UNITED
        STATES
 SECURITIES
        AND EXCHANGE COMMISSION
 WASHINGTON,
        D.C. 20549-1004
 _____________________________________________
 
 **FORM
        10-K**
 
 x  ANNUAL
        REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 SECURITIES
        EXCHANGE ACT OF 1934
 for
        the
        fiscal year ended September 30, 2005
 
 or
 
 o  TRANSITION
        REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 SECURITIES
        EXCHANGE ACT OF 1934
 For
        the
        transition period from  ____
        to ____.
 
 Commission
        File No. 0-21820
  
 **KEY
        TECHNOLOGY, INC.**
 (Exact
        name of Registrant as specified in its charter)
 
 **Oregon**
                (State
                  or jurisdiction of incorporation or organization)
              
              **93-0822509**
                (I.R.S.
                  Employer Identification No.)
 
 **150
                  Avery Street**
                **Walla
                  Walla, Washington**
                (Address
                  of Principal Executive Offices)
              
              **99362**
                (Zip
                  Code)
 
 Registrant’s
        telephone number, including area code: **(509)
        529-2161**
 
 Securities
        registered pursuant to Section 12(b) of the Act:
 **None**
  Securities
        registered pursuant to Section 12(g) of the Act:
 **Common
        Stock, no par value**
 
 Indicated
        by check mark if the registrant is a well-known seasoned issuer, as defined
        in
        Rule 405 of the Securities Act.  Yes o No x
 
 Indicate
        by check mark if the registrant is not required to file reports pursuant
        to
        Section 13 or Section 15(d) of the Act  Yes o No x
 
 Indicate
        by check mark whether the Registrant (1) has filed all reports required to
        be
        filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during
        the
        preceding 12 months (or for such shorter period that the Registrant was required
        to file such reports), and (2) has been subject to such filing requirements
        for
        the past 90 days.   Yes x No o
 
 Indicate
        by check mark if disclosure of delinquent filers pursuant to Item 405 of
        Regulation S-K is not contained herein, and will not be contained, to the
        best
        of Registrant's knowledge, in definitive proxy or information statements
        incorporated by reference in Part III of this Form 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 o No x
 
 The
        aggregate market value of the Registrant's common stock held by non-affiliates
        on March 31, 2005 (based on the last sale price of such shares) was
        approximately $41,208,275.
 
 There
        were 5,353,909 shares of the Registrant's common stock outstanding on December
        2, 2005.
 
 **DOCUMENTS
        INCORPORATED BY REFERENCE**
 
 Parts
        of
        Registrant's Proxy Statement dated on or about January 6, 2006 prepared in
        connection with the Annual Meeting of Shareholders to be held on February
        8,
        2006 are incorporated by reference into Part III of this
        Report.
  
  **KEY
        TECHNOLOGY, INC.**
 **2005
        FORM 10-K**
 **TABLE
        OF CONTENTS**
  **PART
                    I**
                
                **PAGE**Item
                    1.
                BUSINESS
                1Item
                    1A.
                RISK
                    FACTORS
                9Item
                    1B.
                UNRESOLVED
                    STAFF COMMENTS
                11Item
                    2.
                PROPERTIES
                12Item
                    3.
                LEGAL
                    PROCEEDINGS
                12Item
                    4.
                SUBMISSION
                    OF MATTERS TO A VOTE OF SECURITY
                    HOLDERS
                12**PART
                    II**Item
                    5.
                MARKET
                    FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER
                    MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
                13Item
                    6.
                SELECTED
                    FINANCIAL DATA
                15Item
                    7.
                MANAGEMENT'S
                    DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
                    RESULTS OF OPERATIONS
                16Item
                    7A.
                QUANTITATIVE
                    AND QUALITATIVE DISCLOSURES ABOUT MARKET
                    RISK
                27Item
                    8.
                FINANCIAL
                    STATEMENTS AND SUPPLEMENTARY DATA
                29Item
                    9.
                CHANGES
                    IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
                    FINANCIAL DISCLOSURE
                55Item
                    9A.
                CONTROLS
                    AND PROCEDURES
                55Item
                    9B.
                OTHER
                    INFORMATION
                56**PART
                    III**Item
                    10.
                DIRECTORS
                    AND EXECUTIVE OFFICERS OF THE
                    REGISTRANT
                56Item
                    11.
                EXECUTIVE
                    COMPENSATION
                56Item
                    12.
                SECURITY
                    OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
                    AND RELATED STOCKHOLDER MATTERS
                56Item
                    13.
                CERTAIN
                    RELATIONSHIPS AND RELATED TRANSACTIONS
                57Item
                    14.
                PRINCIPAL
                    ACCOUNTANT FEES AND SERVICES
                57**PART
                    IV**Item
                    15.
                EXHIBITS
                    AND FINANCIAL STATEMENT SCHEDULES
                58SIGNATURES
                61EXHIBIT
                    INDEX
                62
 *Table
              of Contents*
  **PART
        I**
 
 From
        time
        to time, Key Technology, Inc. (“Key” or the “Company”), through its management,
        may make forward-looking public statements with respect to the Company
        regarding, among other things, expected future revenues or earnings,
        projections, plans, future performance, product development and
        commercialization, and other estimates relating to the Company’s future
        operations. Forward-looking statements may be included in reports filed under
        the Securities Exchange Act of 1934, as amended (the “Exchange Act”), in press
        releases or in oral statements made with the approval of an authorized executive
        officer of Key. The words or phrases “will likely result,” “are expected to,”
“intends,” “is anticipated,” “estimates,” “believes,” “projects” or similar
        expressions are intended to identify “forward-looking statements” within the
        meaning of Section 21E of the Exchange Act and Section 27A of the Securities
        Act
        of 1933, as amended, as enacted by the Private Securities Litigation Reform
        Act
        of 1995.
 
 Forward-looking
        statements are subject to a number of risks and uncertainties. The Company
        cautions investors not to place undue reliance on its forward-looking
        statements, which speak only as to the date on which they are made. Key’s actual
        results may differ materially from those described in the forward-looking
        statements as a result of various factors, including those listed
        below:
 ·
              adverse
                  economic conditions, particularly in the food processing industry,
                  either
                  globally or regionally, may adversely affect the Company's
                  revenues;
 ·
              competition
                  and advances in technology may adversely affect sales and
                  prices;
 ·
              the
                  Company's new products may not compete successfully in either existing
                  or
                  new markets;
 ·
              the
                  limited availability and possible cost fluctuations of materials
                  used in
                  the Company's products could adversely affect the Company's gross
                  profits;
 ·
              the
                  inability to protect its intellectual property, especially as the
                  Company
                  expands geographically, may adversely affect the Company's competitive
                  advantage; and
 ·
              intellectual
                  property-related litigation expenses and other costs resulting
                  from
                  infringement claims asserted against the Company or its customers
                  by third
                  parties may adversely affect the Company’s results of operations and its
                  customer relations.
 ·
              inadequate
                  internal controls over financial reporting could result in an inability
                  to
                  accurately report the Company’s financial
                  results.
 
 Given
        these uncertainties, readers are cautioned not to place undue reliance on
        the
        forward-looking statements. The Company disclaims any obligation subsequently
        to
        revise or update forward-looking statements to reflect events or circumstances
        after the date of such statements or to reflect the occurrence of anticipated
        or
        unanticipated events.
 
 
 **ITEM
                  1.**
              **BUSINESS.**
 
 **General**
 
 The
        Company was founded in 1948 as a local producer of vegetable processing
        equipment. The Company has evolved into a worldwide supplier of process
        automation solutions to the food processing industry and other industries
        such
        as tobacco, plastics and pharmaceuticals. The present Company was incorporated
        in 1982 as a result of a management buyout of the predecessor
        organization.
 
 The
        Company and its operating subsidiaries design, manufacture, sell and service
        process automation systems that process product streams of discrete pieces
        to
        improve safety and quality. These systems integrate electro-optical automated
        inspection and sorting systems with process systems which include specialized
        conveying and preparation systems. The Company provides parts and service
        for
        each of its product lines to customers throughout the world.
 
 Sales
        for
        the year ended September 30, 2005 were $80.3 million compared with $80.6
        million
        for fiscal 2004. The Company reported net earnings for fiscal 2005 of $2.7
        million, or $0.52 per diluted share, compared with net earnings of $3.7 million,
        or $0.71 per diluted share, for fiscal 2004. Export and international sales
        for
        the fiscal years ended September 30, 2005, 2004 and 2003 accounted for 52%,
        44%
        and 50% of net sales in each such year, respectively.
  1
 *Table
            of Contents*
  **Industry
        Background**
 
 ***Food
        Processing Industry***
 
 The
        Company's primary market is the food processing industry. Food processors
        must
        process large quantities of raw product through different stages, including
        sorting to remove defective pieces and inspection for product quality and
        safety. The frequency and severity of defects in the raw product is highly
        variable depending upon local factors affecting crops. Historically, defect
        removal and quality control in the food processing industry have been labor
        intensive and dependent upon and limited by the variability of the work force.
        The industry has sought to replace manual methods with automated systems
        that
        achieve higher yield, improve product quality and safety, and reduce
        costs.
 
 The
        Company's strategy is to solve processing industry problems of high labor
        costs,
        inadequate yields and inconsistent quality and safety by providing automated
        inspection systems and process systems. The Company's process automation
        systems
        use advanced optical inspection technology to improve product yield (more
        of the
        good product recovered) and quality (higher percentage of defective product
        removed) over the manual sorting and defect removal methods historically
        used by
        food processors. In more developed markets, such as those in North America
        and
        Western Europe, the substitution of automated inspection for manual inspection
        is well underway. However, processors in these areas remain keenly interested
        in
        process yield and product quality improvements.
 
 The
        largest markets for the Company's products have been processors of potatoes,
        vegetables, fruit and snack foods. The Company believes many additional
        applications for its systems exist in both food and non-food markets.
 
 The
        principal potato market served by the Company's systems is french fries.
        French
        fries comprise approximately 90% of the over eight billion pounds of frozen
        potato products processed annually in the United States. The expansion of
        American-style fast food chains in other countries is resulting in development
        of the frozen french fry market overseas. Current investment in new french
        fry
        processing facilities has declined relative to historical levels, largely
        in
        response to changing consumer preferences. However, investments in process
        yield
        enhancement and in greater process throughputs from existing plants remain
        significant items for the Company and its customers in the potato market.
        The
        Company’s recent diversification strategies have resulted in less dependence on
        this industry although it continues to be a strategically important
        market.
 
 The
        Company's products are used in the fruit and vegetable processing market
        where
        field-harvested products are cleaned, graded, automatically sorted, blanched
        and
        processed prior to freezing, canning or packaging for sale to institutional
        and
        retail markets. Principal fruit and vegetable markets for the Company are
        green
        beans, corn, carrots, peas, onions, apples, pears, cranberries and peaches.
        In
        2005, the Company expanded its product offerings for the fresh-cut produce
        market with the acquisition of Freshline Machines Pty. Ltd. (“Freshline”). The
        fresh-cut industry is one of the fastest growing sectors in the processed
        food
        industry and includes pre-prepared, ready-to-eat salads and vegetables, and
        fresh-cut fruit products for retail and food service markets. Freshline’s
        product line includes their core product, high volume automatic dryers, as
        well
        as a range of processing solutions from individual machines to large-scale
        production lines with automated control systems
 
 The
        global food processing industry has been in a consolidation period and market
        conditions suggest further consolidation in the future. The Company believes
        the
        resulting food processing companies are financially stronger, yet are faced
        with
        the need to improve profitability while satisfying external pressures to
        hold or
        reduce prices for their own products and provide safer products to the consuming
        public. Since the Company’s equipment results in higher process yields, improved
        product quality and safety, as well as reduced processing costs, the Company
        believes these surviving companies will have increased interest in the Company’s
        products to satisfy these needs, allowing for expanded sales into the food
        processing industry in future years. Due to the seasonal nature of the food
        processing industry, the Company does experience some seasonality of orders
        and
        shipments. Orders and shipments to this industry in the Company’s first fiscal
        quarter of the year tend to be lower than during the Company’s other fiscal
        quarters. The growth in the Company’s parts and service business has somewhat
        lessened the impact of the seasonal nature of its equipment business. During
        fiscal 2005, the Company experienced relatively weak market demand for its
        products and services in its first fiscal quarter, extending a period of
        weakness that began in fiscal 2004. Demand for the Company’s products improved
        markedly beginning in its second fiscal quarter and held for the balance
        of the
        year due to improved market conditions and new product introductions by the
        Company.
  2
 *Table
            of Contents*
  ***Non-food
        Industries - Tobacco, Pharmaceuticals & Plastics***
 
 Processors
        in non-food industries also implement systems solutions to reduce costs,
        increase yields, and produce higher quality products that are safe for
        consumers.
 
 The
        largest non-food processing market for the Company is the tobacco processing
        market. The Company’s products provide tobacco companies sorting capability to
        remove foreign matter from a stream of stripped tobacco. Although the Company
        experienced project deferrals in the Asian tobacco sector during fiscal 2004,
        the Company experienced a rebound in its business in the tobacco market during
        fiscal year 2005 with both domestic and international customers.
 
 For
        fiscal 2005, the pharmaceutical, plastics and other non-food industries
        represent a relatively small share of the Company’s sales. However, to further
        its growth strategy, the Company is actively pursuing expansion into new
        markets, such as pharmaceutical, nutraceutical, plastics, and recycled paper
        and
        introduced several new products in fiscal 2005 for these markets. During
        its
        second fiscal quarter, the Company received its first customer order for
        its
        VantyxTM inspection system - a product developed for inspection of blister-packed
        solid-dose pharmaceuticals. In its fourth fiscal quarter, the Company received
        its first customer order for a soft gel inspection system that was developed
        to
        address the inspection needs of the nutraceutical market. The Company believes
        market potential exists in the growing recycling industry where input process
        streams include a wide variety of mixed recyclable base materials, particularly
        in the recycling of plastics and paper, which form a large portion of the
        recycling market. During fiscal 2005, the Company conducted several tests
        of its
        inspection products for applications in the recycled paper market and believes
        that one or more of its products and technologies can be deployed in that
        industry.
 
 **Products**
 
 The
        following table sets forth sales by product category for the periods
        indicated:
 
 **Fiscal
                  Year Ended September 30,****2005**
              
              **2004**
              
              **2003****(in
                  thousands)**Automated
                  inspection systems
              
              $
              20,647
              
              
              26%
              
              $
              28,675
              
              
              36%
              
              $
              30,230
              
              
              37%Process
                  systems
              
              
              31,853
              
              
              40%
              
              
              27,713
              
              
              34%
              
              
              31,759
              
              
              38%Aftermarket
              
              
              27,822
              
              
              34%
              
              
              24,222
              
              
              30%
              
              
              20,633
              
              
              25%Net
                  sales
              
              $
              80,322
              
              
              100%
              
              $
              80,610
              
              
              100%
              
              $
              82,622
              
              
              100%
 
 Service
        and maintenance contracts are less than 10% of total net sales and are therefore
        summarized with aftermarket.
 
 The
        following table sets forth the percent of the total gross margin contributed
        by
        each product category for the periods indicated:
 
 **Fiscal
                  Year Ended September 30,****2005**
              
              **2004**
              
              **2003**Automated
                  inspection systems
              
              
              29%
              
              
              42%
              
              
              42%Process
                  systems
              
              
              28%
              
              
              22%
              
              
              28%Aftermarket
              
              
              43%
              
              
              36%
              
              
              30%Total
                  gross margin
              
              
              100%
              
              
              100%
              
              
              100%
 
 ***Automated
        Inspection Systems***
 
 Automated
        inspection systems are used in various applications to detect and eliminate
        defects, most often during processing of raw and semi-finished products.
        The
        Company’s product families within this group include the
        following:
  3
 *Table
            of Contents*
  ADR®
        automatic defect removal systems used in the french fry industry; Tobacco
        Sorter
        3 TM tobacco
        sorting systems used in tobacco threshing and primary processing; and the
        Tegra®
and Optyx® sorter families which are used in a wide variety of applications in
        many industries and markets. In fiscal 2004, the Company introduced G6, a
        new
        vision engine used in its optical sorting systems, including the Tegra, Optyx,
        ADR, and tobacco sorter product lines.
 
 Nearly
        all systems in this group use proprietary linear array, charged coupled device
        ("CCD") monochromatic, color or multi-spectral cameras. Each of the cameras
        scan
        the product-streams, which move at 5 to 20 feet per second, at the rate of
        1,500
        to 4,000 times per second and can identify defects as small as 1/16 of an
        inch
        (1.5 mm) in diameter. Systems with monochromatic cameras generally are sold
        at
        lower price levels and are most effective for product that has a marked
        disparity in shade between the defective and the good product. Systems with
        color cameras are required when a variety of defect and product colors occur
        simultaneously or when the difference in shading between the defective and
        the
        good product is more subtle. Multi-spectral systems utilize either infrared
        or
        ultraviolet technologies, individually or in combination with visible light,
        to
        identify defects that may not be detectable by using solely visible light
        spectra.
 
 In
        fiscal
        2005, the Company introduced Raptor Laser Technology for its Optyx® 3000
        sorters. The new Optyx® 3000
        Series Sorter with Raptor Laser Technology combines Key’s proprietary
        state-of-the-art G6 color cameras and powerful G6 sorting platform with laser
        technology to maximize the simultaneous detection and removal of defects
        and
        foreign material, achieving unmatched product quality and optimizing food
        safety.
 
 With
        Key’s high intensity discharge (HID) illumination system and G6 CCD-based camera
        technology, Optyx analyzes size and shape as well as millions of subtle color
        differences. Raptor Laser Technology reliably detects foreign matter based
        on
        differences in the optical properties of materials.
 
 Key’s
        new
        Optyx Sorter with Raptor Laser Technology is ideal for packaging lines handling
        up to six tons of product per hour. With superior detection of defects and
        foreign material, Optyx with Raptor eliminates costly hand-sorting labor
        and
        offers rapid payback. When located on the packaging line immediately upstream
        of
        final packaging, the new sorter assures processors and their customers that
        packaged products meet specifications.
 
 *Tegra
        System.* Tegra is
        the Company’s highest capacity optical sorter and provides accurate in-air
        defect removal. Tegra incorporates object-specific sorting technology that
        recognizes not only color and size, but also shape. This capability provides
        a
        solution to previously difficult sorting problems, such as differentiation
        between green beans and green bean stems. Tegra also incorporates KeyWare® software
        that substantially reduces operational complexity. KeyWare consists of
        application packages, each specifically designed for a single product category
        that, together with the system’s computer hardware capability and networking
        software, support all standard factory control and automation interfaces.
        These
        features allow Tegra to establish data connectivity and communication with
        a
        processing plant's computer network system. Certain present and potential
        applications for Tegra systems include potato products, green beans, dried
        beans, corn, carrots, peas, spinach and other leafy vegetables, pears, nuts,
        grains, coffee, recycled commodities such as paper and plastic, and
        tobacco.
 
 *Tobacco
        Sorter 3.* The
        tobacco industry has special requirements in the handling and sorting of
        its
        tobacco products, which vary in size and moisture content and other properties
        depending upon the type of product being produced and the point of handling
        and
        inspection. Key’s Tobacco Sorter 3 (TS3), utilizes a specially constructed
        frame, enclosure, and material handling arrangement to meet the specific
        product
        inspection requirements of this industry. TS3 has been installed in North
        America, Latin America, Europe and Asia.
 
 *Optyx
        System* .
        The
        Optyx 3000 series sorter has the power and sorting capabilities of a larger
        sorter in an economical and compact machine. The lower cost Optyx 3000 series
        is
        ideal for smaller processors and lower volume processing lines which are
        unable
        to justify the expense of a larger sorter. The larger Optyx 6000 series sorter
        provides customers with a mid-size sorting option with greater throughput.
        Optyx
        series sorters employ a novel broad-band illumination system and are designed
        to
        require minimal maintenance. The Optyx line of sorters has gained strong
        acceptance in segments of the fruit, vegetable, processed potato and snack
        food
        markets. Additionally, Optyx has been placed in applications inspecting
        pharmaceuticals, nutraceuticals, plastics, tobacco, and paper. In fiscal
        2005,
        the Company added laser-sensing capability to the Optyx 3000 series
        sorter.
  4
 *Table
            of Contents*
  *ADR
        System.* The
        Company's ADR systems are used to transport, inspect and remove defects from
        french fry potatoes. The Company believes its ADR system is the principal
        optical inspection and defect removal system used in the french fry processing
        industry. The Company's full-capacity ADR systems can process up to 27,000
        pounds of product per hour.
 
 *Pharmaceutical
        Inspection Systems.* In
        fiscal 2005, this product line was a minor contributor to the Company’s sales.
        However, to further its growth strategy, the Company is pursuing expansion
        into
        this market. In fiscal 2005, the Company introduced its Vantyx inspection
        system
        - a product developed for inspection of blister-packed solid dose
        pharmaceuticals. Using patented spatial color analysis technology, this product
        line inspects solid-dose pharmaceuticals for broken or missing pieces, foreign
        products, discoloration or coating defects, as well as the integrity of
        capsules. The pharmaceutical inspection system also verifies and detects
        color,
        size, location and shape defects at processing rates of over one million
        pieces
        per hour. In addition, the Company has also developed a soft gel inspection
        system that incorporates advanced adaptations of our existing patented
        high-resolution inspection technology and material handling systems to provide
        a
        complete solution to “end-of-line” finishing of softgels for the nutraceutical
        market.
 
 *ScanTrac* .
        Through
        InspX LLC, a joint venture with Peco Controls Corporation created in fiscal
        2004, the Company added an established product and new technical expertise
        in
        x-ray technology to its product line. ScanTrac is a compact, high performance
        x-ray system used to inspect packaged products for foreign material
        contamination or packaging imperfections.
 
 ***Process
        Systems***
 
 Conveying
        and process systems are utilized worldwide throughout processing industries
        to
        move and process product within a production plant. The Company's conveying
        and
        process systems include the Iso-Flo and
        ImpulseTM branded
        conveyor systems, Farmco rotary grading systems, the Turbo-Flo® steam blancher,
        the Forte Process Control systems, the new Freshline product group and
        additional select conveying and processing equipment. The functions of these
        product lines include conveying, transferring, aligning, feeding, metering,
        separating and grading, as well as blanching, cooking, pasteurizing, cooling,
        cleaning and washing. The process systems group includes standard products
        as
        well as custom designed equipment.
 
 *Iso-Flo
        Vibratory Conveying Systems.* The
        Company's principal specialized conveying system is its Iso-Flo vibratory
        conveyor system. The Iso-Flo conveyor is a type of pan conveyor. Pan conveyors
        are common throughout industries that process product streams of discrete
        pieces, including the food processing industry. Pan conveyors move product
        pieces by vibrating the pan at high frequency along a diagonal axis, upward
        and
        forward. This action propels the product ahead in small increments and
        distributes it evenly for close control of movement and
        presentation.
 
 Iso-Flo
        systems are used in a variety of processing applications, including potato
        products, vegetables and fruits (green beans, peas, carrots, corn, peaches,
        pears, cranberries and apples), snack foods, cereals, fresh salads, cheese,
        poultry, and seafood. Non food processing applications include nutraceuticals,
        tobacco, wood chips, pet food and plastics.
 
 *Impulse* is a
        line of electromagnetic vibratory conveyors which combine the advantage of
        quick
        start/stop with precise metering control. Additionally, the Impulse conveyor
        drive systems are oil-free, which limits the potential for contamination
        and
        improves the safety of food products. This conveyor system was developed
        for
        packaging applications in snack food, dry ingredient, chemical and
        pharmaceutical processing, but is seeing increased application in a wide
        variety
        of food and industrial processes.
 
 *Rotary
        grading systems.* The
        mechanical sizing, sorting, separating, and grading products sold under the
        Farmco brand name are used in many food processing systems. These rotary
        sizing
        and grading technologies optimize yield, increase packaging efficiency, and
        improve product quality primarily by removing either over or undersized and
        small irregular-shaped pieces of product from the line or separating product
        into predetermined size categories. In combination with other Company-provided
        equipment, these products can increase overall line efficiency and systems
        capability.
 
 *Turbo-Flo
        and Preparation Systems* .
        The
        Company designs and manufactures preparation systems to prepare products
        prior
        to cooking, freezing, canning or other processing. Products in this group
        include the Turbo-Flo
  5
 *Table
            of Contents*
  Blancher/Cooker/Pasteurizer,
        air cleaners, air coolers, froth flotation cleaners, vegetable metering and
        blending systems, and bulk handling equipment. These products represent the
        Company's most mature product line. Sales of these products over the years
        have
        formed a customer base for sales of other Company products and are also
        establishing a customer base in developing geographic markets.
 
 Preparation
        system revenues may also include a variety of third-party supplied equipment
        and
        installation services which are sold as components of larger processing lines,
        for which the Company has assumed turn-key sales responsibility. In addition,
        the process systems group includes other custom designed conveying and raw
        food
        sizing, grading, and preparation equipment.
 
 *Forte
        Control Systems.* The
        Company’s primary offering in the area of process control for processing
        systems, Forte provides a foundation for a wide range of control options
        for
        processing lines, from simple on/off commands to data logging and recipe
        entry.
        This product is most often an add-on to the Company’s primary equipment
        lines.
 
 *Freshline
        products* .
        In
        fiscal 2005, the Company acquired Freshline Machines Pty Ltd, a privately-held
        Australian-based company that designs, manufactures and sells food processing
        systems for the fresh-cut food industry worldwide. Freshline, headquartered
        in
        Sydney, Australia, is positioned in the fresh-cut market with a reputation
        for
        reliable and innovative equipment. The company’s product line includes their
        core product, high volume automatic dryers, as well as a range of processing
        solutions from individual machines to large-scale production lines with
        automated control systems.
 
 ***Aftermarket
        (Parts, Upgrades and Service/Contracts)***
 
 The
        Company has a large installed base of inspection and processing systems.
        This
        installed base generates potential business for the Company’s parts, service and
        upgrade products. In contrast to the acquisition of new inspection and
        processing systems products, the offerings in this category can provide the
        customer with less capital intensive choices. The Company has made this an
        area
        of strategic focus, and realigned its organization to leverage the large
        installed base and its strong customer support organization.
 
 The
        Company provides spare parts and post-sale field and telephone-based repair
        services to support its customers’ routine maintenance requirements and seasonal
        equipment startup and winterization processes. The Company considers its
        parts
        and maintenance service sales to be important potential sources of future
        revenue growth. The Company continues to realign its service organization
        so
        that field service personnel are now geographically located closer to its
        customers throughout the world. This strategy has contributed to revenue
        growth
        and improved gross margins in parts and service. The Company also typically
        provides system installation support services which are included in the sales
        price of certain of its products, principally automated inspection
        systems.
 
 The
        Company believes that there is an opportunity for the sale of upgrade product
        offerings to its customers so that newer technology with advanced features,
        lower cost, greater reliability, and performance enhancements can benefit
        owners
        of Key systems. The Company has increased its investment in development of
        specific upgrade products, particularly the G6 vision engine which creates
        upgrade opportunities for many customers in its installed base of sorting
        systems.
 
 **Engineering,
        Research and Development**
 
 At
        September 30, 2005, the Company's research and development department had
        41  employees  who
        conduct new product research and development and sustaining engineering for
        released products. The Company’s technical staff includes electronic, optical,
        mechanical and software engineers, mathematicians and technical support
        personnel.
 
 The
        Company’s project engineering department had 38 employees engaged in project
        engineering for custom systems. The project engineering teams are responsible
        for engineering and designing the details of each custom order. A document
        control team maintains and controls product documentation and the product
        modeling database for the development engineering and project engineering
        teams
        as well as the manufacturing department.
 
 In
        fiscal
        2005, the Company's research and development expenses, together with engineering
        expenses not applied to the manufacturing costs of products, were approximately
        $5.1 million, compared to $5.8 million and $4.9 million in 2004
  6
 *Table
            of Contents*
  and
        2003,
        respectively. The ramp up in spending in fiscal 2004 was the result of projects
        such as G6 and ADR4c which have been released to the market. The reduction
        in
        fiscal 2005 reflects the reduction in workforce action taken late in fiscal
        2004.
 
 **Manufacturing**
 
 The
        Company maintains three domestic manufacturing facilities, two located in
        Walla
        Walla, Washington and one in Redmond, Oregon. The Company also has a European
        manufacturing facility located in The Netherlands and a manufacturing facility
        in Australia. The Company's current manufacturing facilities and its product
        design and manufacturing processes integrate Computer Aided Engineering (CAE),
        Finite Element Analysis (FEA), Computer Aided Design (CAD), Computer Aided
        Manufacturing (CAM) and Computer Integrated Manufacturing (CIM) technologies.
        Manufacturing activities include process engineering; fabrication, welding,
        finishing, and assembly of custom designed stainless steel systems; camera
        and
        electronics assembly; subsystem assembly; and system test and integration.
        The
        Company manufactures specific products in the following locations:
 
 **Location**
              **Size
                  in Square Feet**
              **Products/Services
                  Produced**Walla
                  Walla, Washington
              150,000(1)
              Automated
                  Inspection
                Process
                  Systems
                Parts
                  and ServiceWalla
                  Walla, Washington
              100,000(1)
              Process
                  SystemsRedmond,
                  Oregon
              19,000
              Process
                  Systems
                Parts
                  and ServiceBeusichem,
                  The Netherlands
              45,000
              Process
                  Systems
                Parts
                  and ServiceBeusichem,
                  The Netherlands
              18,000
              Parts
                  Warehouse
                Future
                  Manufacturing ExpansionSydney,
                  Australia
              14,500
              Process
                  Systems
 
 (1)
              In
                  June 2005, the Company announced plans to expand its primary operating
                  facility in Walla Walla by approximately 23,000 square feet and
                  terminate
                  the lease on the second facility in Walla Walla in December
                  2005.
 
 The
        Company manufactures certain of its products to Underwriters Laboratories
        and
        United States Department of Agriculture standards. Certain of the Company’s
        products also comply with the Canadian Standards Association (CSA), European
        CE
        (Conformité Européene) and Electronic Testing Laboratory (ETL) safety standards.
        The Company was recertified to the ISO 9001:2000 standard in 2002.
 
 Certain
        components and subassemblies included in the Company's products are obtained
        from single-source or sole-source suppliers. The Company attempts to ensure
        that
        adequate supplies are available to maintain manufacturing schedules. Although
        the Company seeks to reduce its dependence on sole and limited source suppliers,
        the partial or complete loss of certain sources of supply could have an adverse
        effect on the Company's results of operations and relations with customers.
        During fiscal 2005 and 2004, the Company experienced higher component costs
        and
        reduced margins on certain product lines due to the worldwide shortage of
        stainless steel.
 
 **Environmental**
 
 The
        Company has not received notice of any material violations of environmental
        laws
        or regulations in on-going operations at any of its manufacturing
        locations.
  7
 *Table
            of Contents*
  **Sales
        and Marketing**
 
 The
        Company markets its products directly and through independent sales
        representatives. In North America, the Company operates sales offices in
        Walla
        Walla, Washington; Medford, Oregon; Redmond, Oregon; and Santiago de Querétaro,
        Mexico. The Company’s subsidiary, Key Technology B.V., provides sales and
        service to European and Middle Eastern customers. The Company’s subsidiary, Key
        Technology Australia Pty. Ltd. and its subsidiary Freshline Machines Pty.
        Ltd.,
        provides sales and service to customers primarily in Australia and New Zealand.
        The Company supplies products from both product groups - automated inspection
        systems and process systems - to customers in its primary markets through
        common
        sales and distribution channels. In addition, the Company supplies parts
        and
        service through its worldwide service organization.
 
 Most
        exports of products manufactured in the United States for shipment into
        international markets other than Europe and Australia have been denominated
        in
        U.S. dollars. Sales into Europe of systems, spare parts and service, as well
        as
        products manufactured in Europe, are generally denominated in European
        currencies, most commonly Euros. Sales into Australia are typically denominated
        in its local currency. In its export and international sales, the Company
        is
        subject to the risks of conducting business internationally, including
        unexpected changes in regulatory requirements; fluctuations in the value
        of the
        U.S. dollar, which could increase or decrease the sales prices in local
        currencies of the Company's products in international markets; tariffs and
        other
        barriers and restrictions; and the requirements of complying with a variety
        of
        international laws. Additional information regarding export and international
        sales is set forth in Note 15 to the Company’s Consolidated Financial Statements
        for the fiscal year ended September 30, 2005.
 
 During
        fiscal 2005, 2004 and 2003, sales to McCain Foods represented approximately
        16%,
        13% and 7% of total net sales, respectively. While the Company believes that
        its
        relationship with McCain is satisfactory, the loss of this customer could
        have a
        material adverse effect on the Company’s revenues and results of
        operations
 
 **Backlog**
 
 The
        Company's backlog as of September 30, 2005 and September 30, 2004 was
        approximately $16.6 million and $12.8 million, respectively. The Company
        schedules production based on firm customer commitments and forecasted
        requirements. The Company includes in backlog only those customer orders
        for
        which it has accepted purchase orders.
 
 **Competition**
 
 The
        markets for automated inspection systems and process systems are highly
        competitive. Important competitive factors include price, performance,
        reliability, and customer support and service. The Company believes that
        it
        currently competes effectively with respect to these factors, although there
        can
        be no assurance that existing or future competitors will not introduce
        comparable or superior products at lower prices. Certain of the Company's
        competitors may have substantially greater financial, technical, marketing
        and
        other resources. The Company's principal competitors are believed to be FMC
        Technologies, Inc., Heat & Control, Inc. and its subsidiaries, BEST N.V.,
        Sortex Ltd. and Kiremko B.V. The Company has encountered additional small
        competitors entering its markets, including the introduction of potentially
        competing tobacco sorters into the Chinese market manufactured by Chinese
        companies. As the Company enters new markets, it expects to encounter additional
        new competitors.
 
 **Patents
        and Trademarks**
 
 The
        Company currently holds fifty-eight United States patents issued from 1988
        through 2005, and eleven other national patents issued by other countries.
        The
        first of these patents expires in calendar 2005, and the Company believes
        that
        expiration will not have a significant effect on the Company. As of December
        2,
        2005, nine other national patent applications have been filed and are pending
        in
        the United States and other countries and four international or regional
        applications have been filed that are awaiting the national phase. The Company
        has thirty-six registered trademarks and two pending applications for
        trademarks.
 
 The
        Company also attempts to protect its trade secrets and other proprietary
        information through proprietary information agreements and security measures
        with employees, consultants and others. The laws of certain countries in
        which
        the Company's products are or may be manufactured or sold may not protect
        the
        Company's products and
  8
 *Table
            of Contents*
  intellectual
        property rights to the same extent as the laws of the United States. The
        Company
        is currently evaluating the protections available to its intellectual property
        in China, which has been a significant source of orders for its tobacco sorters
        and has seen the recent introduction of potentially infringing sorters.
 
 **Employees**
 
 At
        September 30, 2005, the Company had 478 full-time employees, including 226
        in
        manufacturing, 79 in engineering, research and development, 117 in marketing,
        sales and service, and 56 in general administration and finance. A total
        of 145
        employees are located outside the United States. The Company utilizes temporary
        contract employees, which improves the Company’s ability to adjust manpower in
        response to changing demand for Company products. Of the total employees
        at
        September 30, 2005, seven were contract employees. None of the Company's
        employees in the United States are represented by a labor union. The
        manufacturing employees located at the Company’s facility in Beusichem, The
        Netherlands are represented by the Small Metal Union. The Company has never
        experienced a work stoppage, slowdown or strike.
 
 **Available
        Information**
 
 The
        Company’s annual and quarterly reports and other filings with the Securities and
        Exchange Commission (“SEC”) are made available free of charge through the
        Investor Relations section of the Company’s website at www.key.net as soon as
        reasonably practicable after the Company files such material with the SEC.
        The
        information on or that can be accessed through the Company’s website is not a
        part of this Annual Report on Form 10-K.
 
 
 **ITEM
                  1A.**
              **RISK
                  FACTORS.**
 
 In
        addition to the other information in this Annual Report on Form 10-K, the
        following risk factors should be considered carefully in evaluating the Company
        and its business because such factors may have a significant effect on its
        operating results and financial condition. As a result of the risk factors
        set
        forth below and the information presented elsewhere in this Annual Report
        on
        Form 10-K, actual results could differ materially from those included in
        any
        forward-looking statements.
 
 **Adverse
        economic conditions in the food processing industry, either globally or
        regionally, may adversely affect the Company's revenues.**
 
 The
        markets the Company serves, particularly the food processing industry, are
        experiencing variable economic conditions. The U.S. and European markets
        in the
        food processing industry are not growing and are experiencing consolidation.
        Additionally, changing consumer dietary preferences, most notably in the
        potato
        market, have resulted in reduced or deferred capital equipment purchases
        for the
        Company’s product lines supplying the potato processing industry. While the
        Company has reacted to these developments with applications directed to the
        growing fresh vegetable and fruit industries as well as the pharmaceutical
        and
        recycling industries, continued loss of business in the potato industry will
        have a negative effect on the Company’s sales and net earnings.
 
 **Competition
        and advances in technology may adversely affect sales and
        prices.**
 
 The
        markets for the Company’s products are highly competitive. Advances in
        technology may remove some barriers to market entry, enabling additional
        competitors to enter the Company’s markets. Such additional competition could
        force the Company to reduce prices to remain competitive, and decrease the
        Company’s profits, having a material adverse affect on the Company’s business
        and financial condition. There can be no assurance that the Company will
        be able
        to continue to compete effectively in the future.
 
 **The
        Company’s new products may not compete successfully in either existing or new
        markets.**
 
 The
        future success and growth of the Company is dependent upon its ability to
        develop, market, and sell products and services in certain food processing
        markets as well as to introduce new products into other existing and
        potential
  9
 *Table
            of Contents*
  markets.
        There can be no assurance the Company can successfully penetrate these potential
        markets or expand into new international markets with its current or new
        products.
 
 **The
        limited availability and possible cost fluctuations of materials used in
        the
        Company's products could adversely affect the Company's
        business.**
 
 Certain
        of the components, subassemblies and materials for the Company’s products are
        obtained from single sources or a limited group of suppliers. Although the
        Company seeks to reduce dependence on sole or limited source suppliers, the
        partial or complete loss of certain of these sources could have an adverse
        effect on the Company’s results of operations and customer relationships. In
        addition, certain basic materials, such as stainless steel, are used extensively
        in the Company’s product fabrication processes. Such basic materials may also be
        subject to worldwide shortages or price fluctuations related to the supply
        of or
        demand for raw materials, such as nickel, which are used in their production
        by
        the Company’s suppliers. A significant increase in the price or decrease in the
        availability of one or more of these components, subassemblies or basic
        materials could also adversely affect the Company’s results of operations. The
        high price of stainless steel worldwide in fiscal 2004 and 2005 resulted
        in
        higher component costs and reduced margins on certain product lines. This
        was
        mitigated, to some extent, through price negotiations.
 
 **The
        inability to protect its intellectual property, especially as the Company
        expands geographically, may adversely affect the Company's competitive
        advantage.**
 
 The
        Company’s competitive position may be affected by its ability to protect its
        proprietary technology. The Company has obtained certain patents and has
        filed a
        number of patent applications. The Company also anticipates filing applications
        for protection of its future products and technology. There can be no assurance
        that any such patents will provide meaningful protection for the Company’s
        product innovations, or that the issuance of a patent will give the Company
        any
        material advantage over its competition in connection with any of its products.
        The Company may experience additional intellectual property risks in
        international markets where it may lack patent protection. The patent laws
        of
        other countries may differ from those of the U.S. as to the patentability
        of the
        Company’s products and processes. Moreover, the degree of protection afforded by
        foreign patents may be different from that of U.S. patents.
 
 **Intellectual
        property-related litigation expenses and other costs resulting from infringement
        claims asserted against the Company or its customers by third parties may
        adversely affect the Company’s results of operations and its customer
        relations.**
 
 The
        technologies used by the Company may infringe the patents or proprietary
        technology of others. In the past, the Company has been required to initiate
        litigation to protect its patents. The Company has experienced a direct
        infringement of its intellectual rights in China and is presently working
        with
        the Chinese patent officials in an effort to protect the intellectual property
        rights regarding its tobacco sorter technology in that country. The cost
        of
        enforcing the Company’s patent rights in lawsuits that it may bring against
        infringers or of defending itself against infringement charges by other patent
        holders or other third parties, including customers, may be high and could
        have
        an adverse effect on the Company’s results of operations and its customer
        relations.
 
 Certain
        users of the Company’s products have received notice of patent infringement from
        the Lemelson Medical, Education and Research Foundation, Limited Partnership
        (the “Partnership”) alleging that their use of the Company’s products may
        infringe certain patents transferred to the Partnership by the late Jerome
        H.
        Lemelson. Certain of these users have notified the Company that, in the event
        it
        is subsequently determined that their use of the Company’s products infringes
        any of the Partnership’s patents, they may seek indemnification from the Company
        for damages or expenses resulting from this matter. The Company does not
        believe
        its products infringe any valid and enforceable claims of the Partnership’s
        patents. Furthermore, the Partnership has stated that it is not the Company’s
        products that infringe the Partnership’s patents, but rather the use of those
        products by the Company’s customers. The Company cannot predict the outcome of
        this matter nor any related litigation or other costs related to mitigation
        activities that may arise in the future, the effect of such litigation or
        mitigation activities on the financial results of the Company, or the effect
        upon its customer relations.
  10
 *Table
            of Contents*
  **Inadequate
        internal controls over financial reporting could result in an inability to
        accurately report the Company's financial results.**
 
 Effective
        internal controls are necessary for the Company to provide reliable financial
        reports. If the Company cannot provide reliable financial reports, the Company's
        business and operating results could be harmed. The Company has in the past
        discovered, and may in the future discover, deficiencies in its internal
        controls. For example, in connection with the Company's year-end closing
        process
        for the fiscal year ended September 30, 2005, management identified control
        deficiencies that in the aggregate constituted a material weakness. As more
        fully described below in Item 9A of this Annual Report on Form 10-K, as of
        September 30, 2005, management concluded that the Company did not maintain
        effective controls over the following:
 
 ·
              documentation
                  of accounting guidance applicable to significant non-recurring
                  events and
                  transactions; and
 ·
              reconciliation
                  procedures and policies related to the monthly closing
                  process.
 
 Management
        determined that these control deficiencies could result in the misstatement
        of
        certain line items in the Company's balance sheet or in its statement of
        operations, which would result in a material misstatement to annual or interim
        financial statements that would not be prevented or detected. Accordingly,
        management determined that these control deficiencies in the aggregate
        constituted a material weakness. As a result of the material weakness
        identified, management concluded that the Company's internal control over
        financial reporting was not effective as of September 30,
        2005.
 
 A
        failure
        to implement and maintain effective internal control over financial reporting,
        including a failure to implement corrective actions to address the control
        deficiencies identified above, could result in a material misstatement of
        the
        Company's financial statements or otherwise cause the Company to fail to
        meet
        its financial reporting obligations.
 
 
 **ITEM
                  1B.**
              **UNRESOLVED
                  STAFF COMMENTS.**
 
 None.
  11
 *Table
            of Contents*
  **ITEM
                  2.**
              **PROPERTIES.**
 
 The
        Company owns or leases the following properties:
 
 **Location**
              **Purpose**
              **Square
                  Feet**
              **Owned
                  or Leased**
              **Lease
                  Expires**
              **Renewal
                  Period**Walla
                  Walla, Washington
              Corporate
                  office, manufacturing, research and development, sales and marketing,
                  administration(1)
              150,000
              Leased
                  with option to purchase within the lease term
              2020
              NoneWalla
                  Walla, Washington
              Manufacturing,
                  research and development, sales and marketing(1)
              100,000
              Leased
                  with option to purchase
              2005
              NoneMedford,
                  Oregon
              Research
                  and development, sales and marketing
              16,000
              Leased
              2007
              NoneRedmond,
                  Oregon
              Manufacturing,
                  research and development, sales, administration
              19,000
              Leased
              2007
              2008Beusichem,
                  The Netherlands
              Manufacturing,
                  sales and marketing, administration
              45,000
              Leased
              2008
              2013Beusichem,
                  The Netherlands
              Parts
                  warehouse, future manufacturing expansion
              18,000
              Owned
              n/a
              n/aSydney,
                  Australia
              Manufacturing,
                  sales and marketing, administration
              14,500
              Leased
              2006
              2007
 
 (1)
              In
                  June 2005, the Company announced plans to expand its primary operating
                  facility in Walla Walla by approximately 23,000 square feet and
                  terminate
                  the lease on the second facility in Walla Walla in December
                  2005.
 
 The
        Company also has leased office space in Dingley, Australia and Santiago de
        Querétaro, Mexico. The Company considers all of its properties suitable for the
        purposes for which they are used.
 
 **ITEM
                  3.**
              **LEGAL
                  PROCEEDINGS.**
 
 From
        time-to-time, the Company is named as a defendant in legal proceedings arising
        out of the normal course of its business. As of December 2, 2005, the Company
        was not a party to any material legal proceedings.
 
 **ITEM
                  4.**
              **SUBMISSION
                  OF MATTERS TO A VOTE OF SECURITY
                  HOLDERS.**
 
 None.
  12
 *Table
            of Contents*
  **PART
        II**
 
 **ITEM
                  5.**
              **MARKET
                  FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
                  ISSUER
                  PURCHASES OF EQUITY
                  SECURITIES.**
  *Common
        Stock*
 
 Shares
        of
        the Company's common stock are quoted on the Nasdaq National Market System
        under
        the symbol “KTEC”. The following table shows the high and low bid prices per
        share of the Company's common stock by quarter for the two most recent fiscal
        years ended September 30, 2005:
 
 Fiscal
                  2005
              
              Fiscal
                  2004High
              
              Low
              
              High
              
              LowFirst
                  Quarter
              
              $
              11.780
              
              $
              8.520
              
              $
              17.250
              
              $
              11.050Second
                  Quarter
              
              
              10.500
              
              
              8.970
              
              
              19.260
              
              
              14.000Third
                  Quarter
              
              
              11.500
              
              
              9.250
              
              
              16.240
              
              
              11.050Fourth
                  Quarter
              
              
              15.190
              
              
              10.500
              
              
              13.690
              
              
              10.480
 
 The
        source of these quotations for the Company’s common stock was the Nasdaq
        Online SM Internet
        site.
 
 The
        Company had approximately 1,343 beneficial owners of its common stock, of
        which
        157 are of record, as of December 2, 2005.
 
 The
        Company has not historically paid dividends on its common or preferred stock.
        The Board of Directors does not anticipate payment of any dividends in the
        foreseeable future and intends to continue its present policy of retaining
        earnings for reinvestment in the operations of the Company. The current credit
        facility with the Company’s principal domestic bank restricts the payment of
        dividends.
 
 **Issuer
        Purchases of Equity Securities**
 
 The
        following table provides information about purchases made by or on behalf
        of the
        Company during the quarter ended September 30, 2005 of equity securities
        registered by the Company under Section 12 of the Exchange Act.
  Mandatorily
          Redeemable Series B Convertible Preferred Stock (1)
 
 Period
                
                Total
                    Number of Shares Purchased
                
                Average
                    Price Paid per Share
                
                Total
                    Number of Shares Purchased as Part of Publicly Announced Plans
                    or
                    Programs
                
                Maximum
                    Number of Shares that May Yet Be Purchased Under the Plans or
                    ProgramsJuly
                    1 - 31, 2005
                
                112,339
                
                $10
                
                -
                
                -August
                    1 - 31, 2005
                
                0
                
                -
                
                -
                
                -September
                    1 - 30, 2005
                
                0
                
                -
                
                -
                
                -Total
                
                112,339
                
                
                
                
                
                0
 13
 *Table
                of Contents*
  Warrants
          (2)
 
 Period
                
                Total
                    Number of Warrants Purchased
                
                Average
                    Price Paid per Warrant
                
                Total
                    Number of Warrants Purchased as Part of Publicly Announced Plans
                    or
                    Programs
                
                Maximum
                    Number of Warrants that May Yet Be Purchased Under the Plans
                    or
                    ProgramsJuly
                    1-31, 2005
                
                12,560
                
                $10
                
                -
                
                -August
                    1-31, 2005
                
                0
                
                -
                
                -
                
                -September
                    1-30, 2005
                
                0
                
                -
                
                -
                
                -Total
                
                12,560
                
                
                
                
                
                0
  (1)
              In
                  July 2000, the Company issued 1,340,366 shares of Series B convertible
                  preferred stock (“Series B”) at a price of $8.60 per share in conjunction
                  with the acquisition of AMVC. Each share of Series B, par value $0.01
                  per share, was convertible into 2/3 of a share of common stock.
                  The Series
                  B was convertible at the option of the holder at any time, unless
                  previously redeemed, or by the Company upon a merger, consolidation,
                  share
                  exchange or sale of substantially all of its assets. The holders
                  of
                  Series B could have required the Company to repurchase any or all of
                  their shares at the redemption price of $10.00. If not converted
                  to common
                  stock or redeemed at the option of the Series B holder prior to
                  July 12, 2005, the Company was required to redeem the Series B
                  for $10.00 per share on July 12, 2005. In July 2005, all remaining
                  unconverted Series B shares were redeemed at the $10.00 per share
                  redemption price.
 
 (2)
              In
                  July 2000, the Company issued 365,222 warrants at a fair market
                  value of
                  $10.00 per warrant in conjunction with the issuance of the convertible
                  preferred stock. Each warrant entitled its holder to purchase at
                  any time
                  for a period of five years from July 12, 2000 one share of common
                  stock at $15.00 per share, subject to certain adjustments. The
                  warrants
                  permitted the holder to engage in a net exercise of the warrants
                  if the
                  fair market value of one share of common stock is greater than
                  $15.00 per
                  share on the date of exercise. Prior to the expiration date of
                  the
                  warrant, the holder could have required the Company to redeem the
                  warrant
                  for cash at a price equal to $10.00 for each whole share of common
                  stock
                  that may be purchased under the warrant. These warrants expired
                  in July
                  2005, and all unconverted warrants presented to the Company were
                  redeemed
                  at the $10.00 per warrant redemption price. There were 12,738 warrants
                  that expired unredeemed and
                  unconverted.
  14
 *Table
            of Contents*
  **ITEM
                  6.**
              **SELECTED
                  FINANCIAL DATA.**
 
 The
        selected consolidated financial information set forth below for each of the
        five
        years in the period ended September 30, 2005 has been derived from the audited
        consolidated financial statements of the Company. The information below should
        be read in conjunction with Management's Discussion and Analysis of Financial
        Condition and Results of Operations and the Company's Consolidated Financial
        Statements and Notes thereto as provided in Item 7 and Item 8 of this Annual
        Report on Form 10-K, respectively.
 
 **Fiscal
                  Year Ended September 30,****2005**
              
              **2004**
              
              **2003**
              
              **2002**
              
              **2001****(in
                  thousands, except per share data)****Statement
                  of Operations Data:**Net
                  sales
              
              $
              80,322
              
              $
              80,610
              
              $
              82,622
              
              $
              70,234
              
              $
              72,954Cost
                  of sales
              
              
              49,015
              
              
              46,887
              
              
              48,626
              
              
              42,352
              
              
              47,186Gross
                  profit
              
              
              31,307
              
              
              33,723
              
              
              33,996
              
              
              27,882
              
              
              25,768Operating
                  expenses
              
              
              27,625
              
              
              28,295
              
              
              25,221
              
              
              23,486
              
              
              28,190Gain
                  (loss) on sale of assets
              
              
              28
              
              
              5
              
              
              4
              
              
              883
              
              
              76Income
                  (loss) from operations
              
              
              3,710
              
              
              5,433
              
              
              8,779
              
              
              5,279
              
              
              (2,346
              )Other
                  income (expense)
              
              
              (117
              )
              
              (132
              )
              
              (327
              )
              
              (1,733
              )
              
              (1,340
              )Earnings
                  (loss) from continuing operations before income taxes
              
              
              3,593
              
              
              5,301
              
              
              8,452
              
              
              3,546
              
              
              (3,686
              )Income
                  tax (benefit) expense
              
              
              902
              
              
              1,617
              
              
              2,693
              
              
              1,238
              
              
              (1,343
              )Net
                  earnings (loss) from continuing operations
              
              
              2,691
              
              
              3,684
              
              
              5,759
              
              
              2,308
              
              
              (2,343
              )Earnings
                  (loss) on discontinued operation (net of tax)
              
              
              --
              
              
              --
              
              
              --
              
              
              39
              
              
              (2,581
              )Change
                  in accounting principle (net of tax)(1)
              
              
              --
              
              
              --
              
              
              --
              
              
              (4,302
              )
              
              --Net
                  earnings (loss)
              
              
              2,691
              
              
              3,684
              
              
              5,759
              
              
              (1,955
              )
              
              (4,924
              )Assumed
                  dividends on mandatorily redeemable preferred stock
              
              
              (33
              )
              
              (69
              )
              
              (132
              )
              
              --
              
              
              --Accretion
                  of mandatorily redeemable preferred stock
              
              
              --
              
              
              --
              
              
              --
              
              
              (582
              )
              
              (939
              )Net
                  earnings (loss) available to common shareholders
              
              $
              2,658
              
              $
              3,615
              
              $
              5,627
              
              $
              (2,537
              )
              $
              (5,863
              )Net
                  earnings (loss) from continuing operations per share
                -
                  basic
              
              $
              0.53
              
              $
              0.74
              
              $
              1.18
              
              $
              0.36
              
              $
              (0.69
              )-
                  diluted
              
              $
              0.52
              
              $
              0.71
              
              $
              1.15
              
              $
              0.36
              
              $
              (0.69
              )Net
                  earnings (loss) from discontinued operation per share
                -
                  basic and diluted
              
              $
              --
              
              $
              --
              
              $
              --
              
              $
              0.01
              
              $
              (0.55
              )Change
                  in accounting principle per share
                -
                  basic and diluted
              
              $
              --
              
              $
              --
              
              $
              --
              
              $
              (0.90
              )
              $
              --Earnings
                  (loss) per share
                -
                  basic
              
              $
              0.53
              
              $
              0.74
              
              $
              1.18
              
              $
              (0.53
              )
              $
              (1.24
              )-
                  diluted
              
              $
              0.52
              
              $
              0.71
              
              $
              1.15
              
              $
              (0.53
              )
              $
              (1.24
              )Cash
                  dividends per share
              
              $
              --
              
              $
              --
              
              $
              --
              
              $
              --
              
              $
              --Shares
                  used in per share calculation
                -
                  basic
              
              
              5,041
              
              
              4,909
              
              
              4,774
              
              
              4,759
              
              
              4,740-
                  diluted
              
              
              5,219
              
              
              5,222
              
              
              4,989
              
              
              4,759
              
              
              4,740
 
 (1)
              The
                  change in accounting principle relates to the Company’s adoption of SFAS
                  No. 142,*Goodwill
                  and Other Intangible Assets*in
                  fiscal year 2002, and the related impairment of goodwill identified
                  in
                  connection with implementation of this standard.
  15
 *Table
            of Contents*
  **September
                    30,****2005**
                
                **2004**
                
                **2003**
                
                **2002**
                
                **2001****(in
                    thousands)****Balance
                    Sheet Data:**Cash
                    and cash equivalents and short-term investments
                
                $
                13,181
                
                $
                8,817
                
                $
                6,442
                
                $
                1,707
                
                $
                738Working
                    capital
                
                
                27,510
                
                
                20,991
                
                
                17,226
                
                
                7,673
                
                
                10,722Property,
                    plant and equipment, net.
                
                
                4,264
                
                
                5,046
                
                
                5,503
                
                
                6,407
                
                
                11,436Total
                    assets
                
                
                57,527
                
                
                52,514
                
                
                51,215
                
                
                49,820
                
                
                74,841Current
                    portion of long-term debt
                
                
                1,121
                
                
                1,210
                
                
                1,066
                
                
                1,668
                
                
                11,739Long-term
                    debt, less current portion
                
                
                1,199
                
                
                2,323
                
                
                3,249
                
                
                3,747
                
                
                6,581Mandatorily
                    redeemable preferred stock and warrants, including current
                    portion
                
                
                --
                
                
                1,595
                
                
                1,882
                
                
                3,467
                
                
                13,531Shareholders'
                    equity
                
                
                40,471
                
                
                36,044
                
                
                30,219
                
                
                23,602
                
                
                25,711
 
 
 **ITEM
                  7.**
              **MANAGEMENT'S
                  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
                  OPERATIONS.**
 
 **Introduction**
 
 The
        Company and its wholly-owned subsidiaries design, manufacture and sell process
        automation systems, integrating electro-optical inspection, sorting and process
        systems.
 
 The
        Company consists of Key Technology, Inc. which directly owns four subsidiaries:
        Key Holdings USA LLC; Key Technology Australia Pty. Ltd.; Productos Key Mexicana
        S. de R. L. de C.V.; and Key Technology AMVC LLC (inactive). Key Holdings
        USA
        LLC owns Suplusco Holdings B.V., its European subsidiary, which owns Key
        Technology B.V. Key Technology Australia Pty. Ltd. owns Freshline Machines
        Pty.
        Ltd. The Company manufactures products in Walla Walla, Washington; Redmond,
        Oregon; Beusichem, The Netherlands, and Sydney, Australia.
 
 **Overview**
 
 Sales
        for
        the year ended September 30, 2005 were $80.3 million compared with $80.6
        million
        for fiscal 2004. The Company reported net earnings for fiscal 2005 of $2.7
        million, or $0.52 per diluted share, compared with net earnings of $3.7 million,
        or $0.71 per diluted share, for fiscal 2004. Gross margins were lower in
        fiscal
        2005 versus fiscal 2004 because of a change in the mix of products sold from
        the
        prior year. Export and international sales for the fiscal years ended September
        30, 2005, 2004 and 2003 accounted for 52%, 44% and 50% of net sales in each
        year, respectively. Export sales are expected to increase as a percentage
        of
        sales. The Company believes there is significant potential for increased
        sales
        of its products outside the United States where sorting and inspection equipment
        is not as widely adopted as in the U.S.
 
 In
        2005,
        the Company focused its effort on three major initiatives to achieve its
        long-term revenue growth plan:
 
 ·
              Expand
                  and grow its participation in the pharmaceutical
                  market;
 ·
              Continue
                  to drive growth in the Company’s aftermarket product
                  lines;
 ·
              Strengthen
                  and grow the level of business in
                  China.
 
 The
        results from 2005 reflected progress on each of these initiatives. The
        pharmaceutical initiative focused on the formation of the SymetixTM business unit
        during fiscal 2005. This business unit was formed to dedicate a team of
        employees to develop and grow Key’s business in the pharmaceutical market. A new
        optical inspection system for high-resolution inspections of solid dose
        pharmaceuticals called Vantyx TM was launched during the year. This new
        product
  16
 *Table
            of Contents*
  extends
        and advances the Company’s existing patented, high-resolution inspection
        technology and material handling platforms.
 
 The
        Company also further developed its aftermarket product lines and introduced
        its
        new G6 family of products with enhanced vision engine technology. Upgrades
        are
        an important aspect of the aftermarket product lines, and the new modular
        G6
        product family, which provides advanced image processing capability, has
        been
        well received by the Company’s current customers. Aftermarket sales in fiscal
        2005 increased substantially over fiscal 2004, and the introduction of
        additional new products and extensions of current technology are expected
        to
        permit the Company to further increase its aftermarket business in fiscal
        2006.
 
 The
        Company has been successful in selling tobacco sorters in China. Larger
        opportunities exist there in the food processing business, and the Company
        is
        planning further investments in China to enhance sales, service and applications
        support to build upon its established base.
 
 In
        February 2005, the Company acquired Freshline Machines Pty. Ltd. as a platform
        to launch its entry into the fresh-cut market. Management continues to see
        opportunity in this growing market.
 
 The
        path
        for 2006 is to continue to build upon our direction and solid base that the
        Company developed during 2005. The focus for the coming year is to continue
        to
        grow the pharmaceutical business, continue to increase revenues in the
        aftermarket **** business,
        and to further increase the Company’s local presence in China by locating
        Company personnel in-country. The Company will also continue to seek investments
        which will allow it to extend its penetration into other markets and to add
        products which are complementary to its existing business.
 
 **Restatement
        of Financial Statements**
 
 The
        Company recently made adjustments in its accounting for deferred rent credits
        that will require a restatement of the Company's financial statements for
        the
        second and third fiscal quarters of fiscal 2005 ended March 31, 2005 and
        June
        30, 2005, respectively. As a result of these adjustments, previously issued
        unaudited quarterly data may not agree to the annual amounts. See Item 9A
        of
        this Annual Report on Form 10-K.
 
 
 **Application
        of Critical Accounting Policies**
 
 The
        Company has identified its critical accounting policies, the application
        of
        which may materially affect the financial statements, either because of the
        significance of the financial statement item to which they relate, or because
        they require management judgment to make estimates and assumptions in measuring,
        at a specific point in time, events which will be settled in the future.
        The
        critical accounting policies, judgments and estimates which management believes
        have the most significant effect on the financial statements are set forth
        below:
  ·
              Revenue
                  recognition
 ·
              Allowances
                  for doubtful accounts
 ·
              Valuation
                  of inventories
 ·
              Long-lived
                  assets
 ·
              Allowances
                  for warranties
 ·
              Accounting
                  for income taxes
 
 Management
        has discussed the development, selection and related disclosures of these
        critical accounting estimates with the audit committee of the Company’s board of
        directors.
 
 *Revenue
        Recognition.* The
        Company recognizes revenue when persuasive evidence of an arrangement exists,
        delivery has occurred or services have been provided, the sale price is fixed
        or
        determinable, and collectibility is reasonably assured. Additionally, the
        Company sells its goods on terms which transfer title and risk of loss at
        a
        specified location, typically shipping point, port of loading or port of
        discharge, depending on the final destination of the goods. Accordingly,
        revenue
        recognition from product sales occurs when all factors are met, including
        transfer of title and risk of loss, which occurs either upon shipment by
        the
        Company or upon receipt by customers at the location specified in
        the
  17
 *Table
            of Contents*
  terms
        of
        sale. Revenue earned from services (maintenance, installation support, and
        repairs) is recognized ratably over the contractual period or as the services
        are performed. If any contract provides for both equipment and services
        (multiple deliverables), the sales price is allocated to the various elements
        based on objective evidence of fair value. Each element is then evaluated
        for
        revenue recognition based on the previously described criteria. The Company’s
        sales arrangements provide for no other, or insignificant, post shipment
        obligations. If all conditions of revenue recognition are not met, the Company
        defers revenue recognition. In the event of revenue deferral, the sale value
        is
        not recorded as revenue to the Company, accounts receivable are reduced by
        any
        amounts owed by the customer, and the cost of the goods or services deferred
        is
        carried in inventory. In addition, the Company periodically evaluates whether
        an
        allowance for sales returns is necessary. Historically, the Company has
        experienced few sales returns. If the Company believes there are potential
        sales
        returns, the Company will provide any necessary provision against sales.
        In
        accordance with the Financial Accounting Standard Board’s Emerging Issues Task
        Force Issue No. 01-9, *“Accounting
        for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s
        Product,”* we
        account for cash consideration (such as sales incentives) that we give to
        our
        customers or resellers as a reduction of revenue rather than as an operating
        expense unless we receive a benefit that we can identify and for which we
        can
        reasonably estimate the fair value. The Company believes that revenue
        recognition is a “critical accounting estimate” because the Company’s terms of
        sale vary significantly, and management exercises judgment in determining
        whether to recognize or defer revenue based on those terms. Such judgments
        may
        materially affect net sales for any period. Management exercises judgment
        within
        the parameters of accounting principles generally accepted in the United
        States
        of America (GAAP) in determining when contractual obligations are met, title
        and
        risk of loss are transferred, the sales price is fixed or determinable and
        collectibility is reasonably assured. At September 30, 2005, the Company
        had
        deferred $1.3 million of revenue compared to $0.7 million deferred at September
        30, 2004.
 
 *Allowances
        for doubtful accounts.* The
        Company establishes allowances for doubtful accounts for specifically
        identified, as well as anticipated, doubtful accounts based on credit profiles
        of customers, current economic trends, contractual terms and conditions,
        and
        customers’ historical payment patterns. Factors that affect collectibility of
        receivables include general economic or political factors in certain countries
        that affect the ability of customers to meet current obligations. The Company
        actively manages its credit risk by utilizing an independent credit rating
        and
        reporting service, by requiring certain percentages of down payments, and
        by
        requiring secured forms of payment for customers with uncertain credit profiles
        or located in certain countries. Forms of secured payment could include
        irrevocable letters of credit, bank guarantees, third-party leasing arrangements
        or EX-IM Bank guarantees, each utilizing Uniform Commercial Code filings,
        or the
        like, with governmental entities where possible. The Company believes that
        the
        accounting estimate related to allowances for doubtful accounts is a “critical
        accounting estimate” because it requires management judgment in making
        assumptions relative to customer or general economic factors that are outside
        the Company’s control. As of September 30, 2005, the balance sheet included
        allowances for doubtful accounts of $504,000. Actual charges to the allowance
        for doubtful accounts for fiscal 2005 and 2004 were $79,000 and $159,000,
        respectively. Accruals for bad debt expense for fiscal 2005 and 2004 were
        ($43,000) and $172,000, respectively. If the Company experiences actual bad
        debt
        expense in excess of estimates, or if estimates are adversely adjusted in
        future
        periods, the carrying value of accounts receivable would decrease and charges
        for bad debts would increase, resulting in decreased net earnings.
 
 *Valuation
        of inventories.* Inventories are stated at the lower of cost or market. The Company’s inventory
        includes purchased raw materials, manufactured components, purchased components,
        work in process, finished goods and demonstration equipment. Provisions for
        excess and obsolete inventories are made after periodic evaluation of historical
        sales, current economic trends, forecasted sales, estimated product lifecycles
        and estimated inventory levels. The factors that contribute to inventory
        valuation risks are the Company’s purchasing practices, electronic component
        obsolescence, accuracy of sales and production forecasts, introduction of
        new
        products, product lifecycles and the associated product support. The Company
        actively manages its exposure to inventory valuation risks by maintaining
        low
        safety stocks and minimum purchase lots, utilizing just in time purchasing
        practices, managing product end-of-life issues brought on by aging components
        or
        new product introductions, and by utilizing inventory minimization strategies
        such as vendor-managed inventories. The Company believes that the accounting
        estimate related to valuation of inventories is a “critical accounting estimate”
because it is susceptible to changes from period to period due to the
        requirement for management to make estimates relative to each of the underlying
        factors ranging from purchasing to sales to production to after-sale support.
        At
        September 30, 2005, cumulative inventory adjustments to lower of cost or
        market
        totaled $2.8 million compared to $3.0 million as of September 30, 2004. Amounts
        charged to expense for fiscal 2005 and 2004 were $728,000 and $841,000,
        respectively. Actual charges to the reserve were $863,000 and $349,000 for
        fiscal 2005 and
  18
 *Table
            of Contents*
  2004,
        respectively. If actual demand, market conditions or product lifecycles are
        adversely different from those estimated by management, inventory adjustments
        to
        lower market values would result in a reduction to the carrying value of
        inventory, an increase in inventory write-offs, and a decrease to gross margins.
 
 *Long-lived
        assets.* The
        Company regularly reviews all of its long-lived assets, including property,
        plant and equipment, investments in joint ventures, and amortizable intangible
        assets, for impairment whenever events or changes in circumstances indicate
        that
        the carrying value may not be recoverable. If the total of projected future
        undiscounted cash flows is less than the carrying amount of these assets,
        an
        impairment loss based on the excess of the carrying amount over the fair
        value
        of the assets is recorded. In addition, goodwill is reviewed based on its
        fair
        value at least annually. As of September 30, 2005, the Company held $14.3
        million of property, plant and equipment, investments in joint ventures,
        goodwill and other intangible assets, net of depreciation and amortization.
        There were no changes in the Company’s long-lived assets that would result in an
        adjustment of the carrying value for these assets. Estimates of future cash
        flows arising from the utilization of these long-lived assets and estimated
        useful lives associated with the assets are critical to the assessment of
        recoverability and fair values. The Company believes that the accounting
        estimate related to long-lived assets is a “critical accounting estimate”
because: (1) it is susceptible to change from period to period due to the
        requirement for management to make assumptions about future sales and cost
        of
        sales generated throughout the lives of several product lines over extended
        periods of time; and (2) the potential effect that recognizing an impairment
        could have on the assets reported on the Company’s balance sheet and the
        potential material adverse effect on reported earnings or loss. Changes in
        these
        estimates could result in a determination of asset impairment, which would
        result in a reduction to the carrying value and a reduction to net earnings
        in
        the affected period.
 
 *Allowances
        for warranties.* The
        Company’s products are covered by warranty plans that extend between 90 days and
        2 years, depending upon the product and contractual terms of sale. The Company
        establishes allowances for warranties for specifically identified, as well
        as
        anticipated, warranty claims based on contractual terms, product conditions
        and
        actual warranty experience by product line. Company products include both
        manufactured and purchased components and, therefore, warranty plans include
        third-party sourced parts which may not be covered by the third-party
        manufacturer’s warranty. Ultimately, the warranty experience of the Company is
        directly attributable to the quality of its products. The Company actively
        manages its quality program by using a structured product introduction plan,
        process monitoring techniques utilizing statistical process controls, vendor
        quality metrics, a quality training curriculum for every employee and feedback
        loops to communicate warranty claims to designers and engineers for remediation
        in future production. Warranty expense has varied widely in the past due
        to such
        factors as significant new product introductions containing defects and design
        errors on individual projects. The Company believes that the accounting estimate
        related to allowances for warranties is a “critical accounting estimate”
because: (1) it is susceptible to significant fluctuation period to period
        due
        to the requirement for management to make assumptions about future warranty
        claims relative to potential unknown issues arising in both existing and
        new
        products, which assumptions are derived from historical trends of known or
        resolved issues; and (2) risks associated with third-party supplied components
        being manufactured using processes that the Company does not control. As
        of
        September 30, 2005, the balance sheet included warranty reserves of $1.2
        million, while $1.8 million of warranty charges were incurred during the
        fiscal
        year then ended, compared to warranty reserves of $889,000 as of September
        30,
        2004 and warranty charges of $1.7 million for the fiscal year then ended.
        If the
        Company’s actual warranty costs are higher than estimates, future warranty plan
        coverages are different, or estimates are adversely adjusted in future periods,
        reserves for warranty would need to increase, warranty expense would increase
        and gross margins would decrease.
 
 *Accounting
        for income taxes.* The
        Company’s provision for income taxes and the determination of the resulting
        deferred tax assets and liabilities involves a significant amount of management
        judgment. The quarterly provision for income taxes is based partially upon
        estimates of pre-tax financial accounting income for the full year and is
        affected by various differences between financial accounting income and taxable
        income. Judgment is also applied in determining whether the deferred tax
        assets
        will be realized in full or in part. In management’s judgment, when it is more
        likely than not that all or some portion of specific deferred tax assets,
        such
        as foreign tax credit carryovers, will not be realized, a valuation allowance
        must be established for the amount of the deferred tax assets that are
        determined not to be realizable. There was no valuation allowance at
        September  30,
        2005
        due to anticipated utilization of all the deferred tax assets as the Company
        believes it will have sufficient taxable income combined with the lengthy
        expiration periods on carryforward items to utilize these assets. The Company
        maintains reserves for estimated tax exposures in jurisdictions of operation.
        These tax jurisdictions include federal, state and various international
        tax
        jurisdictions. Potential income tax exposures include potential challenges
        of
        various tax credits, export-related tax benefits, and issues specific to
        state
        and local tax
  19
 *Table
            of Contents*
  jurisdictions.
        Exposures are typically settled primarily through audits within these tax
        jurisdictions, but can also be affected by changes in applicable tax law
        or
        other factors, which could cause management of the Company to believe a revision
        of past estimates is appropriate. During fiscal 2005, 2004, and 2003, there
        have
        been no significant changes in these estimates. Management believes that
        an
        appropriate liability has been established for estimated exposures; however,
        actual results may differ materially from these estimates. During the fiscal
        year ended September 30, 2003, income tax expense was reduced by approximately
        $150,000 due primarily to changes in tax laws which re-characterized previously
        non-deductible items. The Company believes that the accounting estimate related
        to income taxes is a “critical accounting estimate” because it relies on
        significant management judgment in making assumptions relative to temporary
        and
        permanent timing differences of tax effects, estimates of future earnings,
        prospective application of changing tax laws in multiple jurisdictions, and
        the
        resulting ability to utilize tax assets at those future dates. If the Company’s
        operating results were to fall short of expectations, thereby affecting the
        likelihood of realizing the deferred tax assets, judgment would have to be
        applied to determine the amount of the valuation allowance required to be
        included in the financial statements established in any given period.
        Establishing or increasing a valuation allowance would reduce the carrying
        value
        of the deferred tax asset, increase tax expense and reduce net earnings.
 
 In
        October 2004, the American Jobs Creation Act of 2004 was enacted. This
        legislation phases out the Extra Territorial Income Exclusion (“ETI”) beginning
        January 1, 2005 through December 31, 2006. The ETI exclusion reduced the
        Company’s effective tax rate by 5.4%, 2.8% and 2.3% in 2005, 2004 and 2003,
        respectively. The legislation also provides for a new deduction for
        manufacturing income, which phases in beginning in the Company’s 2006 fiscal
        year through 2010. Although final regulations have not been written for the
        new
        manufacturing income deduction, the Company anticipates that this deduction
        will
        largely, if not completely, offset the loss of the ETI exclusion. However,
        the
        effects in individual fiscal years during the phase-in periods may vary and
        increase the Company’s effective tax rate during these periods. The Company does
        not believe that other provisions of the new legislation will have a material
        effect on the Company’s income taxes.
  20
 *Table
            of Contents*
  **Summary
                  of Financial Information****Fiscal****Yea****r
                  Ended September 30,****2005**
              
              **2004**
              
              **Change
                  $**
              
              **Change
                  %****(in
                  thousands)****Statement
                  of Operations Data**Orders*(unaudited)*
              
              $
              83,716
              
              $
              72,609
              
              $
              11,107
              
              
              15.3Net
                  sales
              
              
              80,322
              
              
              80,610
              
              
              (288
              )
              
              -0.4Gross
                  profit
              
              
              31,307
              
              
              33,723
              
              
              (2,416
              )
              
              -7.2Research
                  & development
              
              
              5,134
              
              
              5,756
              
              
              (622
              )
              
              -10.8Sales
                  and marketing
              
              
              13,071
              
              
              13,514
              
              
              (443
              )
              
              -3.3General
                  & administrative
              
              
              8,087
              
              
              7,702
              
              
              385
              
              
              5.0Amortization
              
              
              1,333
              
              
              1,323
              
              
              10
              
              
              0.8Total
                  operating expense
              
              
              27,625
              
              
              28,295
              
              
              (670
              )
              
              -2.4Gain
                  on sale of assets
              
              
              28
              
              
              5
              
              
              23
              
              
              N/AIncome
                  from operations
              
              
              3,710
              
              
              5,433
              
              
              (1,723
              )
              
              -31.7Other
                  income and expense
              
              
              (117
              )
              
              (132
              )
              
              15
              
              
              -11.4Income
                  tax
              
              
              902
              
              
              1,617
              
              
              (715
              )
              
              -44.2Net
                  income
              
              
              2,691
              
              
              3,684
              
              
              (993
              )
              
              -27.0**Balance
                  Sheet Data**Cash
                  and cash equivalents
              
              
              13,181
              
              
              8,817
              
              
              4,364
              
              
              49.5Accounts
                  receivable
              
              
              10,828
              
              
              9,336
              
              
              1,492
              
              
              16.0Inventories
              
              
              14,860
              
              
              13,633
              
              
              1,227
              
              
              9.0Current
                  portion of redeemable stock
              
              
              -
              
              
              1,279
              
              
              (1,279
              )
              
              -100.0Current
                  portion of warrants
              
              
              -
              
              
              316
              
              
              (316
              )
              
              -100.0Long-term
                  debt
              
              
              1,199
              
              
              2,323
              
              
              (1,124
              )
              
              -48.4
 
 **Results
        of Operations**
 
 *Fiscal
        2005 compared to Fiscal 2004*
 
 Orders
        increased by $11.1 million to $83.7 million in 2005, a 15% increase over
        $72.6
        million in new orders received in 2004. The increased orders resulted in
        a $3.8
        million increase in the Company’s backlog to $16.6 million at September 30, 2005
        from $12.8 million at September 30, 2004. Orders were much stronger in the
        second half of fiscal 2005 versus the second half of fiscal 2004, totaling
        $42.7
        million in the last six months of 2005 versus $34.8 million the same period
        the
        prior year, an increase of 22%.
 
 Net
        sales
        were essentially flat compared to the prior year, totaling $80.3 million
        in
        fiscal 2005 and $80.6 million in fiscal 2004. Sales of $32.8 million in the
        first half of fiscal 2005 were much slower than anticipated and continued
        a
        trend which began during 2004. Second half fiscal 2005 net sales increased
        16%
        to $47.5 million, as compared to net sales of $41.1 million in the second
        half
        of fiscal 2004.
 
 Sales
        in
        the Company’s automated inspection systems product line declined to $20.6
        million in 2005, accounting for 26% of revenues, from $28.7 million in 2004,
        accounting for 36% of revenues. The primary reason for the decrease in automated
        systems sales was the decline in shipments of Tegra, which experienced a
        51%
        decrease in orders as a result of a cyclical decline in the domestic processed
        vegetable market, the major market for this product. An order for tobacco
        sorters to be delivered to China did not ship prior to year-end, further
        affecting the decrease in the automated inspection
  21
 *Table
            of Contents*
  business.
        The reduction in automated inspection system sales was offset by increases
        in
        process system sales and parts and service/contracts sales. Process systems
        increased to $31.9 million and 40% of net sales in fiscal 2005 from $27.7
        million and 34% of net sales in fiscal 2004. Shipments were up in fiscal
        2005
        across all products within the process systems product line and benefited
        from
        the acquisition of Freshline Machines Pty. Ltd. in fiscal 2005. Freshline
        extends the Company’s capacities into the fresh-cut market segment of the food
        processing market.
 
 One
        of
        the major initiatives during 2005 was the focus on aftermarket sales. The
        increased focus on parts/service contracts led to an increase in net sales
        to
        $27.8 million in fiscal 2005 from $24.2 million in fiscal 2004. Parts and
        service/contracts increased to 34% of net sales from 30% in 2004. The primary
        reason for the increase was additional shipments of upgrades which increased
        in
        2005 over the prior year. The addition of the G6 upgrade kit introduced during
        fiscal 2005 is expected to give added emphasis to this product category in
        2006.
        The G6 platform standardizes the electro-optical components across all of
        the
        Company’s sorting product lines and allows customers to upgrade an application
        module instead of replacing an entire sorter.
 
 Gross
        profits decreased in 2005 due primarily to the mix of products sold during
        the
        year. Process systems, which carry the lowest gross margins, increased in
        percent of total sales from 34% to 40% as noted above. The automated inspection
        systems product line, which carries a higher gross margin as a percentage
        of
        sales, saw its share of revenues drop from 36% of net sales to 26%. This
        change
        in mix between product lines caused gross margin dollars to drop to $31.3
        million in fiscal 2005 from $33.7 million the prior year. The gross margin
        percentage decreased to 39.0% in fiscal 2005 from 41.8% in fiscal 2004
        reflecting the product mix change. The gross margin was also adversely affected
        in the fourth quarter by a $325,000 charge to fully accrue for a product
        performance issue, which ultimately resulted in a sales concession to a
        customer.
 
 Research
        and development **** spending
        decreased from year-to-year, dropping to $5.1 million and 6.4% of net sales
        in
        fiscal 2005 from $5.8 million and 7.1% of net sales in fiscal 2004. The decrease
        in spending reflects the reduction in workforce and spending controls
        implemented in the fourth quarter of fiscal 2004. The Company continues to
        invest in R&D to continue the extension of its product lines and development
        of new products.
 
 Sales
        and
        marketing **** expenses
        decreased slightly from the prior year. Sales and marketing expenses in fiscal
        2005 were $13.1 million compared to $13.5 million in fiscal 2004. Sales and
        marketing expenses decreased as a percentage of net sales to 16.4% in fiscal
        2005 from 16.8% in fiscal 2004. Expenditures for sales and marketing totaled
        $6.1 million during the first half of 2005, but increased to $7.0 million
        in the
        second half of the year as expenses were incurred related to the initiatives
        to
        grow the aftermarket business and to increase the Company’s presence in
        China.
 
 General
        and administrative **** expenses
        increased to $8.1 million in fiscal 2005 versus $7.7 million in fiscal 2004.
        General and administrative expense as a percentage of net sales increased
        to
        10.1% in fiscal 2005 from 9.6% the year prior. General and administrative
        expenses increased in fiscal 2005 due to hiring and relocation costs incurred,
        consulting fees, stock compensation expenses recorded, and costs incurred
        in
        connection with an abandoned acquisition.
 
 Other
        income and expense **** improved
        from $132,000 of expense in fiscal 2004 to $117,000 of expense in fiscal
        2005.
        Interest income was higher by $115,000 in fiscal 2005, while interest expense
        decreased to $179,000 in fiscal 2005 from $204,000 in fiscal 2004 due to
        lower
        borrowings, offset slightly by higher interest rates in 2005. Subsequent
        to the
        end of fiscal 2005, the Company’s U.S. term debt aggregating $1.6 million was
        paid from cash on-hand. In 2004, the Company entered into an agreement with
        Peco
        Controls Corporation to form InspX LLC, a 50-50 joint venture. The financial
        results of the joint venture resulted in a $0.7 million charge to other expense
        in 2005, including costs for amortization of patents. In November 2004, the
        Company received a one-time settlement of $500,000 related to the resolution
        of
        a dispute with a licensee over a breach of the licensing agreement which
        was
        included in other income in fiscal 2005.
 
 The
        effective tax rate for the Company was 25.1% in fiscal 2005 compared to 30.5%
        in
        fiscal 2004. Due to permanent differences arising from extra-territorial
        income
        exclusions, research and development tax credits and other permanent
        differences, the effective tax rates varies from the 34% federal statutory
        tax
        rate.
  22
 *Table
            of Contents*
  Net
        earnings from continuing operations for fiscal 2005 were $2.7 million, or
        $0.52
        per diluted share, compared to $3.7 million, or $0.71 per diluted share,
        for
        fiscal 2004. The principal reasons for the reduced net earnings for fiscal
        2005
        compared to fiscal 2004 were lower operating margins related to product mix
        as
        described above.
 
 In
        fiscal
        2006, the Company will begin to account for stock based compensation in
        accordance with SFAS No. 123R (see “Future Accounting Changes”). Although the
        effects of adopting this standard have not been fully quantified, the Company
        estimates that it will increase expenses in fiscal 2006 in the range of $300,000
        to $400,000 before income taxes for incentive stock options. In addition,
        the
        Company will expense a full year of its restricted stock compensation, which
        expense is estimated to be approximately $0.7 million to $0.8 million before
        income taxes, based on the price of our common stock as of September 30,
        2005.
 
 *Fiscal
        2004 compared to Fiscal 2003*
 
 Net
        sales
        decreased 2% to $80.6 million in fiscal 2004, down $2.0 million from $82.6
        million in fiscal 2003. Sales declined 5% in the Company’s automated inspection
        systems product line, primarily in the tobacco sorter product line. Contributors
        to the decline were local competition in China and a strategy change by one
        of
        our customers to push product inspection down to its local suppliers. Partially
        offsetting the decline in tobacco sorters was increased sales in the combined
        Optyx/Prism lines. Net sales in the Company’s process systems product line
        declined 13% in fiscal 2004 with reductions appearing in its vibratory lines
        both in the US and in Europe. Sales of parts and service grew 17% on a
        year-over-year basis due to increased demand for upgrades and a growth in
        parts
        sales. Service sales also showed an improvement year-over-year of
        11%.
 
 Gross
        profit decreased $0.3 million to $33.7 million in fiscal 2004 from $34.0
        million
        in 2003. Gross profit as a percent of sales, however, improved from 41% in
        2003
        to 42% in 2004. The dollar decrease is attributable to the volume drop in
        process systems which also had a slight decrease in gross profit as a percent
        of
        sales. The Company’s automated inspection systems, while reflecting an overall
        volume drop from fiscal 2003, delivered improved gross profit margin
        percentages, particularly in the Tegra and Optyx product lines. Tobacco sorters,
        though lower in sales volume, also delivered higher gross profit margins.
        Partially offsetting the volume drop in process systems and automated inspection
        systems, aftermarket parts and service sales showed volume improvement with
        resulting gross profit contribution. Also affecting gross profit for fiscal
        2004
        was a price increase in stainless steel, which is used in many of the Company’s
        product lines. Although protected somewhat by supply contracts, the higher
        stainless steel prices resulted in higher component costs and reduced margins
        on
        certain product lines by approximately $0.2 million.
 
 Operating
        expenses increased $3.1 million to $28.3 million in fiscal 2004 from $25.2
        million in fiscal 2003, and represented 35% and 31% of net sales in each
        year,
        respectively. The principal components of operating expenses are sales and
        marketing expense, research and development expense and general and
        administrative expense.
 
 As
        part
        of a strategy to grow revenues and expand into new market segments, the Company
        has increased its investment in marketing and product management, spending
        $13.5
        million in fiscal 2004 compared to $11.7 in fiscal 2003. Commission expense
        also
        increased $0.7 million year-over-year as a result of a higher volume of
        equipment sold through independent sales representatives as opposed to the
        Company’s direct sales force.
 
 Research
        and development spending for the year increased by $0.9 million to $5.8 million
        in fiscal 2004 from $4.9 million in fiscal 2003. The Company continues to
        invest
        in research and development, introducing several new products during the
        fiscal
        year. New products introduced during the year were the KPI (Key Package
        Inspector) for the tobacco industry, the ADR4c for the french fry industry,
        a
        multi-split product handling system for the fruit industry, a new mechanical
        size grading approach in vegetable processing, and the G6 vision engine that
        has
        much greater computer processing capacity and speed than prior generation
        engines.
 
 General
        and Administrative expenses for fiscal 2004 were negatively affected by $0.4
        million invested in implementation of Section 404 of the Sarbanes-Oxley Act.
        Although the work is largely completed for the documentation phase, the Company
        expects to incur continued expenses as it enters into the testing and
        maintenance phase of the program. Also affecting the year was a reduction
        to the
        Company’s work force that occurred in late September resulting in a charge of
        approximately $0.2 million.
  23
 *Table
            of Contents*
  Other
        income and expense includes interest income and expense, income or expense
        from
        the Company’s InspX joint venture, royalty income and other income or expense
        from miscellaneous sources. Total other income and expense reflected $0.1
        million expense in fiscal 2004 compared to $0.3 million expense in fiscal
        2003.
        Interest income increased to $114,000 in fiscal 2004 compared to $59,000
        in the
        prior year due to the Company’s short term investment of excess cash throughout
        the year. Interest expense for the period dropped by $195,000 reflecting
        lower
        interest bearing debt levels and an interest rate reduction.
 
 In
        July
        2004, the Company entered into an agreement with Peco Controls Corporation
        to
        form InspX LLC, a 50/50 joint venture. The financial results of the joint
        venture resulted in a $170,000 charge to other expense for fiscal 2004 including
        $59,000 for amortization of patents.
 
 The
        Company’s effective income tax rate was 30.5% in fiscal 2004, compared to 31.9%
        in fiscal 2003. The effective tax rate varies from the statutory rate of
        34% due
        to permanent differences arising from extra-territorial income exclusions,
        research and development tax credits, and other permanent differences, plus
        the
        inclusion of the effective state income tax rate.
 
 Net
        earnings for fiscal 2004 was $3.7 million, or $0.71 per diluted share, compared
        to $5.8 million, or $1.15 per diluted share, for fiscal 2003. The principal
        reasons for the reduced net earnings of fiscal 2004 compared to fiscal 2003
        were
        lower business volume and increased operating expenses as described
        above.
 
 **Liquidity
        and Capital Resources**
 
 *Fiscal
        2005*
 
 Net
        cash
        provided by operating activities during fiscal 2005 was $7.6 million. Net
        income
        generated $2.7 million and non-cash expenses for depreciation and amortization
        provided $1.8 million and $1.3 million respectively. Higher business levels
        at
        the end of 2005 versus 2004 resulted in increased accruals and liabilities
        reflective of the increased business activity. These increases included higher
        accounts payable, $0.6 million; accrued customer support and warranty, $0.5
        million; and other accrued liabilities, $1.2 million. The higher level of
        business activity at the end of 2005 is also reflected in the higher amounts
        of
        trade accounts receivable, which increased $1.1 million over the prior year-end.
        Inventories were higher by $1.0 million, which primarily reflects the tobacco
        sorter which had been produced but not shipped to a customer in China prior
        to
        year-end.
 
 Cash
        used
        in investing activities was $2.0 million during fiscal 2005. The acquisition
        of
        Freshline Machines Pty. Ltd. used $1.1 million in cash and the purchase of
        machinery and equipment used $1.0 million. The Company acquired $1.8 million
        in
        assets related to the Freshline purchase and assumed $0.8 million in
        liabilities.
 
 Cash
        used
        in financing activities totaled $1.1 million in fiscal 2005. Cash used for
        the
        redemption of Series B Preferred Stock and the redemption of warrants was
        $1.3
        million and $0.2 million, respectively. The Company also made debt payments
        which reduced the Company’s long-term debt by $1.2 million. These applications
        of cash were partially offset by the receipt of $1.5 million due to the issuance
        of common stock pursuant to the exercise of stock options.
 
 Accounts
        receivable increased $1.5 million in fiscal 2005 to $10.8 million from $9.3
        million in fiscal 2004. Receivables older than 60 days and those with extended
        terms grew by $1.4 million. This increase in older receivables reflects the
        increase in international shipments during 2005. Because of longer shipment
        times and special banking requirements associated with foreign shipments,
        collection of those accounts takes longer and extended payment terms are
        often
        granted for those shipments.
 
 Inventories **** increased
        by $1.2 million, or 9%, totaling $14.8 million and $13.6 million at the end
        of
        fiscal 2005 and fiscal 2004, respectively. The increases were primarily in
        work-in-process and finished goods. The increase in work-in-process reflects
        the
        higher level of production activity at the end of 2005 versus 2004 due to
        the
        higher level of orders in the fourth quarter of 2005 versus the prior year.
        The
        increase in finished goods was related to a tobacco sorter order for a Chinese
        customer. The Company normally carries a relatively small amount of finished
        goods inventory. The increases in work-in-process and finished goods were
        partially offset by a reduction in raw materials and parts. With
        the
  24
 *Table
            of Contents*
  consolidation
        of the two manufacturing facilities in Walla Walla in fiscal 2006, the Company
        plans to continue to reduce its amount of on-hand materials.
 
 Long
        term
        debt decreased during 2005 as the Company made its scheduled term loan payments.
        The outstanding loan balance declined to $2.3 million at year-end 2005 from
        $3.5
        million at year-end 2004. Borrowings at September 30, 2005 consisted of a
        term
        loan with a balance of $1.6 million, notes payable totaling $0.5 million
        and
        capital leases totaling $0.2 million.
 
 The
        Company’s domestic credit facility provides a credit accommodation totaling
        $11.6 million in the United States consisting of a term loan of
        $1.6 million and a revolving credit facility of up to $10.0 million.
        The revolving credit facility matures in April 2006. The term loan requires
        quarterly payments of principal of $200,000 and matures on July 31, 2007.
        The term loan bears interest at The Wall Street Journal prime rate, which
        was
        6.75% at September 30, 2005. The revolving credit facility bears interest,
        at
        the Company’s option, of either The Wall Street Journal prime rate less 1.5% or
        a LIBOR-based rate. The rate was 5.25% at September 30, 2005. The credit
        facility is secured by all of the Company’s U.S. personal property, including
        patents and other intangibles of the Company and its subsidiaries, and contains
        covenants that require the maintenance of a defined debt ratio, a fixed charge
        coverage ratio, and minimum profitability. The credit facility also restricts
        the payment of dividends. At September 30, 2005, the Company was in compliance
        with all loan covenants. At September 30, 2005, borrowings under the term
        loan
        were $1.6 million and there were no borrowings outstanding under the
        revolving credit facility. Subsequent to year-end, the term loan was paid
        in
        full from available cash. At September 30, 2004, borrowings under the term
        loan
        were $2.4 million. There were no borrowings outstanding under the revolving
        credit facility at September 30, 2004.
 
 Additionally,
        the Company’s credit accommodation with a commercial bank in The Netherlands
        provides a credit facility for its European subsidiary. This credit
        accommodation totals $3.6 million and includes term loans of $545,000, an
        operating line of the lesser of $1.8 million or the available borrowing
        base, which is based on varying percentages of eligible accounts receivable
        and
        inventories, and a bank guarantee facility of $1.2 million. The term loans
        require quarterly principal payments of $37,000 and mature in October 2006
        and
        August 2012. The term loans are secured by real property of the Company’s
        European subsidiary, while the operating line and bank guarantee facility
        are
        secured by all of the subsidiary’s personal property. The credit facility bears
        interest at the bank’s prime rate, with a minimum of 3.00%, plus 1.75%. At
        September 30, 2005, the interest rate was 4.75%. Interest rates on the term
        loans are subject to annual renegotiation. At September 30, 2005, the Company
        had borrowings under this facility of approximately $545,000 in term loans,
        and
        had received bank guarantees of $831,000 under this agreement.
 
 The
        Company anticipates that the ongoing cash flows from operations and borrowing
        capacity under currently available operating credit lines will be sufficient
        to
        fund the Company’s operating needs for at least the next twelve months. Cash
        provided by operating activities was $7.6 million, $5.1 million and $14.5
        million in the last three years, respectively. This operating cash flow has
        allowed the Company to fund capital asset purchases, significantly reduce
        the
        long-term debt outstanding and redeem the preferred stock and associated
        warrants. The Company anticipates that its cash needs will continued to be
        met
        from cash from operations as it embarks on its initiatives to grow the
        pharmaceutical and aftermarket businesses and expand its China operation.
        The
        Company had no material commitments for capital expenditures at September
        30,
        2005.
 
 *Prior
        Years - Fiscal 2004 and 2003*
 
 During
        fiscal 2004, net cash provided by operating activities totaled $5.1 million.
        Cash flow from operating activities was derived from net earnings before
        non-cash expenses, such as depreciation and amortization, of $7.8 million.
        These
        cash flows were offset by increases in non-cash working capital of $2.7 million.
        These increases were primarily due to a reduction of $2.3 million in customer
        deposits caused by a reduced customer order backlog at September 30, 2004
        versus
        September 30, 2003. Working capital also increased as a result of a reduction
        of
        $0.8 million in accrued payroll liabilities primarily from the payment of
        profit
        sharing and other employee incentive plans which were accrued as of the end
        of
        fiscal 2003 and paid in fiscal 2004. These increases in working capital were
        partially offset by reductions of inventory of $0.6 million due primarily
        to
        inventory management activity that reflected the reduced backlog at September
        30, 2004 compared to the prior year end.
  25
 *Table
            of Contents*
  Cash
        flow
        from operating activities in fiscal 2004 was $9.4 million lower than in fiscal
        2003. The reduction in cash flow from operations was largely the result of
        a
        $3.2 million reduction in earnings from continuing operations before tax
        combined with a $1.0 million increase in cash paid for taxes, as the Company
        was
        able to utilize fewer NOL carryforwards in fiscal 2004. While non-cash working
        capital changes provided $3.0 million of cash in fiscal 2003, non-cash working
        capital changes required cash of $2.7 million in fiscal 2004, a $5.7 million
        net
        change. This change was largely driven by changes in customer deposits, which
        totaled $2.5 million at September 30, 2004 compared to $4.8 million at September
        30, 2003 and changes in accrued payroll, as discussed above. These changes
        in
        working capital were offset by the timing of collections, as accounts receivable
        decreased only $0.1 million while sales in the fourth quarter of fiscal 2004
        decreased $2.4 million.
 
 Net
        cash
        resources used in investing activities totaled $3.1 million in fiscal 2004.
        In
        July 2004, the Company invested $2.1 million in the InspX joint venture.
        The
        Company’s acquisition of capital equipment was $1.2 million with offsetting cash
        from the sale of capital equipment of $0.2 million.
 
 Cash
        flows provided by financing activities in fiscal 2004 netted to $0.3 million
        and
        reflect payments for long-term debt reduction of $1.1 million and the redemption
        of preferred stock and warrants of $0.2 million. Proceeds from the issuance
        of
        common stock under the Company’s employee stock option and stock purchase plans
        during fiscal 2004 were $1.5 million.
 
 *Contractual
        Obligations*
 
 The
        Company’s continuing contractual obligations and commercial commitments existing
        on September 30, 2005 are as follows:
 
 Payments
                  due by period (in thousands)Contractual
                  Obligations
              
              Total
              
              Less
                  than 1 year
              
              1
                  -
                  3 years
              
              4
                  -
                  5 years
              
              After
                  5 yearsLong-term
                  debt *
              
              $
              2,145
              
              $
              947
              
              $
              942
              
              $
              121
              
              $
              135Capital
                  lease obligations
              
              
              175
              
              
              174
              
              
              1
              
              
              -
              
              
              -Operating
                  leases
              
              
              14,637
              
              
              1,455
              
              
              2,348
              
              
              1,696
              
              
              9,138Total
                  contractual cash obligations
              
              $
              16,957
              
              $
              2,576
              
              $
              3,291
              
              $
              1,817
              
              $
              9,273
 
 *
              Includes
                  the revolving credit line, term loan and mortgage payments on the
                  Company’s owned facility in Europe. Subsequent to September 30, 2005, the
                  term loan of $1.6 million was paid in full from available
                  cash.
 
 At
        September 30, 2005, the Company had standby letters of credit totaling $1.4
        million, which includes secured bank guarantees under the Company’s credit
        facility in Europe and letters of credit securing certain self-insurance
        contracts and lease commitments. If the Company fails to meet its contractual
        obligations, these bank guarantees and letters of credit may become liabilities
        of the Company. The Company has no off-balance sheet arrangements or
        transactions, arrangements or relationships with “special purpose
        entities.”
 
 **Future
        Accounting Changes**
  In
        December 2004, the FASB issued SFAS No. 123 (revised 2004), *Share-Based
        Payment* (“SFAS
        No. 123R”), which was effective for the Company on October 1, 2005. This
        Statement requires the Company to measure and expense the cost of employee
        services received in exchange for an award of equity instruments based on
        the
        grant date fair value of the award and amends the disclosure requirements
        related to awards of equity instruments. On October 1, 2005, the Company
        began
        expensing the cost of equity instruments awarded as part of the Restated
        Employees’ Stock Incentive Plan and Employee Stock Purchase Plan over the
        requisite service period related to such awards. The Company has elected
        to
        implement this new standard under the modified prospective application. Under
        the modified prospective application, the Company will expense the cost of
        new
        or modified awards over the requisite service period and the cost of previously
        granted unvested awards for the requisite service period remaining after
        October
        1, 2005.
  26
 *Table
            of Contents*
  The
        adoption of SFAS No. 123R is expected to have a significant effect on the
        consolidated financial statements of the Company. See the pro forma impact
        on
        net earnings and earnings per share from calculating stock-related compensation
        costs under the fair value alternative of SFAS No. 123 in Note 1 of Notes
        to the
        Consolidated Financial Statements. The pro forma computation in Note 1 provides
        the possible effect under SFAS No. 123R and SAB 107, which may be different
        from
        the calculation of compensation cost under SFAS No. 123. In addition, full
        year
        effects of share-based payments issued late in fiscal 2005 are not fully
        reflected in these calculations. Such potential differences have not yet
        been
        fully quantified. Also, past usage of option plans and stock purchase plans
        may
        not reflect our practices in future periods.
 
 In
        November 2004, the FASB issued SFAS No. 151, *Inventory
        Costs, an amendment of ARB No. 43, Chapter 4* ,
        to
        clarify the accounting for abnormal amounts of idle facility expense, freight,
        handling costs and wasted material (spoilage). This statement was effective
        October 1, 2005. The Company does not believe SFAS No. 151 will have a material
        effect on its financial position or results of operations.
 
 
 **ITEM
                  7A.**
              **QUANTITATIVE
                  AND QUALITATIVE DISCLOSURES ABOUT MARKET
                  RISK.**
 
 The
        Company has assessed its exposure to market risks for its financial instruments
        and has determined that its exposures to such risks are generally limited
        to
        those affected by the value of the U.S. Dollar compared to the Euro and to
        a
        lesser extent the Australian dollar.
 
 The
        terms
        of sales to European customers are typically denominated in either Euros
        or U.S.
        Dollars. The terms of sales to customers in Australia are typically denominated
        in their local currency. The Company expects that its standard terms of sale
        to
        international customers, other than those in Europe and Australia, will continue
        to be denominated in U.S. dollars. For sales transactions between international
        customers, including European customers, and the Company’s domestic operations,
        which are denominated in currencies other than U.S. dollars, the Company
        assesses its currency exchange risk and may enter into forward contracts
        to
        minimize such risk. At September 30, 2005, the Company was not a party to
        any
        currency hedging transaction. As of September 30, 2005, management estimates
        that a 10% change in foreign exchange rates would affect net earnings before
        taxes by approximately $39,000 on an annual basis as a result of converted
        cash,
        accounts receivable and sales or other contracts denominated in foreign
        currencies.
 
 During
        the Company’s fiscal 2005, the Euro lost a net of 3% in value, ranging between a
        3% loss and an 8% gain for the period, against the U.S. dollar. The effect
        of
        these fluctuations on the operations and financial results of the Company
        were:
 
 ·
              Translation
                  adjustments of ($15,000), net of income tax, were recognized as
                  a
                  component of comprehensive income as a result of converting the
                  Euro
                  denominated balance sheet of Key Technology B.V. into U.S. dollars,
                  and to
                  a lesser extent, the Australian dollar balance sheets of Key Technology
                  Australia Pty. Ltd. and Freshline Machines Pty. Ltd., and the Peso
                  balance
                  sheet of Productos Key Mexicana.
 
 ·
              Foreign
                  exchange losses of $165,000 were recognized in the other income
                  and
                  expense section of the consolidated statement of operations as
                  a result of
                  conversion of Euro and other foreign currency denominated receivables
                  and
                  cash carried on the balance sheet of the U.S. operations, as well
                  as the
                  result of the conversion of other non-functional currency receivables,
                  payables and cash carried on the balance sheets of the European,
                  Australian and Mexican operations.
 
 A
        relatively weaker U.S. dollar on the world markets makes the Company’s
        U.S.-manufactured goods relatively less expensive to international customers
        when denominated in U.S. dollars or potentially more profitable to the Company
        when denominated in a foreign currency. On the other hand, material or
        components imported to the U.S. may be more expensive. A relatively weaker
        U.S.
        dollar on the world markets, especially as measured against the Euro, may
        favorably affect the Company’s market and economic outlook for international
        sales. The Company’s Netherlands-based subsidiary transacts business primarily
        in Euros and does not have significant exports to the U.S.
  27
 *Table
            of Contents*
  Under
        the
        Company’s current credit facilities, the Company may borrow at the lender’s
        prime rate between minus 150 and plus 175 basis points. At September 30,
        2005,
        the Company had $1.6 million of borrowings which had variable interest rates.
        During the year then ended, interest on its various variable rate credit
        facilities varied from 4.25% and 6.75%. At September 30, 2005, the rate was
        6.75% on its term loan, 5.25% on its domestic credit facility and 4.75% on
        its
        European credit facility. As of September 30, 2005, management estimates
        that a
        100 basis point change in these interest rates would affect net income before
        taxes by approximately $16,000 on an annual basis.
  28
 *Table
            of Contents*
  **ITEM
                  8.**
              **FINANCIAL
                  STATEMENTS AND SUPPLEMENTARY
                  DATA.**
 
 Title
              **Page**Report
                  of Independent Registered Public Accounting Firm
              30Report
                  of Independent Registered Public Accounting Firm
              31Consolidated
                  Balance Sheets at September 30, 2005 and 2004
              32Consolidated
                  Statements of Operations for the three years ended September 30,
                  2005
              34Consolidated
                  Statements of Shareholders' Equity for the three years ended September
                  30,
                  2005
              35Consolidated
                  Statements of Cash Flows for the three years ended September 30,
                  2005
              36Notes
                  to Consolidated Financial Statements
              38Supplementary
                  Data
              54
 29
 *Table
              of Contents*
  Report
        of Independent Registered Public Accounting Firm
 
 
 
 
 Board
        of
        Directors and Shareholders of
 Key
        Technology, Inc.
  We
        have
        audited the accompanying consolidated balance sheet of Key Technology, Inc.
        as
        of September 30, 2005, and the related consolidated statements of operations,
        shareholders’ equity, and cash flows for the year then ended. These financial
        statements are the responsibility of the Company’s management. Our
        responsibility is to express an opinion on these financial statements based
        on
        our audit.
 
 We
        conducted our audit in accordance with the standards of the Public Company
        Accounting Oversight Board (United States). Those standards require that
        we plan
        and perform the audit to obtain reasonable assurance about whether the financial
        statements are free of material misstatement. The Company is not required
        to
        have, nor were we engaged to perform, an audit of its internal control over
        financial reporting. Our audit included consideration of internal control
        over
        financial reporting as a basis for designing audit procedures that are
        appropriate in the circumstances, but not for the purpose of expressing an
        opinion on the effectiveness of the Company’s internal control over financial
        reporting. Accordingly, we express no such opinion. An audit also includes
        examining, on a test basis, evidence supporting the amounts and disclosures
        in
        the financial statements, assessing the accounting principles used and
        significant estimates made by management, as well as evaluating the overall
        financial statement presentation. We believe that our audit provides a
        reasonable basis for our opinion.
 
 In
        our
        opinion, the financial statements referred to above present fairly, in all
        material respects, the financial position of Key Technology, Inc. as of
        September 30, 2005, and the results of its operations and its cash flows
        for the
        year then ended, in conformity with accounting principles generally accepted
        in
        the United States of America.
  /s/
        GRANT
        THORNTON LLP
 
 Seattle,
        Washington
 November
        30, 2005
  30
 *Table
            of Contents*
  REPORT
        OF
        INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 Board
        of
        Directors and Shareholders
 Key
        Technology, Inc.
 Walla
        Walla, Washington
 
 We
        have
        audited the accompanying consolidated balance sheet of Key Technology, Inc
        and
        subsidiaries as of September 30, 2004, and the related consolidated statements
        of operations, shareholders’ equity, and cash flows for each of the two years in
        the period ended September 30, 2004. The consolidated financial statements
        are
        the responsibility of the Company’s management. Our responsibility is to express
        an opinion on these consolidated financial statements based on our audits.
 
 We
        conducted our audits in accordance with the standards of the Public Company
        Accounting Oversight Board (United States of America). Those standards require
        that we plan and perform the audit to obtain reasonable assurance about whether
        the financial statements are free of material misstatement. The Company is
        not
        required to have, nor were we engaged to perform, an audit of its internal
        control over financial reporting. Our audit included consideration of internal
        control over financial reporting as a basis for designing audit procedures
        that
        are appropriate in the circumstances, but not for the purpose of expressing
        an
        opinion on the effectiveness of the Company’s internal control over financial
        reporting. Accordingly, we express no such opinion. An audit also includes
        examining, on a test basis, evidence supporting the amounts and disclosures
        in
        the financial statements, assessing the accounting principles used and
        significant estimates made by management, as well as evaluating the overall
        financial statement presentation. We believe that our 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 Key Technology, Inc. and subsidiaries
        as of
        September 30, 2004 and the results of their operations and their cash flows
        for
        each of the two years in the period ended September 30, 2004, in conformity
        with
        accounting principles generally accepted in the United States of America.
 
 /s/
        DELOITTE & TOUCHE LLP
 
 Portland,
        Oregon
 December
        16, 2004
  31
 *Table
            of Contents*
  **KEY
                  TECHNOLOGY, INC. AND SUBSIDIARIES****CONSOLIDATED
                  BALANCE SHEETS****SEPTEMBER
                  30, 2005 AND 2004**(In
                  thousands)**2005**
              
              **2004****ASSETS**CURRENT
                  ASSETS:Cash
                  and cash equivalents
              
              $
              13,181
              
              $
              8,817Trade
                  accounts receivable, net
              
              
              10,828
              
              
              9,336Inventories
              
              
              14,860
              
              
              13,633Deferred
                  income taxes
              
              
              2,382
              
              
              2,119Prepaid
                  expenses and other assets
              
              
              1,490
              
              
              1,097Total
                  current assets
              
              
              42,741
              
              
              35,002PROPERTY,
                  PLANT, AND EQUIPMENT, Net
              
              
              4,264
              
              
              5,046DEFERRED
                  INCOME TAXES
              
              
              10
              
              
              6OTHER
                  ASSETS
              
              
              525
              
              
              630INVESTMENT
                  IN JOINT VENTURE
              
              
              1,254
              
              
              1,914INTANGIBLES,
                  Net
              
              
              6,209
              
              
              7,392GOODWILL,
                  Net
              
              
              2,524
              
              
              2,524TOTAL
              
              $
              57,527
              
              $
              52,514
 
 See
                  notes to consolidated financial statements.
              (Continued)
 32
 *Table
              of Contents*
  **KEY
                  TECHNOLOGY, INC. AND SUBSIDIARIES****CONSOLIDATED
                  BALANCE SHEETS****SEPTEMBER
                  30, 2005 AND 2004**(In
                  thousands, except shares)**2005**
              
              **2004****LIABILITIES
                  AND SHAREHOLDERS’ EQUITY**CURRENT
                  LIABILITIES:Accounts
                  payable
              
              $
              2,280
              
              $
              1,599Accrued
                  payroll liabilities and commissions
              
              
              3,957
              
              
              3,781Accrued
                  customer support and warranty costs
              
              
              1,775
              
              
              1,283Income
                  tax payable
              
              
              5
              
              
              19Customer
                  purchase plans
              
              
              1,316
              
              
              289Other
                  accrued liabilities
              
              
              1,762
              
              
              1,699Customers’
                  deposits
              
              
              3,015
              
              
              2,536Current
                  portion of long-term debt
              
              
              1,121
              
              
              1,210Current
                  portion of mandatorily redeemable preferred stock
              
              
              -
              
              
              1,279Current
                  portion of warrants
              
              
              -
              
              
              316Total
                  current liabilities
              
              
              15,231
              
              
              14,011LONG-TERM
                  DEBT
              
              
              1,199
              
              
              2,323DEFERRED
                  INCOME TAXES
              
              
              626
              
              
              136COMMITMENTS
                  AND CONTINGENCIES
              
              
              -
              
              
              -SHAREHOLDERS’
                  EQUITY:Preferred
                  stock—no par value; 5,000,000 shares authorized;none issued and outstanding
              
              
              -
              
              
              -Common
                  stock—no par value; 15,000,000 shares authorized; 5,347,784
                  and4,982,500 issued and outstanding at September 30, 2005 and 2004,
                  respectively
              
              
              15,301
              
              
              11,493Deferred
                  stock-based compensation
              
              
              (2,057
              )
              
              -Retained
                  earnings
              
              
              27,104
              
              
              24,413Accumulated
                  other comprehensive income
              
              
              123
              
              
              138Total
                  shareholders’ equity
              
              
              40,471
              
              
              36,044TOTAL
              
              $
              57,527
              
              $
              52,514
 
 See
                  notes to consolidated financial statements.
              (Concluded)
 33
 *Table
              of Contents*
 
 **KEY
                  TECHNOLOGY, INC. AND SUBSIDIARIES****CONSOLIDATED
                  STATEMENTS OF OPERATIONS****THREE
                  YEARS ENDED SEPTEMBER 30, 2005**(In
                  thousands, except per share data)**2005**
              
              **2004**
              
              **2003**NET
                  SALES
              
              $
              80,322
              
              $
              80,610
              
              $
              82,622COST
                  OF SALES
              
              
              49,015
              
              
              46,887
              
              
              48,626Gross
                  profit
              
              
              31,307
              
              
              33,723
              
              
              33,996OPERATING
                  EXPENSES:Selling
              
              
              13,071
              
              
              13,514
              
              
              11,695Research
                  and development
              
              
              5,134
              
              
              5,756
              
              
              4,874General
                  and administrative
              
              
              8,087
              
              
              7,702
              
              
              7,329Amortization
                  of intangibles
              
              
              1,333
              
              
              1,323
              
              
              1,323Total
                  operating expenses
              
              
              27,625
              
              
              28,295
              
              
              25,221GAIN
                  ON SALE OF ASSETS
              
              
              28
              
              
              5
              
              
              4INCOME
                  FROM OPERATIONS
              
              
              3,710
              
              
              5,433
              
              
              8,779OTHER
                  INCOME (EXPENSE):Royalty
                  income
              
              
              -
              
              
              6
              
              
              18Interest
                  income
              
              
              229
              
              
              114
              
              
              59Interest
                  expense
              
              
              (179
              )
              
              (204
              )
              
              (399
              )Equity
                  in earnings (loss) of joint venture
              
              
              (659
              )
              
              (170
              )
              
              -Other,
                  net
              
              
              492
              
              
              122
              
              
              (5
              )Total
                  other income (expense)—net
              
              
              (117
              )
              
              (132
              )
              
              (327
              )Earnings
                  before income taxes
              
              
              3,593
              
              
              5,301
              
              
              8,452Income
                  tax expense
              
              
              902
              
              
              1,617
              
              
              2,693Net
                  earnings
              
              
              2,691
              
              
              3,684
              
              
              5,759Assumed
                  dividends on mandatorily redeemable preferred stock
              
              
              (33
              )
              
              (69
              )
              
              (132
              )Net
                  earnings available to common shareholders
              
              $
              2,658
              
              $
              3,615
              
              $
              5,627EARNINGS
                  PER SHARE—Basic
              
              $
              0.53
              
              $
              0.74
              
              $
              1.18EARNINGS
                  PER SHARE—Diluted
              
              $
              0.52
              
              $
              0.71
              
              $
              1.15SHARES
                  USED IN PER SHARE CALCULATION—Basic
              
              
              5,041
              
              
              4,909
              
              
              4,774SHARES
                  USED IN PER SHARE CALCULATION—Diluted
              
              
              5,219
              
              
              5,222
              
              
              4,989
 
 See
        notes
        to consolidated financial statements.
  34
 *Table
            of Contents*
  **KEY
                  TECHNOLOGY, INC. AND SUBSIDIARIES****CONSOLIDATED
                  STATEMENTS OF SHAREHOLDERS' EQUITY****THREE
                  YEARS ENDED SEPTEMBER 30, 2005**(Dollars
                  in thousands)**Common
                  Stock****Shares**
              
              **Amount**
              
              **Deferred
                  Stock- Based Compensation**
              
              **Retained
                  Earnings**
              
              **Accumulated
                  Other Comprehensive Income (Loss)**
              
              **Total**Balance
                  at September 30, 2002
              
              
              4,767,206
              
              $
              9,456
              
              $
              0
              
              $
              14,970
              
              $
              (824
              )
              $
              23,602Components
                  of comprehensive income:Net
                  earnings
              
              
              
              
              
              
              
              
              
              
              
              5,759
              
              
              
              
              
              5,759Comprehensive
                  income—foreign currency translation adjustment, net of tax of
                  $385
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              746
              
              
              746Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              6,505Issuance
                  of common stock upon exercise of stock options
              
              
              11,837
              
              
              67
              
              
              
              
              
              
              
              
              
              
              
              67Issuance
                  of stock for Employee Stock Purchase Plan
              
              
              6,918
              
              
              45
              
              
              0
              
              
              
              
              
              
              
              
              45Balance
                  at September 30, 2003
              
              
              4,785,961
              
              
              9,568
              
              
              0
              
              
              20,729
              
              
              (78
              )
              
              30,219Components
                  of comprehensive income:Net
                  earnings
              
              
              
              
              
              
              
              
              
              
              
              3,684
              
              
              
              
              
              3,684Comprehensive
                  income—foreign currency translation adjustment, net of tax of
                  $111
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              216
              
              
              216Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              3,900Tax
                  benefits from share-based payments
              
              300
              
              
              
              
              
              
              
              
              
              
              
              300Shares
                  converted from mandatorily redeemable preferred stock
              
              
              6,524
              
              
              98
              
              
              
              
              
              
              
              
              
              
              
              98Issuance
                  of common stock upon exercise of stock options
              
              
              186,218
              
              
              1,483
              
              
              
              
              
              
              
              
              
              
              
              1,483Issuance
                  of stock for Employee Stock Purchase Plan
              
              
              3,797
              
              
              44
              
              
              
              
              
              
              
              
              
              
              
              44Balance
                  at September 30, 2004
              
              
              4,982,500
              
              
              11,493
              
              
              0
              
              
              24,413
              
              
              138
              
              
              36,044Components
                  of comprehensive income:Net
                  earnings
              
              
              
              
              
              
              
              
              
              
              
              2,691
              
              
              
              
              
              2,691Comprehensive
                  income—foreign currency translation adjustment, net of tax of
                  $8
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (15
              )
              
              (15
              )Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              2,676Tax
                  benefits from share-based payments
              
              30
              
              
              
              
              
              
              
              
              
              
              
              30Shares
                  converted from mandatorily redeemable preferred stock
              
              
              52Shares
                  converted from warrants
              
              
              230
              
              
              6
              
              
              
              
              
              
              
              
              
              
              
              6Reclass
                  expired warrants to equity
              
              
              
              
              
              127
              
              
              
              
              
              
              
              
              
              
              
              127Issuance
                  of common stock upon exercise of stock options
              
              
              191,858
              
              
              1,481
              
              
              
              
              
              
              
              
              
              
              
              1,481Issuance
                  of stock for Employee Stock Purchase Plan
              
              
              3,644
              
              
              34
              
              
              
              
              
              
              
              
              
              
              
              34Stock
                  grants - employment-based
              
              
              54,500
              
              
              751
              
              
              (751
              )
              
              
              
              
              
              
              
              -Stock
                  grants - performance-based
              
              
              115,000
              
              
              1,379
              
              
              (1,379
              )
              
              
              
              
              
              
              
              -Amortization
                  of deferred stock-based compensation
              
              
              
              
              
              
              
              
              73
              
              
              
              
              
              
              
              
              73Balance
                  at September 30, 2005
              
              
              5,347,784
              
              $
              15,301
              
              $
              (2,057
              )
              $
              27,104
              
              $
              123
              
              $
              40,471
 
 See
        notes
        to consolidated financial statements.
  35
 *Table
            of Contents*
  **KEY
                  TECHNOLOGY, INC. AND SUBSIDIARIES****CONSOLIDATED
                  STATEMENTS OF CASH FLOWS****THREE
                  YEARS ENDED SEPTEMBER 30, 2005**(In
                  thousands)**2005**
              
              **2004**
              
              **2003**CASH
                  FLOWS FROM OPERATING ACTIVITIES:Net
                  earnings
              
              $
              2,691
              
              $
              3,684
              
              $
              5,759Adjustments
                  to reconcile net earnings to net cashprovided by operating activities:Equity
                  in (earnings) loss of joint venture
              
              
              659
              
              
              170
              
              
              -Gain
                  on sale of assets
              
              
              (28
              )
              
              (5
              )
              
              (4
              )Foreign
                  currency exchange (gain) loss
              
              
              165
              
              
              (33
              )
              
              (242
              )Depreciation
                  and amortization
              
              
              3,153
              
              
              3,176
              
              
              3,698Share
                  based payments
              
              
              73
              
              
              -
              
              
              -Tax
                  savings from share-based payments
              
              
              197
              
              
              133
              
              
              -Deferred
                  income taxes
              
              
              235
              
              
              566
              
              
              2,080Deferred
                  rent
              
              
              (79
              )
              
              (53
              )
              
              66Bad
                  debt expense
              
              
              (43
              )
              
              172
              
              
              162Changes
                  in assets and liabilities:Trade
                  accounts receivable
              
              
              (1,054
              )
              
              46
              
              
              (1,646
              )Inventories
              
              
              (980
              )
              
              636
              
              
              799Prepaid
                  expenses and other current assets
              
              
              613
              
              
              172
              
              
              365Income
                  taxes receivable
              
              
              (255
              )
              
              (199
              )
              
              76Accounts
                  payable
              
              
              563
              
              
              (21
              )
              
              27Accrued
                  payroll liabilities and commissions
              
              
              (96
              )
              
              (802
              )
              
              1,702Accrued
                  customer support and warranty costs
              
              
              495
              
              
              212
              
              
              35Income
                  taxes payable
              
              
              (116
              )
              
              (166
              )
              
              237Other
                  accrued liabilities
              
              
              1,151
              
              
              (383
              )
              
              317Customers’
                  deposits
              
              
              152
              
              
              (2,335
              )
              
              1,275Other
              
              
              83
              
              
              126
              
              
              (183
              )Cash
                  provided by operating activities
              
              
              7,579
              
              
              5,096
              
              
              14,523CASH
                  FLOWS FROM INVESTING ACTIVITIES:Investment
                  in joint venture
              
              
              -
              
              
              (2,084
              )
              
              -Proceeds
                  from sale of property
              
              
              28
              
              
              193
              
              
              12Purchases
                  of property, plant, and equipment
              
              
              (977
              )
              
              (1,175
              )
              
              (836
              )Acquisition
                  of Freshline Machines, Pty. Ltd., net of cash acquired
              
              
              (1,059
              )
              
              -
              
              
              -Cash
                  used in investing activities
              
              
              (2,008
              )
              
              (3,066
              )
              
              (824
              )
  See
                    notes to consolidated financial statements.
                (Continued)
 36
 *Table
                of Contents*
 **KEY
                  TECHNOLOGY, INC. AND SUBSIDIARIES****CONSOLIDATED
                  STATEMENTS OF CASH FLOWS****THREE
                  YEARS ENDED SEPTEMBER 30, 2005**(In
                  thousands)**2005**
              
              **2004**
              
              **2003**CASH
                  FLOWS FROM FINANCING ACTIVITIES:Repayments
                  of short-term borrowings
              
              $
              -
              
              $
              -
              
              $
              (6,650
              )Payments
                  on long-term debt
              
              
              (1,199
              )
              
              (1,073
              )
              
              (1,740
              )Proceeds
                  from issuance of long-term debt
              
              
              -
              
              
              -
              
              
              500Redemption
                  of warrants
              
              
              (185
              )
              
              (40
              )
              
              (296
              )Redemption
                  of mandatorily redeemable preferred stock
              
              
              (1,278
              )
              
              (150
              )
              
              (1,289
              )Proceeds
                  from issuance of common stock
              
              
              1,512
              
              
              1,527
              
              
              112Proceeds
                  from exercise of warrants
              
              
              6
              
              
              -
              
              
              -Cash
                  provided by (used in) financing activities
              
              
              (1,144
              )
              
              264
              
              
              (9,363
              )EFFECT
                  OF EXCHANGE RATE CHANGES ON CASH
              
              
              (63
              )
              
              81
              
              
              399NET
                  INCREASE IN CASH AND CASH EQUIVALENTS
              
              
              4,364
              
              
              2,375
              
              
              4,735CASH
                  AND CASH EQUIVALENTS, BEGINNING OF YEAR
              
              
              8,817
              
              
              6,442
              
              
              1,707CASH
                  AND CASH EQUIVALENTS, END OF YEAR
              
              $
              13,181
              
              $
              8,817
              
              $
              6,442SUPPLEMENTAL
                  DISCLOSURES OF CASH FLOWINFORMATION:Cash
                  paid during the year for interest
              
              $
              178
              
              $
              208
              
              $
              443Cash
                  paid during the year for income taxes
              
              
              850
              
              
              1,275
              
              
              306SUPPLEMENTAL
                  DISCLOSURE OF NONCASHINVESTING AND FINANCING ACTIVITIES:Equipment
                  obtained through capital leases
              
              $
              -
              
              $
              245
              
              $
              -
  See
                      notes to consolidated financial statements.
                  (Concluded)
 37
 *Table
                  of Contents*
 **KEY
        TECHNOLOGY, INC. AND SUBSIDIARIES**
  **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **THREE
        YEARS ENDED SEPTEMBER 30, 2005**
 
  **1.**
              **THE
                  COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING
                  POLICIES**
  Key
        Technology, Inc. and its wholly-owned subsidiaries (the “Company”) design,
        manufacture, and sell process automation systems, integrating electro-optical
        inspection and sorting, specialized conveying and product preparation equipment.
        The consolidated financial statements include the accounts of Key Technology,
        Inc. and its wholly-owned subsidiaries: Key Technology Holdings USA LLC;
        Key
        Technology AMVC LLC; Productos Key Mexicana S. de R. L. de C.V. and Key
        Technology Australia Pty. Ltd. Suplusco Holding B.V. is a wholly-owned European
        subsidiary of Key Technology Holdings USA LLC that includes the accounts
        of Key
        Technology B.V. Key Technology Australia Pty. Ltd. includes the accounts
        of
        Freshline Machines Pty. Ltd. All significant intercompany accounts and
        transactions have been eliminated. The financial statements also include
        the
        Company’s investment in InspX LLC, a 50% owned joint venture accounted for by
        the equity method.
  ***Revenue
        Recognition*** —The
        Company recognizes revenue when persuasive evidence of an arrangement exists,
        delivery has occurred or services have been provided, the sale price is fixed
        or
        determinable, and collectibility is reasonably assured. Additionally, the
        Company sells its goods on terms which transfer title and risk of loss at
        a
        specified location, typically shipping point, port of loading or port of
        discharge, depending on the final destination of the goods. Accordingly,
        revenue
        recognition from product sales occurs when all factors are met, including
        transfer of title and risk of loss, which occurs either upon shipment by
        the
        Company or upon receipt by customers at the location specified in the terms
        of
        sale. Revenue earned from services (maintenance, installation support, and
        repairs) is recognized ratably over the contractual period or as the services
        are performed. If any contract provides for both equipment and services
        (multiple deliverables), the sales price is allocated to the various elements
        based on objective evidence of fair value. Each element is then evaluated
        for
        revenue recognition based on the previously described criteria. The Company’s
        sales arrangements provide for no other, or insignificant, post shipment
        obligations. If all conditions of revenue recognition are not met, the Company
        defers revenue recognition. In the event of revenue deferral, the sale value
        is
        not recorded as revenue to the Company, accounts receivable are reduced by
        any
        amounts owed by the customer, and the cost of the goods or services deferred
        is
        carried in inventory. In addition, the Company periodically evaluates whether
        an
        allowance for sales returns is necessary. Historically, the Company has
        experienced little, if any, sales returns. If the Company believes there
        are
        potential sales returns, the Company would provide any necessary provision
        against sales. Upon receipt of an order, the Company generally receives a
        deposit which is recorded as customers’ deposits. The Company makes periodic
        evaluations of the creditworthiness of its customers and generally does not
        require collateral. An allowance for credit losses is provided based upon
        historical experience and anticipated losses.
  In
        accordance with the Financial Accounting Standard Board’s Emerging Issues Task
        Force Issue No. 01-9, *“Accounting
        for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s
        Product,”* the
        Company accounts for cash consideration (such as sales incentives) that the
        Company gives to customers or resellers as a reduction of revenue rather
        than as
        an operating expense unless the Company provided a benefit that the Company
        can
        identify and for which the Company can reasonably estimate the fair
        value.
  ***Cash
        and Cash Equivalents*** — The
        Company considers all highly liquid investments with maturities of 90 days
        or
        less at date of acquisition to be cash equivalents.
  ***Inventories*** are
        stated at the lower of cost (first-in, first-out method) or market.
  38
 *Table
            of Contents*
  ***Property,
        Plant, and Equipment*** are
        recorded at cost and depreciated over estimated useful lives on the
        straight-line basis, and depreciation commences at the time assets are placed
        in
        service. Leasehold improvements are amortized over the lesser of useful life
        or
        the term of the applicable lease using the straight-line method. The range
        of
        useful lives for fixed assets is as follows:
  **Years**Buildings
                  and improvements
              7
                  to 40Manufacturing
                  equipment
              5
                  to 10Office
                  equipment, furniture, and fixtures
              3
                  to 7
 
 ***Goodwill
        and Other Intangibles*** —The
        Company accounts for goodwill in accordance with Statement of Financial
        Accounting Standards (“SFAS”) No. 142, *Goodwill
        and Other Intangible Assets* .
        Goodwill is not amortized, but assessment of potential goodwill impairment
        is
        performed by the Company on an annual basis, or sooner, if
        necessary.
  Other
        intangibles, which consist of patents, developed technologies, trademarks
        and
        trade names, and customer related intangible assets, are amortized over the
        estimated useful lives of the related assets, which are 10 years for the
        majority of the assets. Management periodically evaluates the recoverability
        of
        other intangibles based upon current and anticipated results of operations
        and
        undiscounted future cash flows. Amortization of other intangibles was
        $1,333,000, $1,323,000 and $1,323,000 for the years ended September 30,
        2005, 2004, and 2003, respectively (see Note 3).
  ***Accrued
        Customer Support and Warranty Costs*** —The
        Company provides customer support services consisting of start-up assistance
        and
        evaluation and training to its customers. The Company also provides a warranty
        on its products ranging from ninety days to two years following the date
        of
        shipment. Management establishes allowances for customer support and warranty
        costs based upon the types of products shipped, customer support and product
        warranty experience. The provision of customer support and warranty costs
        is
        charged to cost of sales at the point of sale, and it is periodically assessed
        for the adequacy based on changes in these factors.
  A
        reconciliation of the changes in the Company’s allowances for warranties is as
        follows (in thousands):
  **2005**
              
              **2004**Beginning
                  balance
              
              $
              889
              
              $
              837Warranty
                  costs incurred
              
              
              (1,801
              )
              
              (1,703
              )Warranty
                  expense accrued
              
              
              2,109
              
              
              1,741Translation
                  adjustments
              
              
              (3
              )
              
              14Ending
                  balance
              
              $
              1,191
              
              $
              889
 
 ***Income
        Taxes*** —Deferred
        income taxes are provided for the effects of temporary differences arising
        from
        differences in the reporting of revenues and expenses for financial statement
        and for income tax purposes under the asset and liability method using currently
        enacted tax rates.
  ***Research
        and Development*** —Expenditures
        for research and development are expensed when incurred.
  ***Foreign
        Currency Translation*** —Assets
        and liabilities denominated in a foreign currency are translated to U.S.
        dollars
        at the exchange rate on the balance sheet date. Translation adjustments are
        shown as part of accumulated other comprehensive income (loss). Revenues,
        costs,
        and expenses are translated using an average rate. Realized and unrealized
        foreign currency transaction gains and losses are included in the consolidated
        statement of operations.
  39
 *Table
            of Contents*
  ***Impairment
        of Long-Lived Assets*** —The
        Company regularly reviews all of its long-lived assets, including property,
        plant and equipment, investments in joint ventures, and amortizable intangible
        assets, for impairment whenever events or changes in circumstances indicate
        that
        the carrying value may not be recoverable. If the total of future undiscounted
        cash flows is less than the carrying amount of these assets, an impairment
        loss,
        if any, based on the excess of the carrying amount over the fair value of
        the
        assets, is recorded. In addition, goodwill is reviewed based on its implied
        fair
        value at least annually.
  ***One-Time
        Termination Costs*** — In
        September 2004, the Company initiated adjustments to its work-force in response
        to current market conditions. These reductions in its work force were completed
        in October 2004. As a result, the Company incurred approximately $274,000
        in
        costs associated with one-time termination benefits. Of this amount,
        approximately $247,000 was expensed in fiscal 2004 as part of operating
        expenses, with the remainder expensed in the first quarter of fiscal 2005.
        As of
        September 30, 2004, approximately $80,000 in liabilities remained accrued
        for
        the amounts expensed in fiscal 2004 that were not paid as of that date. These
        amounts were fully paid in the first quarter of fiscal 2005.
  ***Estimates*** — The
        preparation of financial statements in conformity with accounting principles
        generally accepted in the United States of America requires management to
        make
        estimates and assumptions that affect the reported amounts of assets and
        liabilities and disclosure of contingent assets and liabilities at the date
        of
        the financial statements and reported amounts of revenues and expenses during
        the reporting period. Actual results could differ from those
        estimates.
  ***Financial
        Instruments*** —The
        carrying value of the Company’s cash and cash equivalents, accounts and notes
        receivable, accounts payable, accrued payroll liabilities and commissions,
        accrued customer support and warranty costs, long-term debt, mandatorily
        redeemable preferred stock, warrants, and other accrued liabilities approximates
        their estimated fair values due to the short maturities of those
        instruments.
  ***Earnings
        Per Share*** —Basic
        earnings (loss) per share (“EPS”) is computed by dividing net earnings (loss)
        available to common shareholders by the weighted average number of shares
        outstanding for the period. Diluted EPS is computed by dividing net earnings
        (loss) available to common shareholders by the weighted average common stock
        and
        common stock equivalent shares outstanding during each period using the treasury
        stock method for employee stock option plans and warrants, and the if-converted
        method for mandatorily redeemable preferred stock, if the common equivalent
        shares were not anti-dilutive. If the mandatorily redeemable preferred stock
        is
        not anti-dilutive, assumed dividends on these securities is added back into
        net
        earnings available to common shareholders for the computation of diluted
        EPS.
        The calculation of the basic and diluted EPS from continuing operations is
        as
        follows (in thousands except per share data):
  **For
                  the year ended September 30, 2005****Earnings**
              
              **Shares**
              
              **Per-Share
                  Amount**Net
                  earnings from continuing operations
              
              $
              2,691Less:
                  Assumed dividends on mandatorily redeemable preferred
                  stock
              
              
              (33
              )Basic
                  EPS:Net
                  earnings available to common shareholders
              
              
              2,658
              
              
              5,041
              
              $
              0.53Effect
                  of dilutive securities:Common
                  stock options
              
              
              -
              
              
              115Mandatorily
                  redeemable preferred stock
              
              
              33
              
              
              63Diluted
                  EPS:Income
                  available to common shareholders plus assumed conversions
              
              $
              2,691
              
              
              5,219
              
              $
              0.52
 40
 *Table
              of Contents*
  **For
                  the year ended September 30, 2004****Earnings**
              
              **Shares**
              
              **Per-Share
                  Amount**Net
                  earnings from continuing operations
              
              $
              3,684Less:
                  Assumed dividends on mandatorily redeemable preferred
                  stock
              
              
              (69
              )Basic
                  EPS:Net
                  earnings available to common shareholders
              
              
              3,615
              
              
              4,909
              
              $
              0.74Effect
                  of dilutive securities:Common
                  stock options
              
              
              -
              
              
              219Mandatorily
                  redeemable preferred stock
              
              
              69
              
              
              94Diluted
                  EPS:Income
                  available to common shareholders plus assumed conversions
              
              $
              3,684
              
              
              5,222
              
              $
              0.71
  **For
                  the year ended September 30, 2003****Earnings**
              
              **Shares**
              
              **Per-Share
                  Amount**Net
                  earnings from continuing operations
              
              $
              5,759Less:
                  Assumed dividends on mandatorily redeemable preferred
                  stock
              
              
              (132
              )Basic
                  EPS:Net
                  earnings available to common shareholders
              
              
              5,627
              
              
              4,774
              
              $
              1.18Effect
                  of dilutive securities:Common
                  stock options
              
              
              -
              
              
              96Mandatorily
                  redeemable preferred stock
              
              
              132
              
              
              119Diluted
                  EPS:Income
                  available to common shareholders plus assumed conversions
              
              $
              5,759
              
              
              4,989
              
              $
              1.15
 
 The
        weighted average number of diluted shares does not include potential common
        shares which are anti-dilutive, nor does it include performance-based restricted
        stock awards if the performance measurement has not been met. The following
        potential common shares were not included in the calculation of diluted EPS
        as
        they were anti-dilutive:
  **For
                  the year ended September 30****2005**
              
              **2004**
              
              **2003**Common
                  shares from:Assumed
                  exercise of stock options
              
              
              249,100
              
              
              183,600
              
              
              714,125Assumed
                  conversion of warrants
              
              
              -
              
              
              31,636
              
              
              35,553Assumed
                  exercise of:-
                  employment based stock grants
              
              
              52,500
              
              
              -
              
              
              --
                  performance based stock grants
              
              
              115,000
              
              
              -
              
              
              --
                  non-employee stock grants
              
              
              2,000
              
              
              -
              
              
              -
  The
        options expire on dates beginning in February 2006 through February 2015.
        Stock
        grants may become vested and exercisable between May 2006 and December
        2007.
  41
 *Table
              of Contents*
 
 In
        2004,
        the Financial Accounting Standards Board’s (“FASB”) Emerging Issues Task Force
        (“EITF”) reached consensus on issue No. 03-6, *Participating
        Securities and the Two-Class Method*  *under
        FASB Statement No. 128* .
        Issue
        No. 03-6 determined that for participating securities, the two-class method
        of
        computing basic earnings per share is required. Dividends must be calculated
        for
        the participating security on undistributed earnings and are a reduction
        in the
        net income available to common shareholders. The Company’s Series B preferred
        stock is a participating security as it has the right to dividends should
        dividends be declared on common stock. Assumed dividends on undistributed
        earnings are allocated as if the entire net income were distributed and based
        on
        the relationship of the weighted average of common shares outstanding and
        the
        weighted average of common shares outstanding if the preferred stock were
        converted into common. As required by the consensus, prior periods have been
        restated.
  ***Accounting
        for Stock-Based Compensation*** —During
        1995, the FASB issued SFAS No. 123, *Accounting
        for Stock-Based Compensation* (“SFAS
        No. 123”), which defines a fair value based method of accounting for employee
        stock options and similar equity instruments and encourages all entities
        to
        adopt that method of accounting for all of their employee stock compensation
        plans. However, it also allows an entity to continue to measure compensation
        cost for those plans using the method of accounting prescribed by Accounting
        Principles Board Opinion No. 25 (“APB 25”). Entities electing to
        utilize APB 25 must make pro forma disclosures of net income and earnings
        per share as if the fair value based method of accounting defined in
        SFAS No. 123, as amended by SFAS No. 148, *Accounting
        for Stock-Based Compensation - Transition and Disclosure* (“SFAS
        No. 148”), had been adopted.
  The
        Company has elected to account for its stock-based compensation plans under
        APB 25. The Company has computed, for pro forma disclosure purposes, the
        value of all stock and stock options granted under the Employee Stock Purchase
        Plan and the Restated Employees’ Stock Incentive Plan using the Black-Scholes
        option pricing model and using the following weighted average assumptions
        for
        the years ended September 30, 2005, 2004 and 2003:
  **2005**
              **2004**
              **2003**Risk-free
                  interest rate
              4.24
                  %
              2.91
                  %
              2.36
                  %Expected
                  dividend yield
              0
                  %
              0
                  %
              0
                  %Expected
                  lives
              5
                  years
              5
                  years
              4.55
                  yearsExpected
                  volatility
              62
                  %
              70
                  %
              74
                  %
 
  Using
        the
        Black-Scholes methodology, the total value of stock options granted during
        2005,
        2004, and 2003 was $136,000, $267,000, and $991,000, respectively, which
        is
        amortized on a pro forma basis over the vesting period of the options (between
        1-4 years). The weighted average fair value of options granted under the
        Restated Employees’ Stock Incentive Plan during 2005, 2004, and 2003 was $5.43
        per share, $8.90 per share, and $5.43 per share, respectively.
  The
        total
        compensatory value of stock purchased under the Employee Stock Purchase Plan
        during 2005, 2004, and 2003 was $6,000, $8,000, and $8,000, respectively.
        The
        weighted average fair value of the stock purchased during 2005, 2004, and
        2003
        was $1.63 per share, $2.03 per share, and $1.14 per share,
        respectively.
  In
        addition, in September of 2005, the Company awarded 52,500 shares of
        employment-based stock grants and 115,000 shares of performance-based stock
        grants under the Restated Employees’ Stock Incentive Plan. An additional 2,000
        shares of service based stock grants were awarded to non-employees in September
        2005. The value of these stock grants, based on the average fair market value
        at
        the grant date above the exercise price was $13.785 per share for a total
        value
        of $2.3 million. In fiscal 2005, $73,000 was recorded as stock compensation
        expense.
  If
        the
        Company had accounted for the Restated Employees’ Stock Incentive Plan and
        Employee Stock Purchase Plan in accordance with SFAS No. 123, the
        Company’s net earnings and earnings per share would approximate the pro forma
        disclosures below (in thousands, except per share amounts):
  42
 *Table
            of Contents*
  **Year
                  Ended September 30, 2005**
              
              **Year
                  Ended September 30, 2004**
              
              **Year
                  Ended September 30, 2003**Net
                  earnings, as reported
              
              $
              2,691
              
              $
              3,684
              
              $
              5,759Deduct:
                  Total stock-based employee compensation expense determined under
                  fair
                  value based method for all awards, net of related tax
                  effects
              
              
              (361
              )
              
              (670
              )
              
              (498
              )Plus:
                  Stock-based employee compensation expense already included in the
                  determination of net earnings, net of related tax effects
              
              
              47
              
              
              -
              
              
              -Pro
                  forma net earnings
              
              $
              2,377
              
              $
              3,014
              
              $
              5,261Earnings
                  per shareBasic
                  - as reported
              
              $
              0.53
              
              $
              0.74
              
              $
              1.18Basic
                  - pro forma
              
              $
              0.47
              
              $
              0.61
              
              $
              1.15Diluted
                  - as reported
              
              $
              0.52
              
              $
              0.71
              
              $
              1.15Diluted
                  - pro forma
              
              $
              0.46
              
              $
              0.58
              
              $
              1.06
 
 ***Future
        Accounting Changes*** — In
        December 2004, the FASB issued SFAS No. 123 (revised 2004), *Share-Based
        Payment* (“SFAS
        No. 123R”), which was effective for the Company on October 1, 2005. This
        Statement requires the Company to measure and expense the cost of employee
        services received in exchange for an award of equity instruments based on
        the
        grant date fair value of the award and amends the disclosure requirements
        related to awards of equity instruments. On October 1, 2005, the Company
        began
        expensing the cost of equity instruments awarded as part of the Restated
        Employees’ Stock Incentive Plan and Employee Stock Purchase Plan over the
        requisite service period related to such awards. The Company has elected
        to
        implement this new standard under the modified prospective application. Under
        the modified prospective application, the Company will expense the cost of
        new
        or modified awards over the requisite service period and the cost of previously
        granted unvested awards for the requisite service period remaining after
        October
        1, 2005.
  The
        adoption of SFAS No. 123R is expected to have a significant effect on the
        consolidated financial statements of the Company. See the pro forma impact
        on
        net earnings and earnings per share from calculating stock-related compensation
        costs under the fair value alternative of SFAS No. 123 in Note 1. The pro
        forma
        computation in Note 1 provides the possible effect under SFAS No. 123R and
        SAB
        107, which may be different from the calculation of compensation cost under
        SFAS
        No. 123. In addition, full year effects of share-based payments issued late
        in
        fiscal 2005 are not fully reflected in these calculations. Such potential
        differences have not yet been fully quantified. Also, past usage of option
        plans
        and stock purchase plans may not reflect our practices in future
        periods.
  In
        November 2004, the FASB issued SFAS No. 151, *Inventory
        Costs, an amendment of ARB No. 43, Chapter 4* ,
        to
        clarify the accounting for abnormal amounts of idle facility expense, freight,
        handling costs and wasted material (spoilage). This statement was effective
        October 1, 2005. The Company does not believe SFAS No. 151 will have a material
        effect on its financial position or results of operations.
  ***Reclassifications*** — Certain
        reclassifications have been made to prior year amounts to conform to the
        current
        year presentation.
  43
 *Table
              of Contents*
 
 **2.**
              **ACQUISITIONS**
 
 Effective
        February 10, 2005, the Company acquired all the outstanding stock of Freshline
        Machines Pty. Ltd. (“Freshline”). The purchase price, including acquisition
        costs, was approximately $1,477,000. The purchase agreement also provides
        for
        contingent payments if Freshline’s gross revenues in the twelve-month period
        subsequent to acquisition exceed specific targets. The maximum contingent
        purchase price under these contingencies is $700,000. The Company paid the
        cash
        purchase price from cash on hand.
  The
        acquisition was accounted for as a purchase and Freshline’s results of operation
        for the period subsequent to the acquisition have been included in the Company’s
        Consolidated Statements of Operations. The purchase price has been allocated
        to
        the assets and liabilities of Freshline based on their estimated fair values.
        Based on the estimates, the Company recorded approximately $152,000 of Patents
        /
        developed technologies, which is being amortized on a straight-line basis
        over
        10 years, as the product lines associated with these assets are expected
        to
        continue to generate revenues for an extended period of time. Assets and
        liabilities acquired were as follows (in thousands):
  Fair
                  value of assets acquiredTangible
                  assets
              
              $
              1,041Note
                  receivable from previous owner
              
              
              672Patents
                  / developed technologies
              
              
              152Liabilities
                  assumed
              
              
              (806
              )Cash
                  paid for common stock, less cash acquired of $418
              
              $
              1,059
 
 The
        note
        receivable from Freshline’s previous owner was re-paid in March 2005. In
        addition, the Company entered into the following two agreements with the
        previous owner: (1) a one year rental, with a one-year renewal option, of
        the
        building where Freshline is currently operating, and (2) a two-year consulting
        agreement.
  **3.**
              **GOODWILL
                  AND OTHER INTANGIBLE
                  ASSETS**
 
 As
        of
        September 30, 2005, the Company had the following intangible assets (in
        thousands):
  **Cost**
              
              **Net
                  Book Value**Patents
                  and developed technologies
              
              $
              11,083
              
              $
              4,973Purchased
                  trademarks and trade names
              
              
              1,700
              
              
              808Customer
                  related intangibles
              
              
              900
              
              
              428$
              13,683
              
              $
              6,209
  The
        significant majority of these assets are being amortized over 10 years.
        Amortization expense for the next five fiscal years is expected to be
        approximately $1.3 million per year.
  As
        of
        September 30, 2005, the Company had $2.5 million of goodwill which is
        not being amortized.
  **4.**
              **TRADE
                  ACCOUNTS RECEIVABLE**
 
 Trade
        accounts receivable consist of the following (in thousands):
  **September
                  30,****2005**
              
              **2004**Trade
                  accounts receivable
              
              $
              11,332
              
              $
              9,910Allowance
                  for doubtful accounts
              
              
              (504
              )
              
              (574
              )Total
                  trade accounts receivable, net
              
              $
              10,828
              
              $
              9,336
 44
 *Table
              of Contents*
  Actual
        charges to the allowance for doubtful accounts for fiscal 2005, 2004, and
        2003
        were $79,000, $159,000, and $23,000, respectively. Accruals for bad debt
        expense
        for fiscal 2005, 2004, and 2003 were ($43,000), $172,000, and $162,000,
        respectively.
  **5.**
              **INVENTORIES**
 
 Inventories
        consist of the following (in thousands):
  **September
                  30,****2005**
              
              **2004**Purchased
                  components and raw materials
              
              $
              6,170
              
              $
              6,460Sub-assemblies
              
              
              1,390
              
              
              1,473Work-in-process
              
              
              4,310
              
              
              3,276Finished
                  goods
              
              
              2,990
              
              
              2,424Total
                  inventories
              
              $
              14,860
              
              $
              13,633
  At
        September 30, 2005 and 2004, respectively, cumulative inventory adjustments
        to
        lower of cost or market totaled $2.8 million and $3.0 million. Amounts charged
        to expense for fiscal 2005 were $728,000, $841,000 for fiscal 2004, and $294,000
        for fiscal 2003. Actual charges to the reserve were $863,000, $349,000 and
        $177,000 for fiscal 2005, 2004, and 2003, respectively.
  
 **6.**
              **PROPERTY,
                  PLANT, AND EQUIPMENT**
 
 Property,
        plant, and equipment consist of the following (in thousands):
  **September
                  30,****2005**
              
              **2004**Land
              
              $
              258
              
              $
              267Buildings
                  and improvements
              
              
              3,891
              
              
              3,939Manufacturing
                  equipment
              
              
              12,313
              
              
              12,104Office
                  equipment, furniture, and fixtures
              
              
              11,582
              
              
              11,37628,044
              
              
              27,686Accumulated
                  depreciation
              
              
              (23,780
              )
              
              (22,640
              )Total
                  property, plant, and equipment, net
              
              $
              4,264
              
              $
              5,046
 
 **7.**
              **INVESTMENT
                  IN JOINT VENTURE**
 
 In
        July
        2004, the Company entered into a joint venture with Peco Controls Corporation
        to
        form InspX LLC for the product development, manufacturing and sales of x-ray
        inspection systems. The Company invested $2.0 million cash in the joint venture
        plus approximately $0.1 million in capitalized acquisition costs for a 50%
        equity interest in the joint venture and may be subject to additional voluntary
        capital calls if necessary to finance the joint venture operations. At the
        third
        anniversary of formation, if certain sales objectives are not achieved, $1.5
        million of the Company’s capital contribution converts to debt. The Company also
        has a purchase option to acquire the remaining 50% interest in the joint
        venture
        at any time after June 30, 2008, and subject to certain provisions, not prior
        to
        June 30, 2009, at prices determined under valuation formulas provided for
        in the
        operating agreement.
  The
        investment in the joint venture is being accounted for under the equity method
        of accounting. The Company shares equally (50%) in the earnings or loss of
        the
        joint venture. For the periods ending September 30, 2005 and 2004, the Company’s
        equity in earnings of the joint venture was a loss of approximately $659,000
        and
        $170,000, respectively.
  45
 *Table
            of Contents*
  Summarized
        financial information for the joint venture (at 100%, without intercompany
        eliminations, and as adjusted for the purchase method of accounting) is as
        follows (in millions):
  **September
                  30****2005**
              
              **2004**Balance
                  SheetCurrent
                  assets
              
              $
              1.7
              
              $
              1.9Patents
                  and developed technologies
              
              
              3.3
              
              
              3.7Total
                  assets
              
              
              5.2
              
              
              5.6Current
                  liabilities
              
              
              1.1
              
              
              0.3Long-term
                  debt
              
              
              1.5
              
              
              1.5Equity
              
              
              2.6
              
              
              3.8
  **September
                  30****2005**
              
              **since
                  inception 2004**Results
                  of OperationsSales
              
              $
              2.6
              
              $
              0.3Gross
                  profit
              
              
              1.2
              
              
              0.1Operating
                  expenses
              
              
              1.9
              
              
              0.3Amortization
                  of intangibles
              
              
              0.4
              
              
              0.1Net
                  loss before taxes
              
              
              (1.3
              )
              
              (0.3
              )
 
  **8.**
              **FINANCING
                  AGREEMENTS**
 
 The
        Company’s domestic credit facility provides a credit accommodation totaling
        $11.6 million in the United States consisting of a term loan of
        $1.6 million and a revolving credit facility of up to $10.0 million.
        The revolving credit facility matures in April 2006. The term loan requires
        quarterly payments of principal of $200,000 and matures on July 31, 2007.
        The term loan bears interest at The Wall Street Journal prime rate, which
        was
        6.75% at September 30, 2005. The revolving credit facility bears interest,
        at
        the Company’s option, of either The Wall Street Journal prime rate less 1.5% or
        a LIBOR based rate. The rate was 5.25% at September 30, 2005. The credit
        facility is secured by all of the U.S. personal property, including patents
        and
        other intangibles of the Company and its subsidiaries, and contains covenants
        that require the maintenance of a defined debt ratio, a fixed charge coverage
        ratio, and minimum profitability. The credit facility also restricts the
        payment
        of dividends. At September 30, 2005, the Company was in compliance with all
        loan
        covenants. At September 30, 2005, borrowings under the term loan were
        $1.6 million and there were no borrowings outstanding under the revolving
        credit facility. At September 30, 2004, borrowings under the term loan were
        $2.4 million. There were no borrowings outstanding under the revolving
        credit facility at September 30, 2004.
  Additionally,
        the Company’s credit accommodation with a commercial bank in The Netherlands
        provides a credit facility for its European subsidiary. This credit
        accommodation totals $3.6 million and includes term loans of $545,000, an
        operating line of the lesser of $1.8 million or the available borrowing
        base, which is based on varying percentages of eligible accounts receivable
        and
        inventories, and a bank guarantee facility of $1.2 million. The term loans
        require quarterly principal payments of $37,000 and mature in October 2006
        and
        August 2012. The term loans are secured by real property of the Company’s
        European subsidiary, while the operating line and bank guarantee facility
        are
        secured by all of the subsidiary’s personal property. The credit facility bears
        interest at the bank’s prime rate, with a minimum of 3.00%, plus 1.75%. At
        September 30, 2005, the interest rate was 4.75%. Interest rates on the term
        loans are subject to annual renegotiation. At September 30, 2005, the Company
        had borrowings under this facility of approximately $545,000 in term loans,
        and
        had received bank guarantees of $831,000 under this agreement. At September
        30,
        2004, the Company had borrowings under this facility of approximately $715,000
        in term loans and $368,000 of bank guarantees. There were no amounts outstanding
        under the operating line at either September 30, 2005 or September 30, 2004.
  46
 *Table
              of Contents*
 
 Long-term
        debt consists of the following (in thousands):
  **September
                  30,****2005**
              
              **2004**Term
                  loan dated August 2002, variable interest payable quarterly at
                  the bank’s
                  prime rate (6.75% at September 30, 2005), due in quarterly principal
                  payments of $200,000 through July 2007. Secured by business
                  property.
              
              $
              1,600
              
              $
              2,400Note
                  payable, interest rate of 4.10%, due in quarterly principal and
                  interest
                  installments through August 2012, secured by certain land and
                  buildings.
              
              
              436
              
              
              512Note
                  payable, interest rate of 4.25%, due in quarterly principal
                  andinterest installments through October 2006, secured by certain
                  land and
                  buildings.
              
              
              109
              
              
              203Capital
                  leases, interest rates between 6% and 11%, due inprincipal and interest installments through March 2007, secured
                  by certain
                  office and manufacturing equipment.
              
              
              175
              
              
              4182,320
              
              
              3,533Current
                  portion
              
              
              (1,121
              )
              
              (1,210
              )Total
                  long-term debt
              
              $
              1,199
              
              $
              2,323
 
 Principal
        payments on long-term debt are as follows (in thousands):
  **Year
                  Ending September 30**2006
              
              $
              1,1212007
              
              
              8832008
              
              
              602009
              
              
              602010
              
              
              60Thereafter
              
              
              136Total
              
              $
              2,320
 
 Based
        on
        the borrowing rates currently available to the Company for loans with similar
        terms and average maturities, the fair value of long-term debt at
        September 30, 2005 approximates its carrying value.
  On
        November 10, 2005, the term loan under the domestic credit facility was paid
        in
        full from available cash.
  **9.**
              **LEASES**
 
 The
        Company has agreements with the Port of Walla Walla to lease two operating
        facilities, one of which expires on December 31, 2005. The Company plans
        to
        consolidate its operations in Walla Walla into one facility by the end of
        calendar 2005. The Company has amended its lease agreement on its primary
        operating facility in June 2005, which extended the lease term to 2020 and
        will
        add approximately 23,000 square feet of manufacturing and office space under
        the
        lease. The Company currently has the option to purchase the land and plant
        under
        the agreement. The purchase price of the primary facility is determined by
        reducing the original plant construction costs of approximately $8,800,000
        by
        one thirty-fifth for each lease year prior to the exercise of the option
        and
        adding $600,000 for the land, subject to further reductions if exercised
        after
        the fifteenth year of the lease. The Company also has two leased operating
        facilities in Oregon. Both leases expire in 2007. The Company has
        leased
  47
 *Table
            of Contents*
  an
        operating facility in The Netherlands under a lease that expires in 2008.
        The
        Company has leased an operating facility in Australia under a lease that
        expires
        in 2006 (with a one year renewal option).
  Rent
        expense is recognized on a straight-line basis over the term of the lease.
        Rental expense for the Company’s operating leases referred to above was
        $1,476,000 for the year ended September 30, 2005, $1,394,000 for the year
        ended September 30, 2004, and $1,367,000 for the year ended
        September 30, 2003.
  The
        following is a schedule of future minimum rental payments required under
        operating leases and future rental expense (in thousands):
  **Year
                  Ending September 30**
              
              **Rental
                  Payments**
              
              **Rental
                  Expense**2006
              
              $
              1,455
              
              $
              1,3902007
              
              
              1,311
              
              
              1,2542008
              
              
              1,037
              
              
              1,0422009
              
              
              848
              
              
              8532010
              
              
              848
              
              
              853Thereafter
              
              
              9,138
              
              
              8,527Total
              
              $
              14,637
              
              $
              13,919
 
 **10.**
              **MANDATORILY
                  REDEEMABLE PREFERRED STOCK AND
                  WARRANTS**
 
 The
        Company issued 1,340,366 shares of Series B convertible preferred stock (“Series
        B”) at a price of $8.60 per share in conjunction with the acquisition of
        Advanced Machine Vision Corporation (“AMVC”) in 2000. The Series B was accreted
        from its issue price to its scheduled redemption price using the effective
        interest method. Each share of Series B, par value of $0.01 per share, was
        convertible into 2/3 of a share of common stock. The Series B was convertible
        at
        the option of the holder at any time, unless previously redeemed, or by the
        Company upon a merger, consolidation, share exchange or sale of substantially
        all of its assets. The holders of Series B could have required the Company
        to repurchase any or all of their shares at the redemption price of $10.00.
        If
        not converted to common stock or redeemed at the option of the Series B
        holder prior to July 12, 2005, the Company was required to redeem the
        Series B for $10.00 per share on July 12, 2005. In July 2005, all
        remaining unconverted Series B shares were redeemed at the $10.00 per share
        redemption price.
  The
        Company issued 365,222 warrants at a fair market value of $10.00 per warrant
        in
        conjunction with the issuance of the Series B convertible preferred stock
        and
        the acquisition of AMVC. Each warrant entitled its holder to purchase at
        any
        time for a period of five years from July 12, 2000 one share of common
        stock at $15.00 per share, subject to certain adjustments. The warrants
        permitted the holder to engage in a net exercise of the warrants if the fair
        market value of one share of common stock is greater than $15.00 per share
        on
        the date of exercise. Prior to the expiration date of the warrant, the holder
        could have required the Company to redeem the warrant for cash at a price
        equal
        to $10.00 for each whole share of common stock that may be purchased under
        the
        warrant. These warrants expired in July 2005, and all unconverted warrants
        presented to the Company were redeemed at the $10.00 per warrant redemption
        price. There were 12,738 warrants that expired unredeemed and unconverted.
        The
        recorded liability related to such warrants was reclassified to equity upon
        their expiration.
  **11.**
              **CONTRACTUAL
                  GUARANTEES AND INDEMNITIES**
 
 *Intellectual
        property and general contractual indemnities*
  The
        Company, in the normal course of business, provides specific, limited
        indemnification to its customers for liability and damages related to
        intellectual property rights. In addition, the Company may enter into contracts
        with customers where it has agreed to indemnify the customer for personal
        injury
        or property damage caused by the Company’s products and services.
        Indemnification is typically limited to replacement of the items or the actual
        price of the products and services. The Company maintains product liability
        insurance as well as errors and
  48
 *Table
            of Contents*
  omissions
        insurance, which may provide a source of recovery in the event of an
        indemnification claim, but does not maintain insurance coverage for claims
        related to intellectual property rights.
  Historically,
        any amounts payable under these indemnifications have not had a material
        effect
        on the Company’s business, financial condition, results of operations, or cash
        flows. The Company has not recorded any provision for future obligations
        under
        these indemnifications. If the Company determines it is probable that a loss
        has
        occurred under these indemnifications, then any such reasonably estimable
        loss
        would be recognized.
  *Director
        and officer indemnities*
  The
        Company has entered into indemnification agreements with its directors and
        certain executive officers which require the Company to indemnify such
        individuals against certain expenses, judgments and fines in third-party
        and
        derivative proceedings. The Company may recover some of the expenses and
        liabilities that arise in connection with such indemnifications under the
        terms
        of its directors’ and officers’ insurance policies. The Company has not recorded
        any provision for future obligations under these indemnification agreements.
  *Bank
        guarantees and letters of credit*
  At
        September 30, 2005, the Company’s European subsidiary had approximately $831,000
        of outstanding performance guarantees secured by bank guarantees under the
        Company’s credit facility in Europe. Bank guarantees arise when the European
        subsidiary collects customer deposits prior to order fulfillment. The customer
        deposits received are recorded as liabilities on the Company’s balance sheet.
        The bank guarantees repayment of the customer deposit in the event an order
        is
        not completed. The bank guarantee is canceled upon shipment and transfer
        of
        title. These bank guarantees arise in the normal course of the Company’s
        European business and are not deemed to expose the Company to any significant
        risks since they are satisfied as part of the design and manufacturing process.
        In addition, at September 30, 2005, the Company had a standby letter of credit
        for $300,000 securing certain self-insurance contracts related to workers
        compensation and a standby letter of credit for $275,000 securing payments
        under
        a lease contract for a domestic production facility. If the Company fails
        to
        meet its contractual obligations, these bank guarantees and letters of credit
        may become liabilities of the Company.
  **12.**
              **INCOME
                  TAXES**
 
 The
        provision for income taxes from continuing operations consists of the following
        (in thousands):
  **Year
                  Ended September 30,****2005**
              
              **2004**
              
              **2003**Current:Federal
              
              $
              372
              
              $
              1,089
              
              $
              42Foreign
              
              
              31
              
              
              (104
              )
              
              310State
              
              
              67
              
              
              66
              
              
              261470
              
              
              1,051
              
              
              613Deferred:Federal
              
              
              481
              
              
              605
              
              
              2,133Foreign
              
              
              (25
              )
              
              -
              
              
              -State
              
              
              (24
              )
              
              (39
              )
              
              (53
              )432
              
              
              566
              
              
              2,080Total
                  income tax expense
              
              $
              902
              
              $
              1,617
              
              $
              2,693
 49
 *Table
              of Contents*
  The
        tax
        effects of temporary differences that give rise to significant portions of
        deferred tax assets and deferred tax liabilities are as follows (in
        thousands):
  **September
                  30,****2005**
              
              **2004**Deferred
                  tax asset:Reserves
                  and accruals
              
              $
              2,726
              
              $
              2,416Net
                  operating loss and other tax credit carryforwards
              
              
              1,131
              
              
              1,980Tax
                  benefits of share-based payments
              
              
              27
              
              
              158Translation
                  adjustment to equity
              
              
              (63
              )
              
              (71
              )Deferred
                  tax liability:Accumulated
                  depreciation
              
              
              (99
              )
              
              (141
              )Intangible
                  assets
              
              
              (1,956
              )
              
              (2,353
              )Net
                  deferred tax asset
              
              $
              1,766
              
              $
              1,989Deferred
                  tax:Current
                  asset
              
              $
              2,382
              
              $
              2,119Long-term
                  asset
              
              
              10
              
              
              6Long-term
                  liability
              
              
              (626
              )
              
              (136
              )Net
                  deferred tax asset
              
              $
              1,766
              
              $
              1,989
 
 There
        is
        no valuation allowance at September 30, 2005 due to anticipated utilization
        of
        all the deferred tax assets as the Company believes it will have sufficient
        net
        income combined with the lengthy expiration periods on carryforward items
        to
        utilize these assets. The Company also believes that the American Jobs Creation
        Act of 2004, enacted in October 2004, will not affect its utilization of
        deferred tax assets.
  Income
        tax expense is computed at rates different than statutory rates. The
        reconciliation between effective and statutory rates is as follows:
  **Year
                  Ended September 30,****2005**
              
              **2004**
              
              **2003**Statutory
                  rates
              
              
              34.0
              %
              
              34.0
              %
              
              34.0
              %Increase
                  (reduction) in income taxes resulting from:Extraterratorial
                  income exclusion
              
              
              (5.4
              )
              
              (2.8
              )
              
              (2.3
              )Foreign
                  tax credit effects of acquisition
              
              
              (2.2
              )
              
              -
              
              
              -Research
                  and development credit
              
              
              (1.7
              )
              
              (1.0
              )
              
              (0.3
              )State
                  income taxes, net of federal benefit
              
              
              0.6
              
              
              0.5
              
              
              1.6Change
                  in tax laws
              
              
              -
              
              
              -
              
              
              (1.8
              )Other
                  permanent differences
              
              
              0.3
              
              
              (0.2
              )
              
              0.7Tax
                  exempt interest
              
              
              (0.5
              )
              
              -
              
              
              -Income
                  tax combined effective rate
              
              
              25.1
              %
              
              30.5
              %
              
              31.9
              %
 
 At
        September 30, 2005, there were $3.3 million of net operating loss
        carryforwards which expire between 2018 and 2019.
  **13.**
              **STOCK
                  COMPENSATION PLANS**
 
 At
        September 30, 2005, the Company has two stock-based compensation plans which
        are
        described below. The Company accounts for these plans under APB 25 (see
        Significant Accounting Policies in Note 1). The compensation cost that has
        been
        charged against income was $73,000, $0, and $0 for 2005, 2004, and 2003,
        respectively.
  ***Employees’
        Stock Incentive Plan*** —Under
        the Restated Employees’ Stock Incentive Plan (the “Incentive Plan”), eligible
        employees may receive either incentive stock options or nonqualified stock
        options and such options may
  50
 *Table
            of Contents*
  be
        exercised only after an employee has remained in continuous employment for
        one
        year after the date of grant. Thereafter, the options become exercisable
        as
        stipulated by the individual option agreements, generally 25% per year on
        the
        anniversary date of the grant for incentive stock options and 100% on the
        one
        year anniversary for non-qualified stock options. The option exercise price
        is
        the fair market value of the underlying stock at the date of grant. In addition,
        under the Incentive Plan, eligible employees may be granted restricted stock
        awards which vest either on employment-based or performance-based
        measures.
  **Incentive
        Stock Options**
 
 **Number
                  of Shares**
              
              **Weighted-
                  Average Exercise Price**Balance
                  at September 30, 2002
              
              
              818,933
              
              $
              10.14Options
                  granted
              
              
              182,500
              
              $
              8.98Options
                  exercised
              
              
              (11,837
              )
              $
              5.71Options
                  forfeited
              
              
              (52,033
              )
              $
              9.32Balance
                  at September 30, 2003
              
              
              937,563
              
              $
              10.02Options
                  granted
              
              
              30,000
              
              $
              14.83Options
                  exercised
              
              
              (186,218
              )
              $
              7.97Options
                  forfeited
              
              
              (17,238
              )
              $
              9.60Balance
                  at September 30, 2004
              
              
              764,107
              
              $
              10.71Options
                  granted
              
              
              25,000
              
              $
              9.64Options
                  exercised
              
              
              (191,858
              )
              $
              7.73Options
                  forfeited
              
              
              (65,960
              )
              $
              11.28Balance
                at September 30, 2005
              
              
              531,289
              
              $
              11.67
  The
        following table summarizes information about stock options outstanding at
        September 30, 2005:
  **Options
                  Outstanding**
              
              **Options
                  Exercisable****Range
                  of Exercise Prices**
              
              **Number
                  Outstanding**
              
              **Weighted
                  Average Remaining Contractual Life (years)**
              
              **Weighted
                  Average Exercise Price**
              
              **Number
                  of Shares Exercisable**
              
              **Weighted
                  Average Exercise Price**$2.51
                  - 5.00
              
              
              79,689
              
              
              2.4
              
              $
              2.91
              
              
              48,849
              
              $
              2.89$5.00
                  - 10.00
              
              
              182,500
              
              
              4.4
              
              
              8.89
              
              
              102,000
              
              
              8.66$10.01
                  - 15.00
              
              
              105,800
              
              
              2.9
              
              
              11.46
              
              
              92,050
              
              
              11.61$15.01
                  - 20.00
              
              
              98,000
              
              
              2.8
              
              
              16.93
              
              
              98,000
              
              
              16.93$20.01
                  - 23.25
              
              
              65,300
              
              
              0.6
              
              
              22.59
              
              
              65,300
              
              
              22.59$2.51
                  - 23.25
              
              
              531,289
              
              
              3.0
              
              $
              11.67
              
              
              406,199
              
              $
              12.87
 
 **Employment-Based
        Stock Awards** —In
        September 2005, the Company awarded 52,500 shares of employment-based stock
        grants. The fair value of these grants is $13.785 per share based on the
        average
        fair market value at the grant date. The restrictions on the grants lapse
        at the
        end of the required three-year employment period and the awards have a weighted
        average remaining contractual life of 2.6 years. The Company accounts for
        these
        awards in accordance with APB 25, under which stock compensation expense
        is
        recognized based on the grant date fair value of the stock over the vesting
        period.
  51
 *Table
            of Contents*
  **Employee
        Performance-Based Stock Awards** —In
        September 2005, the Company awarded 115,000 shares of performance-based stock
        grants, the lapse of the restrictions on which is contingent upon the increase
        in the Company’s net earnings over a three year period beginning with fiscal
        2005. If the Company’s net income from continuing operations has a compound
        annual growth rate of 7.5%, the restrictions on 50% of the shares lapse;
        at 10%,
        the restrictions on 80% of the shares lapse; and at 25%, the restrictions
        on
        100% of the shares lapse. The lapse of the restrictions on the shares is
        linear
        between the stated levels. No restrictions lapse if the compound annual growth
        rate is less than 7.5%, and 10% of the shares may be forfeited if net income
        in
        any one year does not equal at least 90% of the prior year’s net income from
        continuing operations, although up to 25% of the forfeited shares may be
        reinstated at the discretion of the Board of Directors. In addition, recipients
        must be in continued employment with the Company through December 2007 for
        the
        restrictions on the awards to lapse. The remaining weighted average contractual
        life is 2.12 years. Final measurement of the awards is variable until vesting
        becomes probable. Compensation expense is recognized over the period the
        employee performs related services based on the estimated number of shares
        expected to vest.
  At
        September 30, 2005, the total number of shares reserved for issuance under
        the
        Incentive Plan was 897,570, of which 198,781 were available for grant. At
        that
        date, options on 406,199 shares were exercisable at prices from $2.51 to
        $23.25
        per share. In addition, there were 125,090 unvested options outstanding and
        167,500 employment or performance-based stock awards whose restrictions had
        not
        lapsed. In 2004, the shareholders approved the addition of 100,000 shares
        for
        issuance under this Incentive Plan. At September 30, 2004, the total number
        of shares reserved for option exercises was 1,089,428, of which 325,321 were
        available for grant. At that date, options for 519,677 shares were exercisable
        at prices from $2.51 to $23.25 per share. At September 30, 2003, the total
        number of shares reserved for option exercises was 1,175,646, of which 238,083
        were available for grant. At that date, options for 565,046 shares were
        exercisable at prices from $7.00 to $23.25 per share.
  ***Employee
        Stock Purchase Plan*** — Most
        employees are eligible to participate in the Company’s Employee Stock Purchase
        Plan (the “Purchase Plan”). Shares are not available to employees who already
        own 5% or more of the Company’s stock. Employees can withhold, by payroll
        deductions, up to 5% of their regular compensation to purchase shares at
        a
        purchase price of 85% of the fair market value of the common stock on the
        purchase date. There were 500,000 shares reserved for purchase under the
        Purchase Plan of which 413,654 remain available. During the years ended
        September 30, 2005, 2004, and 2003, the Company issued shares totaling
        3,644, 3,797; and 6,918, respectively, under the Purchase Plan.
  ***Non
        employee Service-Based Stock Awards*** —In
        September 2005, the Company awarded 2,000 shares of service-based stock grants
        to non-employees. Under the terms of the award, 50% of the shares vest if
        the
        non-employees perform services through May 31, 2006 and the remaining 50%
        vest
        if the services are performed through May 31, 2007. The grants have a weighted
        average remaining contractual life of 1.67 years. In accordance with EITF
        96-18,
        the value of the instrument is amortized to expense over the vesting period
        with
        final valuation measured on the vesting date.
  **14.**
              **EMPLOYEE
                  BENEFIT PLANS**
 
 The
        Company has a 401(k) profit sharing plan which covers substantially all
        employees. The Company is required to match 50% of employee contributions
        for a
        maximum match of 2% of each participating employee’s compensation. The Company
        contributed $281,000, $297,000, and $285,000 in matching funds to the plan
        for
        the years ended September 30, 2005, 2004, and 2003,
        respectively.
  The
        401(k) plan also permits the Company to make discretionary profit sharing
        contributions to all employees. Discretionary profit sharing contributions
        are
        determined annually by the Board of Directors. Profit sharing plan expense
        was
        $248,000, $182,000, and $860,000 for the years ended September 30, 2005,
        2004, and 2003, respectively.
  52
 *Table
            of Contents*
  **15.**
              **SEGMENT
                  INFORMATION**
 
 The
        Company’s business units serve customers in its primary market—the food
        processing and agricultural products industry—through common sales and
        distribution channels. Therefore, the Company reports on one segment. The
        following table summarizes information about products and services (in
        thousands).
  **Year
                  Ended September 30,****2005**
              
              **2004**
              
              **2003**Net
                  sales by product category:Automated
                  inspection systems
              
              $
              20,647
              
              $
              28,675
              
              $
              30,230Process
                  systems
              
              
              31,853
              
              
              27,713
              
              
              31,759Aftermarket
              
              
              27,822
              
              
              24,222
              
              
              20,633Total
                  net sales by product category
              
              $
              80,322
              
              $
              80,610
              
              $
              82,622
 
 Net
        sales
        for service/contracts were less than 10% of total net sales for the years
        ended
        September 30, 2005, 2004, and 2003, respectively, and are therefore
        summarized with aftermarket.
  The
        following table summarizes information about geographic areas:
  **Year
                  Ended September 30,****2005**
              
              **2004**
              
              **2003**Net
                  sales:Domestic
              
              $
              38,475
              
              $
              45,263
              
              $
              41,538International
              
              
              41,847
              
              
              35,347
              
              
              41,084Total
                  net sales
              
              $
              80,322
              
              $
              80,610
              
              $
              82,622Long-lived
                  assets:Domestic
              
              $
              11,658
              
              $
              14,270
              
              $
              14,067International
              
              
              2,593
              
              
              2,606
              
              
              2,675Total
                  long-lived assets
              
              $
              14,251
              
              $
              16,876
              
              $
              16,742
 
 There
        was
        one customer that accounted for approximately 16% and 13% of net sales during
        fiscal 2005 and 2004, respectively. There was no customer that accounted
        for
        greater than 10% of net sales during fiscal 2003.
  No
        single
        country outside the United States accounted for more than 10% of net sales
        in
        2005 or 2004. During 2003, net sales to various customers in Canada accounted
        for approximately 11% of total net sales. Location of the customer is the
        basis
        for the categorization of net sales.
  ******
  53
 *Table
            of Contents*
  **SUPPLEMENTARY
        DATA**
  **QUARTERLY
        FINANCIAL INFORMATION** *(Unaudited)*
  The
        following is a summary of operating results by quarter for the years ended
        September 30, 2005 and 2004 (in thousands, except per share
        data):
  **2005
                  Quarter Ended**
              
              **December
                  31,**
              
              **March
                  31,**
              
              **June
                  30,**
              
              **September
                  30,**
              
              **Total**Net
                  sales
              
              $
              14,571
              
              $
              18,269
              
              $
              25,917
              
              $
              21,565
              
              $
              80,322Gross
                  profit
              
              
              5,305
              
              
              6,864
              
              
              11,087
              
              
              8,051
              
              
              31,307Net
                  earnings (loss)
              
              
              (442
              )
              
              62
              
              
              2,646
              
              
              425
              
              
              2,691Net
                  earnings (loss) per share—basic
              
              $
              (0.09
              )
              $
              0.01
              
              $
              0.52
              
              $
              0.08
              
              $
              0.53Net
                  earnings (loss) per share—diluted
              
              $
              (0.09
              )
              $
              0.01
              
              $
              0.51
              
              $
              0.08
              
              $
              0.52
 
 **2004
                  Quarter Ended**
              
              **December
                  31,**
              
              **March
                  31,**
              
              **June
                  30,**
              
              **September
                  30,**
              
              **Total**Net
                  sales
              
              $
              18,743
              
              $
              20,761
              
              $
              22,170
              
              $
              18,936
              
              $
              80,610Gross
                  profit
              
              
              7,056
              
              
              8,892
              
              
              10,216
              
              
              7,560
              
              
              33,723Net
                  earnings
              
              
              505
              
              
              1,138
              
              
              2,008
              
              
              34
              
              
              3,684Net
                  earnings per share—basic
              
              $
              0.10
              
              $
              0.23
              
              $
              0.40
              
              $
              0.01
              
              $
              0.74Net
                  earnings per share—diluted
              
              $
              0.10
              
              $
              0.22
              
              $
              0.38
              
              $
              0.01
              
              $
              0.71
  Note:
        Annual totals may not agree to the summarization of quarterly information
        due to
        insignificant rounding and the required calculation conventions. In addition,
        basic net earnings per share for 2004 may vary from previously reported amounts
        due to the adoption of EITF 03-6, *Participating
        Securities and the Two-Class Method,*  *under
        FASB Statement No. 128* ,
        during
        fiscal 2004.
 
 Quarterly
        information for the quarters ending March 31 and June 30 of fiscal 2005 has
        been
        restated due to the final determination of the appropriate accounting treatment
        for the termination of the lease of one of the operating facilities in Walla
        Walla that, when considered in connection with modification of a second lease,
        should not result in the reversal of a deferred rent obligation. Beginning
        in
        the second quarter of fiscal 2005 and continuing through the end of fiscal
        2005,
        the Company had been reducing the deferred rent obligation over the remaining
        term of the expiring lease. This determination resulted in reduced annual
        net
        earnings of $360,000 before income taxes. In addition, the Company reversed
        a
        gain related to redeemable warrants that expired in the fourth quarter of
        fiscal
        2005 to equity on the expiration date, which reduced annual net earnings
        by
        $127,000 before income taxes. Adjusted figures for the quarters and fiscal
        2005
        are as follows:
  **Quarter
                  ended****Fiscal
                  year 2005**
              
              **March
                  31,**
              
              **June
                  30,**
              
              **September
                  30,**
              
              **Year
                  ended****September
                  30,**Net
                  earnings - as adjusted
              
              $
              62
              
              $
              2,646
              
              $
              425
              
              $
              2,691Net
                  earnings - as reported
              
              
              167
              
              
              2,709
              
              
              569
              
              
              3,003Net
                  earnings per share (basic) - as adjusted
              
              $
              0.01
              
              $
              0.52
              
              $
              0.08
              
              $
              0.53Net
                  earnings per share (basic) - as reported
              
              $
              0.03
              
              $
              0.53
              
              $
              0.11
              
              $
              0.59Net
                  earnings per share (diluted) - as adjusted
              
              $
              0.01
              
              $
              0.51
              
              $
              0.08
              
              $
              0.52Net
                  earnings per share (diluted) - as reported
              
              $
              0.03
              
              $
              0.52
              
              $
              0.11
              
              $
              0.58
 
 *
        * * * *
        *
  54
 *Table
              of Contents*
 
 **ITEM
                  9.**
              **CHANGES
                  IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
                  DISCLOSURE.**
 
 None.
 
 **ITEM
                  9A.**
              **CONTROLS
                  AND PROCEDURES.**
 
 **Disclosure
        Controls and Procedures**
 
 The
        Company's Chief Executive Officer and Chief Financial Officer, after evaluating
        the effectiveness of the Company's "disclosure controls and procedures" (as
        defined in Securities Exchange Act Rules 13a-15(e) or 15d-15(e)) as of the
        end
        of the period covered by this report (the "Evaluation Date"), have concluded
        that, as of the Evaluation Date, the Company's disclosure controls and
        procedures were ineffective because of the material weakness discussed below.
        Disclosure controls and procedures are controls and other procedures designed
        to
        ensure that information required to be disclosed in the Company's reports
        filed
        or submitted under the Securities Exchange Act of 1934 is recorded, processed,
        summarized and reported within the time periods specified in the Securities
        and
        Exchange Commission's rules and forms and include, without limitation, controls
        and procedures designed to ensure that information the Company is required
        to
        disclose in such reports is accumulated and communicated to management,
        including the Company's Chief Executive Officer and Chief Financial Officer,
        as
        appropriate to allow timely decisions regarding required
        disclosure.
 
 The
        Company's management assessed the effectiveness of the Company's internal
        control over financial reporting, as defined in Securities Exchange Act
        Rule 13a-15(f), as of September 30, 2005 and this assessment
        identified the following control deficiencies that in the aggregate constitute
        a
        material weakness in the Company's internal control over financial
        reporting:
 
 1.
              Deficiencies
                  existed with respect to the documentation of accounting guidance
                  applicable to significant non-recurring events and transactions
                  which,
                  when considered in the aggregate, constitute a material weakness
                  over
                  financial reporting. These deficiencies included failures to prepare
                  concurrent documentation of the application of generally accepted
                  accounting principles to significant non-recurring transactions
                  during the
                  year as related to, for example, the accounting for lease terminations
                  and
                  the expiration of redeemable
                  warrants.
 
 2.
              Deficiencies
                  existed with respect to reconciliation procedures and policies
                  related to
                  the Company's monthly closing process. These deficiencies included
                  deficiencies in areas related to, among others, accounts payable
                  cut-off
                  procedures, accounting estimates and presentation or disclosure
                  matters.
 
 In
        making
        its assessment of internal control over financial reporting, management used
        the
        criteria issued by the Committee of Sponsoring Organizations of the Treadway
        Commission (COSO) in Internal Control—Integrated Framework. Because of the
        material weakness described in the preceding paragraphs, management believes
        that, as of September 30, 2005, the Company's internal control over
        financial reporting was not effective based on those criteria.
 
 In
        light
        of the material weakness, the Company performed additional manual controls,
        procedures and analyses and other pre- and post-closing procedures designed
        to
        ensure that the Company's consolidated financial statements are presented
        fairly
        in all material respects in accordance with generally accepted accounting
        principles. The Company relied on increased monitoring and review to compensate
        for the weakness noted above in the preventative and detective controls.
        Accordingly, management believes that the consolidated financial statements
        included in this report fairly present in all material respects the Company's
        financial position, results of operations and cash flows for the periods
        presented.
 
 Since
        the
        discovery of the material weakness in internal controls described above,
        management is strengthening the Company's internal controls over financial
        reporting and is taking various actions to improve the Company's internal
        controls including, but not limited to, the following:
 
 Additional
        Personnel .
        The
        Company is actively seeking to hire additional qualified finance and accounting
        staff with significant depth and expertise to supplement existing personnel,
        including a corporate controller.
  55
 *Table
            of Contents*
  Implementation
        of Closing Controls and Procedures .
        Concurrently with the hiring of additional staff, the Company is implementing
        additional procedures and levels of review to improve reconciliation procedures
        and policies and generally strengthen the closing process.
 
 The
        Company has assigned a high priority to remediating the material weakness
        in the
        Company's internal control over financial reporting.
 
 **Changes
        in Control Over Financial Reporting**
 
 There
        were no changes in the Company's internal control over financial reporting
        during the quarter ended September 30, 2005 that materially affected, or
        are reasonably likely to materially affect, the Company's internal control
        over
        financial reporting. Subsequent to the end of the quarter, after discovering
        a
        material weakness in internal controls over financial reporting in the areas
        of
        documentation and reconciliation procedures, the Company plans to make changes
        in its internal controls over financial reporting during the first quarter
        of
        fiscal 2006 ending December 31, 2005 in order to address the material
        weakness identified. The Company plans to take further remediation steps
        by the
        end of the second quarter of fiscal 2006 to confirm that effective controls
        are
        in place and continue to operate as designed.
 
 
 **ITEM
                  9B.**
              **OTHER
                  INFORMATION.**
 
 None.
 **PART
        III**
 
 **ITEM
                  10.**
              **DIRECTORS
                  AND EXECUTIVE OFFICERS OF THE
                  REGISTRANT.**
 
 There
        is
        hereby incorporated by reference the information under the captions "Election
        of
        Directors" and “Section 16(a) Beneficial Ownership Reporting Compliance” in the
        Company's definitive Proxy Statement to be filed pursuant to Regulation 14A,
        which Proxy Statement is anticipated to be filed with the Securities and
        Exchange Commission within 120 days after the end of Registrant's fiscal
        year
        ended September 30, 2005.
 
 **ITEM
                  11.**
              **EXECUTIVE
                  COMPENSATION.**
 
 There
        is
        hereby incorporated by reference the information under the caption "Executive
        Compensation" in the Company's definitive Proxy Statement to be filed pursuant
        to Regulation 14A, which Proxy Statement is anticipated to be filed with
        the
        Securities and Exchange Commission within 120 days after the end of Registrant's
        fiscal year ended September 30, 2005.
 
 **ITEM
                  12.**
              **SECURITY
                  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
                  STOCKHOLDER MATTERS.**
 
 There
        is
        hereby incorporated by reference the information under the caption "Principal
        Shareholders" in the Company's definitive Proxy Statement to be filed pursuant
        to Regulation 14A, which Proxy Statement is anticipated to be filed with
        the
        Securities and Exchange Commission within 120 days after the end of Registrant's
        fiscal year ended September 30, 2005.
  56
 *Table
            of Contents*
  **Equity
        Compensation Plan Information**
 
 The
        following table provides information as of September 30, 2005 with respect
        to
        the shares of the Company’s Common Stock that may be issued under the Company’s
        existing equity compensation plans.
 
 A
              
              B
              
              CPlan
                  Category
              
              Number
                  of Securities to be Issued upon Exercise of Outstanding
                  Options
              
              Weighted
                  Average Exercise Price of Outstanding Options
              
              Number
                  of Securities Remaining Available for Future Issuance Under Equity
                  Compensation Plans (Excluding Securities Reflected in Column
                  A)Equity
                  Compensation Plans
                Approved
                  by ShareholdersRestated
                  Employees’ Stock Incentive Plan
              
              
              531,289
              
              $
              11.67
              
              
              198,781(3)1996
                  Employee Stock Purchase Plan
              
              
              (1)
              
              
              (1)
              
              
              413,654Equity
                  Compensation Plans Not
                Approved
                  by Shareholders(2)
              
              
              -
              
              
              -
              
              
              -Total
              
              
              531,289
              
              $
              11.67
              
              
              612,435
 
 (1)
              We
                  are unable to ascertain with specificity the number of securities
                  to be
                  issued under the 1996 Employee Stock Purchase Plan or the weighted
                  average
                  purchase price of the shares that may be purchased under the plan.
                  Under
                  the plan, eligible employees may make contributions to the plan
                  of not
                  more than five percent of the participant’s compensation during each pay
                  period in the offering period. The offering periods commence quarterly
                  beginning October 1, January 1, April 1, and July 1 of each year.
                  Purchases are made on the last business day of each offering period
                  at a
                  purchase price per share equal to 85% of the fair market value
                  of the
                  Common Stock on the purchase date. There are 500,000 shares of
                  Common
                  Stock reserved under the plan.
 (2)
              There
                  are no Equity Compensation Plans that have not been approved by
                  Shareholders.
 (3)
              The
                  number of securities remaining may be used for issuance of either
                  options
                  or restricted stock.
 
 
 **ITEM
                  13.**
              **CERTAIN
                  RELATIONSHIPS AND RELATED
                  TRANSACTIONS.**
 
 On
        July
        14, 2003, with the approval of its board of directors, the Company entered
        into
        a Consulting Agreement with former President and CEO, Thomas C. Madsen, to
        be in
        effect from January 1, 2004 through December 31, 2006. The agreement provides
        for a monthly fee of $6,250, wherein Mr. Madsen, as an independent contractor,
        will provide certain services to the Company. Mr. Madsen is responsible for
        all
        attributable taxes. The agreement contains a non-compete provision whereby
        Mr.
        Madsen will not solicit for hire or assist others in the solicitation for
        hire
        of any employees of the Company, or engage in any activity, whether directly
        or
        through or on behalf of one or more entities or other persons, that competes
        directly or indirectly with any product or service provided by the Company
        to
        its customers in any geographic region then served by the Company.
 
 **ITEM
                  14.**
              **PRINCIPAL
                  ACCOUNTANT FEES AND
                  SERVICES.**
 
 There
        is
        hereby incorporated by reference the information under the caption “Audit
        Committee Report and Other Related Matters” in the Company's definitive Proxy
        Statement to be filed pursuant to Regulation 14A, which Proxy Statement is
        anticipated to be filed with the Securities and Exchange Commission within
        120
        days after the end of Registrant's fiscal year ended September 30,
        2005.
  57
 *Table
            of Contents*
  **PART
        IV**
  **ITEM
                    15.**
                **EXHIBITS
                    AND FINANCIAL STATEMENT
                    SCHEDULES.**
 PAGE
  **(a)**
              **The
                  following documents are filed as part of this
                  report:**
 
 **1.**
              **Financial
                  Statements:**
 
 Reference
                  is made to Part II, Item 8, for a listing of required financial
                  statements
                  filed with this report
              29
 
 **2.**
              **Financial
                  Statement Schedules:**
 
 Financial
        statement schedules are omitted because they are not applicable or the required
        information is included in the accompanying consolidated financial statements
        or
        notes thereto.
 
 **3.**
              **Exhibits:**
 
 (3)
              Articles
                  of Incorporation and Bylaws
 
 (3.1)
              Restated
                  Articles of Incorporation (filed as Exhibit 3.1 to the Registration
                  Statement on Form S-1 (Registration No. 33-63194) filed with the
                  Securities and Exchange Commission on May 24, 1993 and incorporated
                  herein
                  by reference)
 (3.2)
              Registrant's
                  Restated Bylaws dated February 7, 2001 (filed as Exhibit 3.2 to
                  the Form
                  10-Q filed with the Securities and Exchange Commission on May 15,
                  2002 and
                  incorporated herein by reference)
 
 (4)
              Instruments
                  defining the rights of security holders, including
                  indentures
 
 (4.1)
              Registrant’s
                  First Amended and Restated Rights Agreement, dated as of April
                  1, 2001,
                  between the Registrant and American Stock Transfer & Trust Company
                  (filed as Exhibit 10.1 to the Form 10-Q filed with the Securities
                  and
                  Exchange Commission on August 13, 2004 and incorporated herein
                  by
                  reference)
 
 (10)
              Material
                  contracts
 
 (10.1)
              Construction
                  and Lease Agreement dated October 17, 1989 between the Port of
                  Walla Walla
                  and Registrant (filed as Exhibit 10.1 to the Registration Statement
                  on
                  Form S-1 (Registration No. 33-63194) filed with the Securities
                  and
                  Exchange Commission on May 24, 1993 and incorporated herein by
                  reference)
 (10.2)*
              Registrant's
                  1989 Employees' Stock Option Plan, as amended (filed as Exhibit
                  10.5 to
                  the Registration Statement on Form S-1 (Registration No. 33-63194)
                  filed
                  with the Securities and Exchange Commission on May 24, 1993 and
                  incorporated herein by reference)
 (10.3)*
              Registrant's
                  401(k) Profit Sharing Plan dated May 11, 1992 (filed as Exhibit
                  10.6 to
                  Amendment No. 1 to Form S-1 (Registration No. 33-63194) filed with
                  the
                  Securities and Exchange Commission on May 24, 1993 and incorporated
                  herein
                  by reference)
 (10.4)*
              Registrant's
                  Restated 1989 Employees' Stock Option Plan, as amended (filed as
                  Exhibit
                  10.1 to the Form 10-Q filed with the Securities and Exchange Commission
                  on
                  May 12, 1995 and incorporated herein by reference)
 (10.5)*
              Registrant's
                  1996 Employees' Stock Option Plan (filed as Exhibit 10.1 to the
                  Form 10-Q
                  filed with the Securities and Exchange Commission on May 2, 1996
                  and
                  incorporated herein by reference)
  58
 *Table
            of Contents*
  (10.6)*
              Registrant's
                  1996 Employee Stock Purchase Plan (filed as Exhibit 10.2 to the
                  Form 10-Q
                  filed with the Securities and Exchange Commission on May 2, 1996
                  and
                  incorporated herein by reference)
 (10.7)
              Lease
                  Agreement dated April 18, 1996 between the Port of Walla Walla
                  and
                  Registrant (filed as Exhibit 10.1 to the Form 10-Q filed with the
                  Securities and Exchange Commission on August 7, 1996 and incorporated
                  herein by reference)
 (10.8)*
              Registrant’s
                  Restated Employees’ Stock Option Plan (1996 Plan as amended through July
                  12, 2000) (filed as Exhibit 10.13 to the Form 10-K filed with the
                  Securities and Exchange Commission on December 19, 2002 and incorporated
                  herein by reference)
 (10.9)*
              Registrant’s
                  Profit Sharing and 401(k) Plan 2001 Restatement (filed as Exhibit
                  10.14 to
                  the Form 10-K filed with the Securities and Exchange Commission
                  on
                  December 19, 2002 and incorporated herein by
                  reference)
 (10.10)*
              Registrant’s
                  Profit Sharing and 401(k) Plan 2001 Restatement, Amendment No.
                  1 (filed as
                  Exhibit 10.15 to the Form 10-K filed with the Securities and Exchange
                  Commission on December 19, 2002 and incorporated herein by
                  reference)
 (10.11)*
              Registrant’s
                  Profit Sharing and 401(k) Plan 2001 Restatement, Amendment No.
                  2 (filed as
                  Exhibit 10.16 to the Form 10-K filed with the Securities and Exchange
                  Commission on December 19, 2002 and incorporated herein by
                  reference)
 (10.12)*
              Registrant’s
                  Profit Sharing and 401(k) Plan 2001 Restatement, Amendment No.
                  3 (filed as
                  Exhibit 10.17 to the Form 10-K filed with the Securities and Exchange
                  Commission on December 19, 2002 and incorporated herein by
                  reference)
 (10.13)
              Loan
                  Agreement dated August 9, 2002 between Registrant and Banner Bank
                  (filed
                  as Exhibit 10.18 to the Form 10-K filed with the Securities and
                  Exchange
                  Commission on December 19, 2002 and incorporated herein by
                  reference)
 (10.14)
              Revolving
                  Note dated August 9, 2002 between Registrant and Banner Bank (filed
                  as
                  Exhibit 10.19 to the Form 10-K filed with the Securities and Exchange
                  Commission on December 19, 2002 and incorporated herein by reference)
 (10.15)
              Term
                  Note dated August 9, 2002 between Registrant and Banner Bank (filed
                  as
                  Exhibit 10.20 to the Form 10-K filed with the Securities and Exchange
                  Commission on December 19, 2002 and incorporated herein by
                  reference)
 (10.16)
              Reducing
                  Non-Revolving Note dated August 9, 2002 between Registrant and
                  Banner Bank
                  (filed as Exhibit 10.21 to the Form 10-K filed with the Securities
                  and
                  Exchange Commission on December 19, 2002 and incorporated herein
                  by
                  reference)
 (10.17)
              Credit
                  Agreement dated August 8, 2002 between Suplusco Holding B.V., Key
                  Technology B.V. and ABN AMRO Bank N.V. (filed as Exhibit 10.22
                  to the Form
                  10-Q filed with the Securities and Exchange Commission on February
                  14,
                  2003 and incorporated herein by
                  reference)
 (10.18)
              Amendment
                  to Loan Documents dated December 11, 2002 between Registrant and
                  Banner
                  Bank (filed as Exhibit 10.23 to the Form 10-Q filed with the Securities
                  and Exchange Commission on February 14, 2003 and incorporated herein
                  by
                  reference)
 (10.19)
              Addendum
                  No. 1 to Construction and Lease Agreement executed December 31,
                  2002
                  between the Port of Walla Walla and Registrant (filed as Exhibit
                  10.24 to
                  the Form 10-Q filed with the Securities and Exchange Commission
                  on
                  February 14, 2003 and incorporated herein by
                  reference)
 (10.20)
              Amendment
                  to Loan Documents dated July 31, 2003 between Registrant and Banner
                  Bank
                  (filed as Exhibit 10.20 to the Form 10-K filed with the Securities
                  and
                  Exchange Commission on December 19, 2003 and incorporated herein
                  by
                  reference)
 (10.21)*
              Registrant’s
                  2003 Restated Employees’ Stock Incentive Plan, (1996 Plan as amended and
                  restated as of December 15, 2003) (filed as Exhibit 10.1 to Form
                  10-Q
                  filed with the Securities and Exchange Commission on May 14, 2004
                  and
                  incorporated herein by reference)
  59
 *Table
            of Contents*
  (10.22)
              Second
                  Amendment to Loan Agreement dated March 31, 2005 between Registrant
                  and
                  Banner Bank (filed as Exhibit 10.22 to the Form 10-Q filed with
                  the
                  Securities and Exchange Commission on May 13, 2005 and incorporated
                  herein
                  by reference)
 (10.23)
              Addendum
                  No. 2 to Construction and Lease Agreement executed June 8, 2005
                  between
                  the Port of Walla Walla and Registrant (filed as Exhibit 10.1 to
                  the Form
                  8-K filed with the Securities and Exchange Commission on June 13,
                  2005 and
                  incorporated herein by reference)
 (10.24)
              Amended
                  and Restated Loan Agreement dated June 6, 2005 between Registrant
                  and
                  Banner Bank (filed as Exhibit 10.1 to the Form 8-K filed with the
                  Securities and Exchange Commission on June 20, 2005 and incorporated
                  herein by reference)
 (10.25)
              Amended
                  and Restated Revolving Note dated June 6, 2005 between Registrant
                  and
                  Banner Bank (filed as Exhibit 10.2 to the Form 8-K filed with the
                  Securities and Exchange Commission on June 20, 2005 and incorporated
                  herein by reference)
 (10.26)*
              Form
                  of Restricted Stock Bonus Agreement (Continued Employment Vesting)
                  (filed
                  as Exhibit 10.1 to the Form 8-K filed with the Securities and Exchange
                  Commission on September 12, 2005 and incorporated herein by
                  reference)
 (10.27)*
              Form
                  of Restricted Stock Bonus Agreement (Performance Vesting) (filed
                  as
                  Exhibit 10.2 to the Form 8-K filed with the Securities and Exchange
                  Commission on September 12, 2005 and incorporated herein by
                  reference)
 (14)
              Registrant’s
                  Code of Business Conduct and Ethics, dated August 12, 2004 (filed
                  as
                  Exhibit 99.1 to the Form 8-K filed with the Securities and Exchange
                  Commission on August 18, 2004 and incorporated herein by
                  reference)
 (21)
              List
                  of Subsidiaries
 (23.1)
              Consent
                  of Independent Registered Public Accounting Firm from Grant Thornton
                  LLP
 (23.2)
              Consent
                  of Independent Registered Public Accounting Firm from Deloitte
&
                  Touche LLP
 (31.1)
              Certification
                  pursuant to Section 302 of the Sarbanes-Oxley Act of
                  2002
 (31.2)
              Certification
                  pursuant to Section 302 of the Sarbanes-Oxley Act of
                  2002
 (32.1)
              Certification
                  pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section
                  906 of
                  the Sarbanes-Oxley Act of 2002
 (32.2)
              Certification
                  pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section
                  906 of
                  the Sarbanes-Oxley Act of 2002
 _______________
 *
              Management
                  contract or compensatory plan or
                  arrangement.
  60
 *Table
            of Contents*
  ***SIGNATURES***
 
 Pursuant
        to the requirements of Section 13 or 15(d) of the Securities Exchange Act
        of
        1934, the Registrant has duly caused this report to be signed on its behalf
        by
        the undersigned, thereunto duly authorized.
  KEY
                TECHNOLOGY, INC.By:
              /s/
                  Kirk W. MortonKirk
                  W. MortonPresident
                  and Chief Executive Officer
 
 By:
              /s/
                  Ronald W. BurgessRonald
                  W. BurgessSenior
                  Vice President and Chief Financial Officer
                (Principal
                  Financial and Accounting Officer)
 
 December
        22, 2005
 
 
 Pursuant
        to the requirements of the Securities Exchange Act of 1934, this report has
        been
        signed by the following persons on behalf of the Registrant and in the
        capacities and on the dates indicated.
  /s/
                  Thomas C. Madsen
              
              December
                  22, 2005Thomas
                  C. Madsen, Chairman/s/
                  John E. Pelo
              
              December
                  22, 2005John
                  E. Pelo, Director/s/
                  Michael L. Shannon
              
              December
                  22, 2005Michael
                  L. Shannon, Director/s/
                  Charles H. Stonecipher
              
              December
                  22, 2005Charles
                  H. Stonecipher, Director/s/
                  Donald A. Washburn
              
              December
                  22, 2005Donald
                  A. Washburn, Director/s/
                  Kirk W. Morton
              
              December
                  22, 2005Kirk
                  W. Morton, Director, President and Chief Executive Officer/s/
                  Ronald W. Burgess
              
              December
                  22, 2005Ronald
                  W. Burgess, Senior Vice President and Chief Financial
                  Officer(Principal
                  Financial and Accounting Officer)
  61
 *Table
            of Contents*
  KEY
        TECHNOLOGY, INC.
  **FORM
        10-K**
 **EXHIBIT
        INDEX**
 
 EXHIBITNUMBER21.1
              
              List
                  of Subsidiaries23.1
              
              Consent
                  of Independent Registered Public Accounting Firms from Grant Thornton
                  LLP23.2
              
              Consent
                  of Independent Registered Public Accounting Firms from Deloitte
&
                  Touche LLP31.1
              
              Certification
                  pursuant to Section 302 of the Sarbanes-Oxley Act of
                  200231.2
              
              Certification
                  pursuant to Section 302 of the Sarbanes-Oxley Act of
                  200232.1
              
              Certification
                  pursuant to 18 U.S. C. Section 1350 as adopted pursuant to Section
                  906 of
                  the Sarbanes-Oxley Act of 200232.2
              
              Certification
                  pursuant to 18 U.S. C. Section 1350 as adopted pursuant to Section
                  906 of
                  the Sarbanes-Oxley Act of
                  2002






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