


(9,449
)


(6,478
)Loss before cumulative effect of
    change in accounting principle


(466
)


(1,297
)


(7,051
)


(13,984
)


(58,606
)Cumulative effect of change in
    accounting principle


















(14,932
)Net loss

$
(466
)

$
(1,297
)

$
(7,051
)

$
(13,984
)

$
(73,538
)Basic and diluted net loss per
    share:Loss from continuing operations

$
(0.05
)

$
(0.14
)

$
(0.08
)

$
(0.49
)

$
(5.73
)Loss from discontinued operations










(0.66
)


(1.01
)


(0.71
)Cumulative effect of change in
    accounting principle


















(1.64
)Basic and diluted net loss per
    share

$
(0.05
)

$
(0.14
)

$
(0.74
)

$
(1.50
)

$
(8.08
)      Cost of revenue  service

$
190


$



$



$



$
Selling, general and administrative


445



17











Research and development


80















Total stock-based compensation
    expense

$
715


$
17


$



$



$
  27




---



##### Table of Contents



December 31,2006


2005


2004


2003


2002(In thousands)Consolidated Balance Sheet
    Data:Cash, cash equivalents, short-term
    investments and restricted cash

$
11,109


$
10,694


$
12,943


$
17,745


$
35,425Working capital

$
10,252


$
9,502


$
11,125


$
16,490


$
27,957Total assets

$
19,676


$
19,570


$
18,944


$
30,113


$
53,569Long-term obligations, net of
    current portion

$
355


$
379


$
375


$



$
5,431Shareholders equity

$
12,076


$
11,463


$
12,734


$
19,338


$
32,634   Item 7.
    Managements
    Discussion and Analysis of Financial Condition and Results of
    Operations.    Overview
  ® ® point-of-sale tm .
      Critical
    Accounting Judgments
   28




---



##### Table of Contents



Revenue
    Recognition
             29




---



##### Table of Contents



Allowance
    for Doubtful Accounts
    Stock-Based
    Compensation
  Share-Based Payment Accounting for Stock
    Issued to Employees, Accounting for Stock-Based
    Compensation
    Taxes
     30




---



##### Table of Contents



Results
    of Operations
    As a Percentage of Total RevenueYear Ended December 31,2006


2005


2004Consolidated Statements of
    Operations Data:Revenue:Software


66
%


73
%


73
%Service


34



27



27Total revenue


100



100



100Cost of revenue:Software


52



58



56Service


24



19



21Total cost of revenue


76



77



77Gross profit


24



23



23Operating expenses:Selling, general and administrative


20



22



24Research and development


6



5



2Total operating expenses


26



27



26Loss from operations


(2
)%


(4
)%


(3
)%   Comparison
    of the Years Ended December 31, 2006, 2005 and
    2004
  Revenue
       31




---



##### Table of Contents



Software
    revenue
    Year Ended December 31,2006


2005


2004Software revenue:Third-party software

$
30,317


$
28,561


$
25,663BSQUARE proprietary software


2,617



2,649



2,701Total software revenue

$
32,934


$
31,210


$
28,364Software revenue as a percentage
    of total revenue


66
%


73
%


73
%Third-party software revenue as a
    percentage of total software revenue


92
%


92
%


90
%          32




---



##### Table of Contents



50-85%
  Service
    revenue
    Year Ended December 31,2006


2005


2004Total service revenue

$
16,881


$
11,713


$
10,556Service revenue as a percentage of
    total revenue


34
%


27
%


27
%       Gross
    profit
      Year Ended December 31,2006


2005


2004Software gross profit

$
6,817


$
6,531


$
6,471As a percentage of software revenue


21
%


21
%


23
%Service gross profit

$
5,170


$
3,353


$
2,579As a percentage of service revenue


31
%


29
%


24
%Total gross profit

$
11,987


$
9,884


$
9,050As a percentage of total revenue


24
%


23
%


23
%   Software
    gross profit
  cost-of-sales
 33




---



##### Table of Contents



Service
    gross profit
    Operating
    expenses
  Selling,
    general and administrative
        Research
    and development
   34




---



##### Table of Contents



Interest
    and other
    Taxes
       35




---



##### Table of Contents



Loss
    from discontinued operations
    Year Ended December 31,2006


2005


2004Hardware revenue

$



$



$
890Cost of hardware revenue










3,138Gross profit (loss)










(2,248
)Operating expenses










2,272Amortization of intangible assets










267Restructuring and related charges










312Impairment of assets










1,157Loss from discontinued operation

$



$



$
(6,256
)       Year Ended December 31,2006


2005


2004Employee separation

$



$



$
194Impairment of assets










1,157Other charges










118Total restructuring and impairment
    charges

$



$



$
1,469       Liquidity
    and Capital Resources
     36




---



##### Table of Contents



Tabular
    Disclosure of Contractual Obligations
    Payments Due through Year Ended December 31:Contractual Obligations

2007


2008


2009


2010


2011


Thereafter


TotalLong-term debt obligations

$



$



$



$



$



$



$
Equipment financing obligations


























Operating lease obligations


1,024



952



853



926



975



2,889



7,619Purchase obligations


























Other long-term obligations


























Total

$
1,024


$
952


$
853


$
926


$
975


$
2,889


$
7,619     
    In February 2004, we signed an amendment to the lease for our
    former corporate headquarters and simultaneously entered into a
    ten-year lease for a new corporate headquarters, also located in
    Bellevue, Washington. The amendment of the former headquarters
    lease, which was scheduled to terminate on December 31,
    2004, provided that no cash lease payments were to be made for
    the remainder of that lease term. Similarly, the new corporate
    headquarters lease also provided that no cash lease payments
    were to be made during 2004. However, if we default under our
    new corporate headquarters lease, the landlord has the ability
    to demand payment for cash payments forgiven in 2004 under the
    former headquarters lease. The amount of the forgiven payments
    for which the landlord can demand repayment was
    $1.8 million at December 31, 2006. The amount of the
    forgiven payments for which the landlord has the ability to
    demand repayment decreases on the straight-line basis over the
    length of our new ten-year headquarters lease.    Related
    Party Transactions
   37




---



##### Table of Contents



Impact
    of New Accounting Pronouncements
  Share-Based Payment
  Year Ended December 31,2006


2005


2004Cost of revenue  service

$
190


$



$
Selling, general and administrative


445



17



Research and development


80







Total stock-based compensation
    expense

$
715


$
17


$
   SFAS No. 154, Accounting Changes and Error
    Corrections, a Replacement of APB Opinion No. 20 and FASB
    Statement No. 3.
  SFAS No. 155, Accounting for Certain Hybrid
    Financial Instruments  an amendment of FASB
    Statements No. 133 and 140.
  SFAS No. 157, Fair Value Measurements.
  Financial
    Accounting Standards Board Staff Positions and
    Interpretations
  FASB Staff Position (FSP)
    No. 115-1,
    The Meaning of
    Other-Than-Temporary
    Impairment and Its Application to Certain Investments. 115-1 other-than-temporary,
 38




---



##### Table of Contents



other-than-temporary, 115-1 No. 03-1, Other-Than-Temporary 03-1 115-1
  FASB Interpretation No. 48, Accounting for
    Uncertainty in Income Taxes, an interpretation of FASB
    Statement 109.
  SEC Staff
    Accounting Bulletins
  Staff Accounting Bulletin (SAB) No. 108,
    Considering the Effects of a Prior Year Misstatements When
    Quantifying Misstatements in Current Year Financial
    Statements.
  Item 7A.
    Quantitative
    and Qualitative Disclosures About Market Risk.  Interest Rate Risk.
 39




---



##### Table of Contents



Maturing inThree Months


Three Months





Fairor Less


to One Year


Total


Value(Dollars in thousands)As of December 31,
    2006Included in short-term investments

$
7,200


$
226


$
7,426


$
7,426Weighted average interest rate


5.34
%










As of December 31,
    2005Included in short-term investments

$
1,800


$



$
1,800


$
1,800Weighted average interest rate


4.39
%










   Foreign Currency Exchange Rate
    Risk.
     40




---



##### Table of Contents



Item 8.
    Financial
    Statements and Supplementary Data.  BSQUARE
    CORPORATION
  INDEX TO
    CONSOLIDATED FINANCIAL STATEMENTS
  Report of Moss
    Adams LLP, Independent Registered Public Accounting
    Firm


42Report of
    Ernst & Young LLP, Independent Registered Public
    Accounting Firm


43Consolidated
    Balance Sheets


44Consolidated
    Statements of Operations


45Consolidated
    Statements of Shareholders Equity


46Consolidated
    Statements of Cash Flows


47Notes to
    Consolidated Financial Statements


48  41




---



##### Table of Contents



REPORT OF
    MOSS ADAMS, LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING
    FIRM           Share-Based Payment.
      42




---



##### Table of Contents



REPORT OF
    ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC
    ACCOUNTING FIRM          
    43




---



##### Table of Contents



BSQUARE
    CORPORATION
  CONSOLIDATED
    BALANCE SHEETS
  December 31,2006


2005(In thousands, except share amounts)ASSETSCurrent assets:Cash and cash equivalents

$
2,483


$
7,694Short-term investments


7,426



1,800Accounts receivable, net of
    allowance for doubtful accounts of $198 at December 31,
    2006 and $687 at December 31, 2005


7,167



7,296Prepaid expenses and other current
    assets


421



440Total current assets


17,497



17,230Equipment, furniture and leasehold
    improvements, net


821



792Intangible assets, net


101



304Restricted cash


1,200



1,200Other non-current assets


57



44Total assets

$
19,676


$
19,570LIABILITIES AND
    SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable

$
2,634


$
2,662Other accrued expenses


2,877



3,298Accrued compensation


1,046



964Accrued legal fees


534



534Deferred revenue


154



270Total current liabilities


7,245



7,728Deferred rent


355



379Commitments and contingencies
    (Note 7)Shareholders equity:Preferred stock, no par value:
    10,000,000 shares authorized; no shares issued and
    outstanding






Common stock, no par value:
    37,500,000 shares authorized; 9,617,755 shares issued
    and outstanding at December 31, 2006 and
    9,553,566 shares issued and outstanding at
    December 31, 2005


119,229



118,393Accumulated other comprehensive
    loss


(180
)


(423
)Accumulated deficit


(106,973
)


(106,507
)Total shareholders equity


12,076



11,463Total liabilities and
    shareholders equity

$
19,676


$
19,570    44




---



##### Table of Contents



BSQUARE
    CORPORATION
  CONSOLIDATED
    STATEMENTS OF OPERATIONS
  Year Ended December 31,2006


2005


2004(In thousands, except per shareamounts)Revenue:Software

$
32,934


$
31,210


$
28,364Service


16,881



11,713



10,556Total revenue


49,815



42,923



38,920Cost of revenue:Software


26,117



24,679



21,893Service(1)


11,711



8,360



7,977Total cost of revenue


37,828



33,039



29,870Gross profit


11,987



9,884



9,050Operating expenses:Selling, general and
    administrative(1)


10,046



9,504



9,176Research and development(1)


2,820



1,950



855Restructuring and other related
    charges










40Total operating expenses


12,866



11,454



10,071Loss from operations


(879
)


(1,570
)


(1,021
)Interest and other income


442



287



237Loss from continuing operations
    before income taxes


(437
)


(1,283
)


(784
)Income tax provision


(29
)


(14
)


(11
)Loss from continuing operations


(466
)


(1,297
)


(795
)Loss from discontinued operations










(6,256
)Net loss

$
(466
)

$
(1,297
)

$
(7,051
)Basic and diluted loss per share:Loss from continuing operations

$
(0.05
)

$
(0.14
)

$
(0.08
)Loss from discontinued operations


(0.00
)


(0.00
)


(0.66
)Basic and diluted loss per share

$
(0.05
)

$
(0.14
)

$
(0.74
)Shares used in calculation of
    basic and diluted loss per share


9,586



9,541



9,464     (1)
    
    Includes the following amounts related to stock-based
    compensation expense: Cost of revenue  service

$
190


$



$
Selling, general and administrative


445



17



Research and development


80







Total stock-based compensation
    expense

$
715


$
17


$
    45




---



##### Table of Contents



BSQUARE
    CORPORATION
 CONSOLIDATED
    STATEMENTS OF SHAREHOLDERS EQUITY  Accumulated Other





TotalPreferred Stock


Common Stock


Comprehensive


Accumulated


ShareholdersShares


Amount


Shares


Amount


Loss


Deficit


Equity(In thousands, except share amounts)Balance, January 1, 2004










9,375,493


$
117,889


$
(392
)

$
(98,159
)

$
19,338Net loss






















(7,051
)


(7,051
)Foreign currency translation
    adjustment


















(14
)






(14
)Comprehensive loss


























(7,065
)Exercise of stock options










157,589



461











461Balance, December 31, 2004










9,533,082



118,350



(406
)


(105,210
)


12,734Net loss






















(1,297
)


(1,297
)Foreign currency translation
    adjustment


















(17
)






(17
)Comprehensive loss


























(1,314
)Exercise of stock options










20,484



26











26Stock-based compensation














17











17Balance, December 31, 2005










9,553,566



118,393



(423
)


(106,507
)


11,463Net loss






















(466
)


(466
)Foreign currency translation
    adjustment


















17







17Unrealized gain on
    available-for-sale
    securities


















226







226Comprehensive loss


























(223
)Exercise of stock options










64,189



121











121Stock-based compensation














715











715Balance, December 31, 2006





$




9,617,755


$
119,229


$
(180
)

$
(106,973
)

$
12,076    46




---



##### Table of Contents



BSQUARE
    CORPORATION
  CONSOLIDATED
    STATEMENTS OF CASH FLOWS
  Year Ended December 31,2006


2005


2004(In thousands)Cash flows from operating
    activities:Net loss

$
(466
)

$
(1,297
)

$
(7,051
)Adjustments to reconcile net loss
    to net cash provided by (used in) operating activities:Depreciation and amortization


532



379



584Stock-based compensation


715



17



Impairment and restructuring
    charges of discontinued operations










3,069Decrease of assets of discontinued
    operations










781Restructuring and other related
    charges










40Other










(37
)Changes in operating assets and
    liabilities, net of effects of acquisitions and discontinued
    operations:Restricted cash










2,706Accounts receivable, net


133



(2,465
)


1,422Prepaid expenses and other assets


7



(41
)


841Accounts payable and accrued
    expenses


(367
)


1,979



(3,826
)Deferred revenue


(117
)


(118
)


(756
)Deferred rent


(24
)


4



375Net cash provided by (used in)
    operating activities


413



(1,542
)


(1,852
)Cash flows from investing
    activities:Purchases of furniture, equipment
    and leasehold improvements


(357
)


(226
)


(776
)Maturity (purchases) of short-term
    investments, net


(5,400
)


5,000



1,339Acquisition of Vibren assets






(500
)


Proceeds from the disposal of
    equipment










85Net cash provided by (used in)
    investing activities


(5,757
)


4,274



648Cash flows from financing
    activities:Proceeds from exercise of stock
    options


121



26



461Net cash provided by financing
    activities


121



26



461Effect of exchange rate changes on
    cash


12



(7
)


(14
)Net increase (decrease) in cash
    and cash equivalents


(5,211
)


2,751



(757
)Cash and cash equivalents,
    beginning of year


7,694



4,943



5,700Cash and cash equivalents, end of
    year

$
2,483


$
7,694


$
4,943    47




---



##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL STATEMENTS
  1.
    Description
    of Business and Accounting Policies  Description
    of Business
  ® ® point-of-sale
  tm .
  Principles
    of Consolidation
    Use of
    Estimates
    Earnings
    Per Share
    Cash
    and Cash Equivalents
    Restricted
    Cash
   48




---



##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
   Short-term
    Investments
  held-to-maturity available-for-sale.
  Financial
    Instruments and Concentrations of Risk
    Allowance
    for Doubtful Accounts
    Furniture,
    Equipment and Leasehold Improvements
    Computer equipment and system
    software


3 yearsOffice furniture and equipment


3-5 years     Acquired
    Intangible Assets
  Accounting for the Impairment
    or Disposal of Long-Lived Assets.
  Software
    Development Costs
   49




---



##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Research
    and Development
    Advertising
    Costs
    Stock-Based
    Compensation
  Share-Based
    Payment Accounting for Stock Issued to Employees Accounting
    for Stock-Based Compensation
    Comprehensive
    Income (Loss)
  available-for-sale.
 50




---



##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
     December 31,2006


2005Accumulated net unrealized gain on
    available-for-sale
    securities

$
226


$
Accumulated foreign currency
    translation


(406
)


(423
)Accumulated other comprehensive
    loss

$
(180
)

$
(423
)   Income
    Taxes
    Foreign
    Currency Translation
    Revenue
    Recognition
     51




---



##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
           Recent
    Accounting Pronouncements
  SFAS No. 123, Share-Based Payment (Revised
    2004).
  SFAS No. 154, Accounting Changes and Error
    Corrections, a Replacement of APB Opinion No. 20 and FASB
    Statement No. 3.
  SFAS No. 155, Accounting for Certain Hybrid
    Financial Instruments  an amendment of FASB
    Statements No. 133 and 140.
 52




---



##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    SFAS No. 157, Fair Value Measurements.
  Financial
    Accounting Standards Board Staff Positions and
    Interpretations
  FASB Staff Position (FSP)
    No. 115-1,
    The Meaning of
    Other-Than-Temporary
    Impairment and Its Application to Certain Investments. 115-1 other-than-temporary, other-than-temporary, 115-1 No. 03-1, Other-Than-Temporary 03-1 115-1
  FASB Interpretation No. 48, Accounting for
    Uncertainty in Income Taxes, an interpretation of FASB
    Statement 109.
  SEC Staff
    Accounting Bulletins
  Staff Accounting Bulletin (SAB) No. 108,
    Considering the Effects of a Prior Year Misstatements When
    Quantifying Misstatements in Current Year Financial
    Statements.
 53




---



##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    2.
    Cash,
    Cash Equivalents, Short-Term Investments and Restricted
    Cash    December 31,2006


2005Cash and equivalents:Money market funds

$
1,504


$
6,348Cash


979



1,346$
2,483


$
7,694Short-term investments:Municipal securities

$
7,200


$
1,800Equity securities,
    available-for-sale


226



$
7,426


$
1,800Restricted cash:Commercial time deposits

$
1,200


$
1,200     3.
    Equipment,
    Furniture and Leasehold Improvements    December 31,2006


2005Computer equipment and software

$
2,660


$
2,344Office furniture and equipment


1,079



1,041Leasehold improvements


529



5244,268



3,909Less: accumulated depreciation and
    amortization


(3,447
)


(3,117
)$
821


$
792     4.
    Asset
    Purchase   54




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##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
     PurchasePriceAllocationInventory

$
63Lease deposit


5Equipment


61Acquired technology


406Total assets acquired


535Accrued transaction expenses


(26
)Accrued compensation


(9
)Net assets acquired

$
500     5.
    Intangible
    Assets      6.
    Income
    Taxes    December 31,2006


2005Deferred income tax assets:Depreciation and amortization

$
1,594


$
1,915Accrued expenses and reserves


500



744Net operating loss carryforwards


23,912



22,589Capital loss carryforwards


2,898



2,773Research and development credit
    carryforwards


2,048



2,010Stock-based compensation


118



Other


2



154Gross deferred tax assets


31,072



30,185Less: valuation allowance


(31,072
)


(30,185
)Total deferred tax assets

$



$
  55




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##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  :
  Year Ended December 31,2006


2005


2004Taxes at the U.S. statutory
    rate


34.0
%


34.0
%


34.0
%Increase (decrease) resulting from:Increase in valuation allowance


(41.9
)


(28.1
)


(37.3
)International operations


(6.4
)


1.7



(0.2
)State income tax


1.5







Other, net


6.4



(8.7
)


3.3(6.7
)%


(1.1
)%


(0.2
)%       7.
    Commitments
    and Contingencies  Contractual
    Commitments
  month-to-month
   56




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##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
          Operating leases:2007

$
1,0242008


9522009


8532010


9262011


975Thereafter


2,889Total commitments

$
7,619   Legal
    Proceedings
  IPO
    Litigation
       57




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##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
   en banc. en banc
        Customer
    Litigation
   58




---



##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
      8.
    Shareholders
    Equity  Stock
    Options
      Stock-Based
    Compensation
  Share-Based
    Payment Accounting for Stock Issued to Employees Accounting
    for Stock-Based Compensation
 59




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##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
      Year Ended December 31,2006


2005


2004Cost of revenue  service

$
190


$



$
Selling, general and administrative


445



17



Research and development


80







Total stock-compensation expense

$
715


$
17


$
       Key
    Assumptions
    Year Ended December 31,2006


2005


2004SFAS 123R


SFAS 123


SFAS 123Dividend yield


0
%


0
%


0
%Expected life


4 years



4 years



4 yearsExpected volatility


92
%


99
%


140
%Risk-free interest rate


4.8
%


4.1
%


3.1
%Estimated forfeitures


36
%


n/a



n/a   Expected Dividend
  Expected Life:
  Expected Volatility:
 60




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##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
   Risk-Free Interest Rate:
  Estimated Forfeitures:
  Stock
    Option Activity
    Weighted AverageRemainingNumber


Weighted Average


Contractual


Aggregate IntrinsicStock Options

of Shares


Exercise Price


Life (In Years)


ValueOutstanding at January 1, 2004


1,443,427


$
9.69Granted at fair value


794,233



2.59Exercised


(157,589
)


2.86Forfeited


(260,044
)


6.61Expired


(154,969
)


21.50Outstanding at December 31,
    2004


1,665,058



6.33



8.52


$
3,578,918Granted at fair value


580,351



2.89Exercised


(20,484
)


1.29Forfeited


(201,490
)


3.15Expired


(263,067
)


12.15Outstanding at December 31,
    2005


1,760,368



4.75



8.26


$
905,851Granted at fair value


558,400



2.38Exercised


(64,189
)


1.94Forfeited


(138,084
)


2.91Expired


(146,965
)


9.02Outstanding at December 31,
    2006


1,969,530


$
3.98



7.98


$
712,000Vested and expected to vest at
    December 31, 2006


1,596,116


$
4.31



0.35


$
545,000Exercisable at December 31,
    2006


1,058,280


$
5.12



7.04


$
320,000   in-the-money in-the-money
 61




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##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Pro
    Forma Disclosure
    Year Ended December 31,2005


2004Net loss, as reported

$
(1,297
)

$
(7,051
)Compensation expense recognized
    under APB No. 25






Employee compensation expense
    under SFAS No. 123


(848
)


(1,592
)Pro forma net loss

$
(2,145
)

$
(8,643
)Basic and diluted loss per share,
    as reported

$
(0.14
)

$
(0.74
)Pro forma basic and diluted loss
    per share

$
(0.22
)

$
(0.91
)Shares used to calculate pro forma
    basic and diluted loss per share


9,541



9,464   Common
    Stock Reserved for Future Issuance
    December 31,2006


2005Stock options outstanding


1,969,530



1,760,368Stock options available for future
    grant


516,572



319,438Warrants outstanding


100,000



100,0002,586,102



2,179,806   Warrants
    Reverse
    Stock Split
  one-for-four
 62




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##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    9.
    Employee
    Benefit Plan  Profit
    Sharing and Deferred Compensation Plan
    10.
    Supplemental
    Disclosure of Cash Flow Information (in thousands)  Year Ended December 31,2006


2005


2004Cash paid for income taxes

$
38







     11.
    Significant
    Customers    12.
    Related
    Party Transactions    13.
    Geographic
    and Segment Information   63




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##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
     Year Ended December 31,2006


2005


2004Total revenue:North America

$
47,108


$
40,600


$
35,812Asia


2,561



2,261



2,887Other foreign


146



62



221Total revenue(1)

$
49,815


$
42,923


$
38,920   At December 31,2006


2005Long-lived assets:North America

$
877


$
1,047Asia


45



49Total long-lived assets

$
922


$
1,096     (1)
    
    Revenue is attributed to countries based on location of customer
    invoiced.  14.
    Discontinued
    Operations    Year Ended December 31,2006


2005


2004Hardware revenue

$



$



$
890Cost of hardware revenue










3,138Gross profit (loss)










(2,248
)Operating expenses










2,272Amortization of intangible assets










267Restructuring and related charges










312Impairment of assets










1,157Loss from discontinued operations

$



$



$
(6,256
)    64




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##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Year Ended December 31,2006


2005


2004Employee separation

$



$



$
194Impairment of assets










1,157Other charges










118Total restructuring and impairment
    charges

$



$



$
1,469       15.
    Quarterly
    Financial Information (Unaudited)    2006 Quarter Ended

March 31


June 30


September 30


December 31Revenue

$
11,584


$
12,645


$
11,495


$
14,091Gross profit


2,317



3,007



2,827



3,836Income (loss) from operations(1)


(936
)


(177
)


(355
)


589Net income (loss)

$
(849
)

$
(88
)

$
(235
)

$
706Basic and diluted income (loss)
    per share

$
(0.09
)

$
(0.01
)

$
(0.02
)

$
0.07Shares used in calculation of
    income (loss) per share:Basic


9,564



9,586



9,589



9,604Diluted


9,564



9,586



9,589



9,651(1) Stock-based compensation
    expense included in cost of revenue and operating expenses

$
154


$
175


$
185


$
201   65




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##### Table of Contents



BSQUARE
    CORPORATION
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  2005 Quarter Ended

March 31


June 30


September 30


December 31Revenue

$
9,815


$
10,316


$
10,096


$
12,696Gross profit


1,908



2,525



2,254



3,197Loss from operations(2)(3)


(604
)


(54
)


(544
)


(368
)Net loss

$
(545
)

$
(37
)

$
(469
)

$
(246
)Basic and diluted loss per share

$
(0.06
)

$
(0.00
)

$
(0.05
)

$
(0.03
)Shares used in calculation of
    basic and diluted loss per share


9,535



9,536



9,542



9,551(2) Stock-based compensation
    expense included in operating expenses

$



$



$
17


$
   (3)
    In the fourth quarter of 2005, the Company incurred bad debt
    expense of $399,000 related to an ongoing customer dispute. 66




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##### Table of Contents



Item 9.
    Changes
    in and Disagreements with Accountants on Accounting and
    Financial Disclosure.    Item 9A.
    Controls
    and Procedures.  Rules 13a-15(e) 15d-15(e)
   PART III  Item 10.
    Directors,
    Executive Officers and Corporate Governance.        investorrelations@bsquare.com 425-519-5998.
  Item 11.
    Executive
    Compensation.    Item 12.
    Security
    Ownership of Certain Beneficial Owners and Management and
    Related Stockholder Matters.   67




---



##### Table of Contents



Item 13.
    Certain
    Relationships and Related Transactions, and Director
    Independence.    Item 14.
    Principal
    Accounting Fees and Services.   PART IV  Item 15.
    Exhibits,
    Financial Statement Schedules.  (a)
    Financial
    Statements and Schedules  Financial Statements.
            Financial Statement Schedules.
        (b)
    Exhibits  Form 10-K.
 68




---



##### Table of Contents



SIGNATURES        By:
    /s/  Brian
    T. Crowley  President and Chief Executive Officer
    By:
    /s/  Scott
    C. Mahan  Vice President, Finance and
    Chief Financial Officer
  POWER OF
    ATTORNEY
  attorney-in-fact attorneys-in-fact
    Signature

Title/s/  Brian
    T. CrowleyBrian
    T. Crowley

President and Chief Executive
    Officer (Principal Executive Officer)/s/  Scott
    C. MahanScott
    C. Mahan

Vice President, Finance and Chief
    Financial Officer(Principal Financial and Accounting Officer)/s/  Donald
    B. BibeaultDonald
    B. Bibeault

Chairman of the Board/s/  Scot
    E. LandScot
    E. Land

Director 69




---



##### Table of Contents



Signature

Title/s/  Elwood
    D.
    Howse, Jr.Elwood
    D. Howse, Jr.

Director/s/  Elliott
    H.
    Jurgensen, Jr.Elliott
    H. Jurgensen, Jr.

Director/s/  William
    D. SavoyWilliam
    D. Savoy

Director/s/  Kendra
    VanderMeulenKendra
    VanderMeulen

Director  70




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##### Table of Contents



BSQUARE
    CORPORATION
  SCHEDULE II 
    VALUATION AND QUALIFYING ACCOUNTS
  Allowance
    for doubtful accounts
  Balance at


Charged to


Charged toBeginning


Costs and


Other


Amounts


Balance atYear Ended

of Period


Expenses


Accounts


Written Off


End of Period(In thousands)December 31, 2006(1)

$
687


$



$



$
489


$
198December 31, 2005(2)

$
222


$
399


$
86


$
20


$
687December 31, 2004

$
320


$
59


$



$
157


$
222     (1)
    
    In the fourth quarter of 2006, the Company settled an ongoing
    dispute with a former customer, which resulted in a write off of
    $475,000.(2)
    
    In the fourth quarter of 2005, the Company incurred bad debt
    expense of $399,000 related to an ongoing customer dispute. 71




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##### Table of Contents



BSQUARE
    CORPORATION
  INDEX TO
    EXHIBITS
  ExhibitNumber

Description3
.1

Amended and Restated Articles of
    Incorporation(1)3
.1(a)

Articles of Amendment to Amended
    and Restated Articles of Incorporation(2)3
.1(b)

Articles of Amendment to Amended
    and Restated Articles of Incorporation(20)3
.2

Bylaws and all amendments
    thereto(14)4
.1

See Exhibits 3.1, 3.1(a),
    3.1(b) and 3.2 for provisions defining the rights of the holders
    of common stock4
.2

Form of Warrant to purchase common
    stock(16)10
.1

Amended and Restated Stock Option
    Plan, as amended(25)10
.1(a)

1998 Mainbrace Stock Option Plan(3)10
.1(b)

2000 Non-Qualified Stock Option
    Plan(4)10
.1(c)

Infogation Corporation 1996 Stock
    Option Plan(12)10
.1(d)

Infogation Corporation 2001 Stock
    Options/Stock Issuance Plan(12)10
.1(e)

Form of Stock Option Agreement(24)10
.2

Employee Stock Purchase Plan(1)10
.2 (a)

Amendment No. 1 to the
    Employee Stock Purchase Plan(13)10
.3

401(k) Plan(1)10
.4

Form of Indemnification
    Agreement(1)10
.6

Office Lease Agreement between
    Seattle Office Associates, LLC and BSQUARE Corporation dated
    March 24, 1997 (for Suite 100)(1)10
.7

Sunset North Corporate Campus
    Lease Agreement between WRC Sunset North and
    BSQUARE Corporation(1)10
.8

First Amendment to Office Lease
    Agreement between WRC Sunset North LLC and BSQUARE(5)10
.9*

Master Development &
    License Agreement between Microsoft Corporation and
    BSQUARE Corporation dated effective as of October 1,
    1998(1)10
.9(a)*

Amendment No. 1 to the Master
    Development and License Agreement between
    BSQUARE Corporation and Microsoft Corporation dated
    December 23, 1999(6)10
.9(b)*

Amendment No. 2 to the Master
    Development and License Agreement between
    BSQUARE Corporation and Microsoft Corporation dated
    July 26, 2001(6)10
.10

Stock Purchase and Shareholders
    Agreement dated as of January 30, 1998(1)10
.11

Stock Purchase Agreement dated
    August 18, 1999 by and between BSQUARE Corporation and
    Vulcan Ventures Incorporated(1)10
.12

Agreement and Plan of Merger among
    BSQUARE, BlueWater Systems, Inc. and H2O Merger Corporation
    dated as of January 5, 2000(7)10
.13

Agreement and Plan of Merger among
    BSQUARE Corporation, Mainbrace Corporation and Mainbrace
    Acquisition Inc. dated as of May 10, 2000(8)10
.14

Single-Tenant Commercial Space
    Lease among One South Park Investors, Paul Enterprises and FKLM
    as Landlord and BSQUARE as Tenant(9)10
.14 (a)

Lease cancellation, termination,
    and release agreement among One South Park Investors,
    Partnership as Landlord and BSQUARE as Tenant(16)10
.15

Single-Tenant Commercial Space
    Lease (NNN), dated as of August 30, 2000, by and between
    One South Park Investors, Partnership and BSQUARE Corporation(10)10
.16

Fourth Amendment to Office Lease
    Agreement between WRC Sunset North LLC and
    BSQUARE Corporation(11) 72




---



##### Table of Contents



ExhibitNumber

Description10
.16 (a)

Fifth Amendment to Office Lease
    Agreement between WA  Sunset North Bellevue LLC and
    BSQUARE Corporation(18)10
.16(b)

Rent Deferral Agreement between
    WA  Sunset North Bellevue, L.L.C and
    BSQUARE Corporation(18)10
.17

Agreement and Plan of Merger among
    BSQUARE, BSQUARE San Diego Corporation and Infogation
    Corporation dated as of March 10, 2002(14)10
.18*

OEM Distribution Agreement for
    Software Products for Embedded Systems between
    BSQUARE Corporation and Microsoft Licensing, GP dated
    September 16, 2003(17)10
.18(a)*

OEM Distribution Agreement for
    Software Products for Embedded Systems between
    BSQUARE Corporation and Microsoft Licensing, GP dated
    effective as of October 1, 2004(19)10
.18(b)*

OEM Distribution Agreement for
    Software Products for Embedded Systems between
    BSQUARE Corporation and Microsoft Licensing, GP dated
    effective as of October 1, 2005(21)10
.18(c)+

OEM Distribution Agreement for
    Software Products for Embedded Systems between
    BSQUARE Corporation and Microsoft Licensing, GP dated
    effective as of October 1, 2006(26)10
.19

Office lease Agreement between WA
    110 Atrium Place, LLC and BSQUARE Corporation(18)10
.20

Employment Agreement between Scott
    C. Mahan and BSQUARE Corporation(18)10
.21

Employment Agreement between Carey
    E. Butler and BSQUARE Corporation(18)10
.22

Employment Offer Letter Agreement
    between Pawan Gupta and BSQUARE Corporation(24)10
.22(a)

Separation and Release Agreement
    between Pawan Gupta and BSQUARE Corporation dated effective as
    of October 30, 200610
.23

Employment Agreement between Brian
    T. Crowley and BSQUARE Corporation(22)10
.24

Asset Purchase Agreement between
    Vibren Technologies, Inc. and BSQUARE Corporation dated
    effective June 30, 2005(23)10
.25

Employment offer letters, as
    amended, between Larry Stapleton and BSQUARE Corporation(25)21
.1

Subsidiaries of the registrant23
.1(a)

Consent of Moss Adams LLP,
    Independent Registered Public Accounting Firm23
.1(b)

Consent of Ernst & Young
    LLP, Independent Registered Public Accounting Firm24
.1

Power of Attorney (included on
    signature page hereof)31
.1

Certification of Chief Executive
    Officer pursuant to Exchange Act
    Rule 13a-14(a)
    under the Securities and Exchange Act of 193431
.2

Certification of Chief Financial
    Officer pursuant to Exchange Act
    Rule 13a-14(a)
    under the Securities and Exchange Act of 193432
.1

Certification of Chief Executive
    Officer Pursuant to 18 U.S.C. Section 1350, as Adopted
    Pursuant to Section 906 of the Sarbanes-Oxley Act of 200232
.2

Certification of Chief Financial
    Officer Pursuant to 18 U.S.C. Section 1350, as Adopted
    Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002     *
    
    Subject to confidential treatment.+
    
    Confidential treatment requested.(1)
    
    Incorporated by reference to the registrants registration
    statement on
    Form S-1
    (File
    No. 333-85351)
    filed with the Securities and Exchange Commission on
    October 19, 1999.(2)
    
    Incorporated by reference to the registrants quarterly
    report on Form
    10-Q filed
    with the Securities and Exchange Commission on August 7,
    2000.(3)
    
    Incorporated by reference to the registrants registration
    statement on
    Form S-8
    (File
    No. 333-44306)
    filed with the Securities and Exchange Commission on
    August 23, 2000.(4)
    
    Incorporated by reference to the registrants registration
    statement on
    Form S-8
    (File
    No. 333-70290)
    filed with the Securities and Exchange Commission on
    September 27, 2001. 73




---



##### Table of Contents



(5)
    
    Incorporated by reference to the registrants annual report
    on
    Form 10-K
    filed with the Securities and Exchange Commission on
    March 2, 2000.(6)
    
    Incorporated by reference to the registrants quarterly
    report on Form
    10-Q filed
    with the Securities and Exchange Commission on November 9,
    2001.(7)
    
    Incorporated by reference to the registrants Current
    Report on
    Form 8-K
    filed with the Securities and Exchange Commission on
    January 18, 2000.(8)
    
    Incorporated by reference to the registrants Current
    Report on
    Form 8-K
    filed with the Securities and Exchange Commission on
    May 23, 2000.(9)
    
    Incorporated by reference to the registrants registration
    statement on
    Form S-1
    (File
    No. 333-45506)
    filed with the Securities and Exchange Commission on
    September 14, 2000.(10)
    
    Incorporated by reference to the registrants annual report
    on
    Form 10-K
    filed with the Securities and Exchange Commission on
    March 26, 2001.(11)
    
    Incorporated by reference to the registrants quarterly
    report on Form
    10-Q filed
    with the Securities and Exchange Commission on November 14,
    2002.(12)
    
    Incorporated by reference to the registrants statement on
    Form S-8
    (File
    No. 333-85340)
    filed with the Securities and Exchange Commission on
    April 2, 2002.(13)
    
    Incorporated by reference to the registrants statement on
    Form S-8
    (File
    No. 333-90848)
    filed with the Securities and Exchange Commission on
    June 20, 2002.(14)
    
    Incorporated by reference to the registrants annual report
    on
    Form 10-K
    filed with the Securities and Exchange Commission on
    March 19, 2003.(15)
    
    Incorporated by reference to the registrants quarterly
    report on Form
    10-Q filed
    with the Securities and Exchange Commission on May 8, 2003.(16)
    
    Incorporated by reference to the registrants quarterly
    report on Form
    10-Q filed
    with the Securities and Exchange Commission on August 14,
    2003.(17)
    
    Incorporated by reference to the registrants quarterly
    report on Form
    10-Q filed
    with the Securities and Exchange Commission on November 14,
    2003.(18)
    
    Incorporated by reference to the registrants annual report
    on
    Form 10-K
    filed with the Securities and Exchange Commission on
    March 30, 2004.(19)
    
    Incorporated by reference to the registrants quarterly
    report on Form
    10-Q filed
    with the Securities and Exchange Commission on November 5,
    2004.(20)
    
    Incorporated by reference to the registrants Current
    Report on
    Form 8-K
    filed with the Securities and Exchange Commission on
    October 11, 2005.(21)
    
    Incorporated by reference to the registrants quarterly
    report on Form
    10-Q filed
    with the Securities and Exchange Commission on November 8,
    2005.(22)
    
    Incorporated by reference to the registrants quarterly
    report on Form
    10-Q filed
    with the Securities and Exchange Commission on May 12, 2005.(23)
    
    Incorporated by reference to the registrants quarterly
    report on Form
    10-Q filed
    with the Securities and Exchange Commission on August 12,
    2005.(24)
    
    Incorporated by reference to the registrants annual report
    on
    Form 10-K
    filed with the Securities and Exchange Commission on
    March 11, 2005.(25)
    
    Incorporated by reference to the registrants annual report
    on
    Form 10-K
    filed with the Securities and Exchange Commission on
    March 10, 2006.(26)
    
    Incorporated by reference to the registrants quarterly
    report on Form
    10-Q filed
    with the Securities and Exchange Commission on November 9,
    2006. 74