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U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549



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FORM 10-KSB



(Mark One)

|x |  | Annual report under Section 13 or 15(d) of the Securities Exchange Act of 1934
|- |  | ------------------------------------------------------------------------------

For the Fiscal Year Ended September 30, 2003



| ̈ |  | Transition report under Section 13 or 15(d) of the Securities Exchange Act of 1934
|- |  | ----------------------------------------------------------------------------------

For the transitional period from  to



Commission File No. 0-029024



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BENTHOS, INC.

(Name of
Small Business Issuer in Its Charter)



|Massachusetts                                                  |  | 04-2381876                          
|-------------------------------------------------------------- |  | ------------------------------------
|(State or Other Jurisdiction of Incorporation or Organization) |  | (I.R.S. Employer Identification No.)
|                                                              
|49 Edgerton Drive, No. Falmouth, Massachusetts    02556       
|(Address of Principal Executive Offices)    (Zip Code)        



508-563-1000

(Issuers Telephone Number, Including Area Code)



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Securities registered under Section
12(b) of the Exchange Act:



|Title of Each Class |  | Name of Each Exchange on Which Registered
|------------------- |  | -----------------------------------------
|None                |  |                                          



Securities registered under
Section 12(g) of the Exchange Act:

Common Stock, $.062/3par value



Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the past 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   ̈



Check if there is no
disclosure of delinquent filers in response to item 405 of Regulation S-B contained in this form, and no disclosure will 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-KSB or any amendment to this Form 10-KSB x



The registrant had total operating revenues of $17,024,000 for its most recent fiscal
year ended September 30, 2003.



The aggregate market value of the Common
Stock held by non-affiliates of the registrant as of December 16, 2003, based on the closing price for the stock on such date as reported on the Nasdaq SmallCap Market of $5.10 per share was $3,158,624. Shares of Common Stock held by each officer
and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for
other purposes.



APPLICABLE ONLY TO CORPORATE REGISTRANTS



State the number of shares outstanding of each of the issuers
classes of common equity, as of the latest practicable date:



1,383,102 Shares of Common Stock, as of December 16, 2003



DOCUMENTS INCORPORATED BY REFERENCE



See Exhibit Index



Transitional Small Business Issuer Format (check
one):    Yes   ̈    No  x



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This report contains forward-looking statements that involve certain risks and uncertainties. See Item 6,
Managements Discussion and AnalysisForward-Looking Information herein. Actual results and events may differ from those discussed in the forward-looking statements.



PART I



ITEM 1.    DESCRIPTION OF BUSINESS



Benthos, Inc. (the Company) was founded in 1962 to act as a manufacturer of oceanographic products. It was incorporated as
a Massachusetts corporation in 1965. Over the last 41 years, the Company has developed and acquired new technology and products. Currently, the Company consists of two distinct divisions: the Undersea Systems Division and the Package Inspection
Systems Division.



Historically, the Company has focused its efforts on
the Undersea Systems marketplace with particular emphasis placed on the military and government markets. Early in the 1990s, funding for these markets declined and the Companys sales to these markets suffered a corresponding reduction.
As a result, the Company shifted its priorities to business development efforts in commercial markets. These markets include the geophysical industry, where the Companys hydrophone products are used in the search for oil and gas deposits
offshore, as well as the scientific research and environmental markets. Also as a result of these efforts, the Companys Package Inspection Systems Division was formed in 1971 using aspects of acoustic technology (originally developed for
oceanographic products) and applied to the testing of cans, bottles and other containers for the purpose of finding leaks and other package defects. A series of new products was introduced and these products gained rapid acceptance into major market
segments such as the beer and beverage markets. The Company plans to continue its emphasis on these markets in the future.



Undersea Systems Division



The Companys Undersea Systems Division designs, develops, manufactures and sells products and services used in oceanographic and underwater environments. The
markets for these products include oceanographic research, oil and gas exploration and production, hydrographic survey, and underwater relocation, marking and navigation. The product range includes acoustic transponders used for location marking and
navigation, acoustic release devices used for recovering instrumentation packages from the depths of the ocean, hydrophones used for geophysical exploration and sound detection, remotely operated vehicles for inspection and survey tasks, glass
flotation products used to house instruments and to provide buoyancy, side scan sonars, swath bathymetry and sub bottom profilers used for seabed imaging, acoustic modems used to transmit digital data underwater, and acoustic pingers used to locate
and mark objects lost underwater such as aircraft flight data and voice recorders. The Companys undersea products are marketed under the trade name Benthos.



Package Inspection Systems Division



The Companys Package Inspection Systems Division designs, develops, manufactures and sells systems used to inspect the integrity of containers in the food,
pharmaceutical, dairy, chemical, personal care, beer, and both alcoholic and non-alcoholic beverage industries. The customers for these systems include manufacturers of products packaged in glass bottles, aluminum and steel cans, glass jars, and
flexible plastic containers. These systems are marketed under the trade name TapTone. TapTone systems integrate various sensor technologies with digital signal processing techniques in order to inspect containers for leakage, seal
integrity, low or high pressure or vacuum, fill level, and similar packaging defects. TapTone systems may be used on-line as continuous inspection systems that operate at production speeds or as off-line inspection systems to periodically validate
package integrity.



1



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1.    Principal Products



Undersea Systems



The Companys undersea products and services are divided into three distinct groups as follows:



A.  Underwater Acoustics



1.  Acoustic Devices



The Acoustics product group includes transponders, acoustic releases and companion deck control systems, and altimeters. Transponders are used to transmit and
receive acoustic signals underwater for the purposes of determining location, navigation, or sending and receiving data. These products are used for scientific research, salvage and ship positioning operations. Both expendable and recoverable
products are manufactured. The transponder line includes low cost versions that transmit a limited signal selection in response to a command received, as well as more sophisticated versions that can be programmed to transmit a wide variety of
functions in response to received commands. Transponders are monitored by and communicate with companion deck units that are typically located on board a ship.



Acoustic releases are used to release underwater anchored products, allowing them to float to the surface, in response to an acoustic command signal transmitted
from the surface. The acoustic release product line includes both deep water (up to 12,000 meters), heavy duty, releases as well as shallow water (up to 600 meters), light duty, low cost releases. Releases may be operated with companion deck control
units.



Altimeters are used to determine the distance from the seabed to
an object or vehicle in the water column.



2.  Locator
Pingers and Transponders



Locator pingers are small acoustic
transmitters designed to operate in water to produce a steady acoustic signal. Using a suitable receiver, an underwater object equipped with a locator pinger may be found by listening for the pingers pressure-emitted signal. Locator pingers
are most commonly installed on commercial and military flight data and voice recorders (black boxes) but may also be used on other objects such as torpedoes, remotely operated vehicles and shipping containers.



Locator transponders are similar to pingers, which enable a diver to determine
distance, in addition to direction, as an added feature. Customers for transponders primarily include the military and scientific communities.



3.  Acoustic Modems



Acoustic modems are used to send and receive digital data underwater using sound as the transmitting signal. The Company manufactures several different
configurations of modems dependent on the specific requirements of the applications. Underwater acoustic modems utilize a sending and/or receiving transducer, suitable digital electronics for coding and decoding the acoustic signals and proprietary
software algorithms to enable the modems to work in the underwater environment.



4.  Contract Research and Engineering Services



The Company periodically performs research under contract and custom engineering design for both commercial and government agencies. Generally these contract research and development activities support the Companys primary product
development efforts and are used to offset a portion of the costs associated with advanced research and development.



2



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B.  Geophysical Exploration Equipment



1.  Hydrophones



Hydrophones are underwater sensors designed to produce an output signal in response to
an acoustic pressure signal. They can be thought of as underwater microphones. The Companys hydrophone products are typically used in the offshore oil and gas exploration industry, where they listen to acoustic sound waves generated by the
reflections of an acoustic signal as it bounces off of the various geological layers beneath the ocean floor. These data are used to generate information about the geological structure beneath the ocean as a means of locating promising oil and gas
exploration sites. The Companys hydrophone product line is also used in military applications to listen for and detect submarines and other vessels under and on the surface of the ocean. Hydrophones may also be sold to research institutions
for various applications such as listening to marine animals.



The
Companys hydrophone product line includes sophisticated versions that offer high sensitivity and can operate at great depth without significant variation in response, as well as low cost hydrophones for the seismic research industry that are
produced in high production volumes. The Companys hydrophone products may be used with companion amplifiers that convert the electrical signals to usable formats and they may be integrated into arrays, which are groupings of hydrophones
assembled together in long tubes for the purpose of added acoustic sensitivity and for listening to acoustic signals over a long distance. The Company holds a U.S. patent on a pressure-sensitive switch that enables hydrophones to be sold in
compliance with U.S. export control regulations.



2.  Geophysical Systems



The geophysical
systems product line has two main components:



Side scan sonar systems
consist of an underwater towed body, commonly referred to as a towfish and an electronic control and display package. The towfish emits an acoustic signal while it is being towed and then listens for the signals reflections that
are generated by objects on the sea floor. These echoes are then manipulated electronically and by software and used to generate an image of the sea floor. Side scan sonars are commonly used to conduct underwater surveys in order to plan the routing
of pipes and cables, locate shipwrecks and similar objects and determine the overall structure and nature of the ocean bottom. The Company has recently added swath bathymetry to the side scan sonar enabling a topographic representation of the data
in a three (3) dimensional view.



Sub bottom profilers utilize a towfish
or hull-mounted transducer array and topside electronic control and display devices. The towfish emits acoustic signals that penetrate the surface of the sea floor. Some of the acoustic energy is reflected back and received by the towfish. These
reflected signals are processed electronically and by software and are used to generate a visual image of the structure beneath the sea floor. Sub bottom profilers are used to locate buried objects such as shipwrecks and shallow mineral deposits and
to aid in hydrographic surveys by providing information about the seabed structure.



C.  Other



This category of
products in the Undersea Systems Division includes:



1.  Remotely Operated Vehicles (ROVs)



ROVs
are unmanned underwater vehicles that are controlled from the surface by a skilled operator. The Companys ROV product line includes a number of specialized designs that are aimed at specific markets. These markets include the research sector,
where ROVs may be used as a camera delivery system for visual documentation and inspection, and the government sector (military, state and local municipalities), where they may be used for remote inspection and to retrieve or deliver objects. The
Companys ROV products are also used for dam and hydroelectric plant inspections as well as sewer and pipeline inspections. ROV systems have also been used by the entertainment industry.



3



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2.  Glass Flotation



The Company manufactures a line of glass spheres that are used to provide buoyancy to underwater products and systems and may be used
to house underwater instruments and electronics, such as transponders. Glass spheres are offered in three sizes depending on the individual requirements of buoyancy and/or housing size. The Company also customizes its glass spheres for individual
customer requirements by providing various penetrations, machined surfaces and electrical connectors. The Company pressure tests all of its glass sphere products in order to insure successful operation at desired depths. Glass spheres are normally
provided with companion plastic hard hats that allow for protection of the glass from breakage and for safe transport.



Package Inspection Systems



The Companys package inspection systems are used to inspect glass bottles, aluminum and steel cans, glass jars and flexible plastic containers for a variety
of defects. The TapTone product line includes the following:



a.  TapTone 100



The TapTone 100 system is a
low cost universal inspection system that uses a proximity sensor to measure the deflection of the metal lid on a container. These data are used to determine if the container meets preset quality acceptance criteria based upon lid deflection and its
correlation with the pressure or vacuum inside the container. TapTone 100 systems are normally used to inspect steel and aluminum cans. TapTone 100 systems are on-line, high speed inspection systems designed to test 100% of the containers on a
production line, rejecting containers that are determined to be defective. TapTone 100 systems are self-contained inspection systems and may be fitted with a variety of optional sensors for additional inspections such as label presence, cocked cap
and missing cap.



b.  TapTone PBI-100



The PBI-100 utilizes a side transport conveyor to apply a uniform force to a
container. During transport, the container is monitored by one or more sensors. The sensors output is analyzed using algorithms developed by the Company to determine if the package has a detectable defect. The PBI-100 is used to test package
integrity on products such as household and industrial chemicals, pharmaceuticals packaged in flexible packages, personal health care products and food and beverages packaged in flexible packages.



c.  TapTone 300



The TapTone 300 is a fill level device that expands on TapTones X-ray based
inspection technology and offers underfill and overfill detection on cans, bottles, and jars. This system accommodates up to six optional inspection inputs for cocked cap, missing cap, missing foil seal, missing label, missing tamper bands, and
other optional inputs selected by the customer. The TapTone 300 is a replacement for the Companys previous Ray TRAK product.



d.  TapTone 500



The TapTone 500 is a universal inspection controller that replaces earlier products such as the TapTone II and the Turbo Tracker. The TapTone 500 offers several
improvements over earlier products and is designed to accept a wide variety of inspection sensors as inputs.



2.    Distribution and Marketing Methods



The Undersea Systems Division and the Package Inspection Systems Division market their products through an international network of independent sales representatives and distributors. The Package



4



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Inspection Systems Division also utilizes direct salespersons for certain territories in the United States. Sales representatives and distributors are located in North
America, South America, Europe, the Far East, Africa and Australia. Domestic and international customers may also order the Companys products directly from its headquarters in Massachusetts. Both divisions of the Company participate in a
number of trade shows and exhibitions around the world. The Company also maintains an internal staff of trained sales and marketing personnel with experience and expertise in the markets served by the Company.



3.    New Products



During fiscal year 2003, the Company introduced three principal new products. These
are:



| |  |  | The PBI 100-L, which is based on the inspection principle of the PBI-100. The PBI 100-L was introduced to address the leak detection requirements of the packaging industry where height
adjustment is not required due to dedicated production lines.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The TapTone 500 Force Sensor, which was launched to address the leak detection and low pressure inspection requirements of the food and beverage markets where liquid nitrogen (LN2) is used to
stabilize containers for extended shelf life and stability during the transportation and storage cycle. The sensor integrates into new and existing TapTone 500 Universal Controllers.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The ADSL Communications Data Link (CL-160), which is a system that provides the customer with the means for transmitting data via a coaxial cable with a 10-Base-T Ethernet connection
point-to-point. The maximum raw data rates of this system are dependent on the length of the cable. For a 6,000 meter coaxial cable, the data rate is 6 Megabits per second (Mbps.). The CL-160 may be interfaced to any surface and subsea system that
utilizes Ethernet for its input/output. The CL-160 comes complete with the surface and subsea components necessary to interface the Ethernet data and power requirements of the system to be integrated.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



4.    Competition



Undersea Systems Division



The Company competes with a variety of companies in various product markets. The
Companys policy is to compete based upon technical superiority and quality and to differentiate itself through strong post-sale support. The Company also has a policy of pursuing patent protection for its products when possible. The Company
also competes by providing customers with well trained field service and application engineering support.



In some markets, such as glass flotation and geophysical hydrophones, the Company is one of the larger participants in the market. In other markets, such as ROV
systems, the Company is a minor participant and competes with larger, well established companies that have significantly more resources than the Company.



A partial listing of competitors for the various markets in which the Company competes appears below:



|Product Market      |  | Competitor(s)                                                                                   
|------------------- |  | ------------------------------------------------------------------------------------------------
|Hydrophones         |  | Sensor Technology Limited; Teledyne Brown Engineering; Input/Output, Inc.                       
|Glass Flotation     |  | Jena Glass Works division of Schott Glass Technologies, Inc.; McLane Research Laboratories, Inc.
|ROV Systems         |  | Hydrovision Ltd.; SeaEye Marine Ltd.; Deep Ocean Engineering, Inc.                              
|Acoustic Devices    |  | InterOcean Systems, Inc.; Edgetech, Inc.; Sonardyne International Ltd.                          
|Geophysical Systems |  | GeoAcoustics Ltd.; Klein Associates, Inc.; Edgetech, Inc.                                       
|Locator Pingers     |  | Dukane Corporation                                                                              
|Acoustic Modems     |  | LinkQuest, Inc.; Orca Instrumentation                                                           



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Package Inspection Systems Division



The Package Inspection Systems Division competes with a number of domestic and international competitors. At least two of these
companies are larger than the Company and offer a broader range of products. All of these competitors offer some products that compete with certain models offered by the Company. One German competitor and one U.S. competitor compete with the Company
in the bottled beer leak detection market with products substantially similar to those produced by the Company.



5.    Sources and Availability of Raw Materials



The products of both divisions generally utilize mechanical and electrical components that are readily available from a wide variety of domestic and foreign
vendors. Some components are specially designed for specific products and are purchased from a single vendor. A ceramic component that is used in the geophysical hydrophone product is purchased from a single vendor, CTS Wireless Components, Inc.,
although the Company believes that there are other vendors that possess the capability to provide a replacement component. The Companys glass flotation products are also purchased from a single vendor, Holophane Corp., although similar
products could be obtained from other vendors. The Company has not experienced any problems with the supply of its raw materials and it believes that its sources of supply are adequate for its present and future requirements.



6.    Dependence on Major Customers



Although the Company has a number of major customers, during fiscal 2003 no single
customer represented more than 10% of the Companys total revenue. In fiscal 2002, the Companys largest customer represented $2,368,000, or 13%, of the Companys total revenue.



7.    Patents, Trademarks and Other Agreements



The Company possesses several patents pertaining to the design and manufacture of its
products. Several names utilized by the Company are also trademarked. It is the Companys policy to seek patent protection on products and designs that it considers important to its future. However, the Company believes that quality and
technical superiority, rather than patent protection, are the most important criteria for its future success. The Company does not license any of its patents or designs to others at this time. The Company is currently a licensee under a
non-exclusive license pertaining to the design of its seismic hydrophone product from The Penn State Research Foundation. The Company is also a licensee under an exclusive agreement with Sercel, Inc. for a patent pertaining to the design of the
Companys GeoPoint hydrophone product. The Company is also a licensee under an exclusive agreement with Simon Fraser University regarding certain technology in the geophysical product line.



8.    Government Approvals and Contracts



There are no government approvals required for any of the products currently
manufactured by the Company. Certain products of the Undersea Systems Division cannot be sold to certain countries under U.S. export controls. Also, certain hydrophone products must conform to regulations that limit the ability of the hydrophone to
be utilized for military applications. The Company does not anticipate that these export restrictions will be removed in the near future.



During fiscal 2003, 16.5% of the sales of the Undersea Systems Division were derived from military procurement contracts, primarily contracts with the U.S. Navy.



9.    Effect of Government Regulations



The Company is not aware of any government regulations or pending legislation that
would adversely affect the future sales of its products. The U.S. Commerce Department has recently increased scrutiny of



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transactions with certain foreign countries in view of the international war on terrorism. While the Company believes its activities are in compliance with all
applicable export control regulations, such increased scrutiny has resulted and may continue to result in delays in completing international customer orders.



10.    Research and Development



The Company maintains an internal staff of engineers and external consultants with experience and expertise in the technologies it utilizes. The majority of
research and development programs are internally funded. Research and development expenditures were $1,700,000, $1,396,000, and $1,695,000 for the fiscal years ended September 30, 2003, 2002 and 2001, respectively.



11.    Environmental Protection Regulations



The Company believes that its compliance with current federal, state, and local
environmental regulations will not have a material adverse effect on its capital expenditures, earnings, or competitive position.



12.    Employees



As of September 30, 2003, the Company employed 94 full-time individuals, 25 of whom were engaged in research and development, 42 in manufacturing and 27 in sales,
marketing and administrative positions. Of the 94 full-time employees, one is employed on a temporary basis. None of the Companys employees is covered by a collective bargaining agreement. The Company believes that it maintains good relations
with its employees.



ITEM 2.    DESCRIPTION OF PROPERTY



The Company owns its corporate offices in North Falmouth,
Massachusetts, which consist of 26,000 square feet of office and light industrial manufacturing space in a single-story, industrial building on a six acre rural setting. The Undersea Systems Division and the Package Inspection Systems Division share
the same facility. The facility has been recently modernized and is in good condition. The Company consolidated these facilities and staff during the fourth quarter of fiscal 2003 and at the same time sold certain excess real estate.



ITEM 3.    LEGAL PROCEEDINGS



Not Applicable.



ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS



No matters were submitted during the fourth quarter of the fiscal year covered by this
report to a vote of security holders, whether through the solicitation of proxies or otherwise.



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PART II



ITEM 5.    MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS



The Companys Common Stock is traded over-the-counter and is listed on the Nasdaq SmallCap Market under the symbol BTHS.



The following table sets forth the high and low bid information for the
Companys Common Stock for the periods shown. Said quotations reflect inter-dealer prices, without retail mark-up, mark-down, or commission, and may not represent actual transactions.



|Quarter Ended      |  | High |      | Low
|------------------ |  | ---- | ---- | ---
|December 31, 2001  |  | $    | 4.00 |    
|March 31, 2002     |  |      | 7.25 |    
|June 30, 2002      |  |      | 7.44 |    
|September 30, 2002 |  |      | 5.75 |    
|December 31, 2002  |  |      | 4.91 |    
|March 31, 2003     |  |      | 3.30 |    
|June 30, 2003      |  |      | 5.25 |    
|September 30, 2003 |  |      | 5.80 |    



As of December 16, 2003, there
were approximately 229 holders of record of the Companys Common Stock.



The Company has never declared dividends on its Common Stock and does not anticipate paying dividends in the foreseeable future.



The Company did not issue any equity securities during the fiscal year ended September 30, 2003 that were not registered under the Securities Act of 1933.



ITEM 6.    MANAGEMENTS DISCUSSION AND ANALYSIS



Overview



The Company was founded in 1962 to act as a manufacturer of oceanographic products. Over the last 41 years, the Company has developed
and acquired new technology and products. Currently, the Company consists of two distinct divisions: the Undersea Systems Division and the Package Inspection Systems Division. The Package Inspection Systems Division was formed in 1971 using aspects
of acoustic technology (originally developed for oceanographic products) and applied to the testing of cans, bottles and other containers for the purpose of finding leaks and other package defects.



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Results of Operations



The following table presents, for the periods indicated, certain consolidated statements of operations data. The Company has reclassified certain prior year
information to conform with the current years presentation.



|                                                          |  | Year Ended September 30, |       
|--------------------------------------------------------- |  | ------------------------ | ------
|                                                          |  | 2003                     |       
|                                                          |  | (In thousands)           |       
|Net sales                                                 |  | $                        | 17,024
|Cost of sales                                             |  |                          | 10,728
|                                                          |  |                          |       
|Gross profit                                              |  |                          | 6,296 
|Selling, general and administrative expenses              |  |                          | 4,956 
|Research and development expenses                         |  |                          | 1,700 
|Amortization of goodwill                                  |  |                          |      
|Amortization of acquired intangibles                      |  |                          | 239   
|Goodwill impairment                                       |  |                          |      
|                                                          |  |                          |       
|Loss from operations                                      |  |                          | (599  
|Interest income                                           |  |                          | 3     
|Interest expense                                          |  |                          | (208  
|Gain on sale of real estate                               |  |                          | 2,208 
|                                                          |  |                          |       
|Income (loss) before provision (benefit) for income taxes |  |                          | 1,404 
|Provision (benefit) for income taxes                      |  |                          | 831   
|                                                          |  |                          |       
|Net income (loss)                                         |  | $                        | 573   
|                                                          |  |                          |       



The following table presents,
for the periods indicated, the percentage relationship of consolidated statements of operations items to net sales.



|                                                          |  | Year Ended September 30 |  
|--------------------------------------------------------- |  | ----------------------- | -
|                                                          |  | 2003                    |  
|Net sales                                                 |  | 100.0                   | %
|Cost of sales                                             |  | 63.0                    |  
|                                                          |  |                         |  
|Gross profit                                              |  | 37.0                    |  
|Selling, general and administrative expenses              |  | 29.1                    |  
|Research and development expenses                         |  | 10.0                    |  
|Amortization of goodwill                                  |  |                        |  
|Amortization of acquired intangibles                      |  | 1.4                     |  
|Goodwill impairment                                       |  |                        |  
|                                                          |  |                         |  
|Loss from operations                                      |  | (3.5                    | )
|Interest income                                           |  |                        |  
|Interest expense                                          |  | (1.2                    | )
|Gain on sale of real estate                               |  | 13.0                    |  
|                                                          |  |                         |  
|Income (loss) before provision (benefit) for income taxes |  | 8.3                     |  
|Provision (benefit) for income taxes                      |  | 4.9                     |  
|                                                          |  |                         |  
|Net income (loss)                                         |  | 3.4                     | %
|                                                          |  |                         |  



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The following table presents, for the periods indicated, the net sales of each product line of the Undersea Systems
Division.



|                                  |  | Year Ended September 30
|--------------------------------- |  | -----------------------
|                                  |  | 2003                   
|                                  |  | (In thousands)         
|Product Line:                     |  |                        
|Underwater Acoustics              |  | $                      
|Geophysical Exploration Equipment |  |                        
|Other Undersea Products           |  |                        
|                                  |  |                        
|Total:                            |  | $                      
|                                  |  |                        



The Package Inspection Systems
Division has only one product line.



Years ended September 30, 2003 and 2002



Sales.    Total Sales decreased 3.9% to
$17,024,000 for fiscal year 2003 as compared to $17,720,000 for fiscal year 2002. Sales by the Package Inspection Systems Division increased by 19.9% to $7,325,000 for fiscal year 2003 as compared to $6,109,000 for fiscal year 2002. This increase
was attributable to increased market penetration and new product introductions for leak detection of flexible plastic bottles and fill level inspection. Sales of the Undersea Systems Division decreased by 16.5% to $9,699,000 for fiscal year 2003 as
compared to $11,611,000 for fiscal year 2002. This decrease was experienced in some of the product lines within the Undersea Systems Division and is a result of decreased demand for geophysical hydrophones for use in exploration by the oil and gas
industries and a multi-million dollar sale of remotely operated vehicles (ROVs) in fiscal year 2002 that was not repeated in fiscal year 2003. The decrease in sales in fiscal year 2003 was partially offset by strong performance by the acoustic
release, locator products and acoustic modem lines within the Underwater Acoustics line.



Gross Profit.    Gross Profit increased by 26.5% to $6,296,000 for fiscal year 2003 as compared to $4,976,000 for fiscal year 2002. As a percentage of sales, gross profit for fiscal year 2003 was
37.0% as compared to 28.1% for fiscal year 2002. The increase in the gross profit percentage in fiscal year 2003 is a result of improved product mix within the Undersea Systems Division, the success of an ongoing program to reduce scrap and other
manufacturing related variances and product pricing and was partially offset by product mix and product start-up expenses in the Package Inspection Systems Division. Gross profit for fiscal year 2002 reflected increases of $100,000 in the general
product warranty reserve and $165,000 in the inventory reserves for excess and obsolescence that were offset by a $405,000 reversal of a warranty reserve in that year related to an older model hydrophone that was not repeated in fiscal year 2003.



Selling, General, and Administrative
Expenses.    Selling, general, and administrative expenses increased 0.2% to $4,956,000 for fiscal year 2003 as compared to $4,944,000 for fiscal year 2002. As a percentage of sales, selling, general and administrative
expenses increased to 29.1% for fiscal year 2003 as compared to 27.9% for fiscal year 2002. The increase in these expenses was a result of increased selling expenses of $225,000, offset by a reduction in the accounts receivable reserve of $98,000 as
the Companys exposure to bad debts was reduced, and other reductions in general and administrative expenses compared to fiscal year 2002.



Research and Development Expenses.    Research and development expenses increased 21.8% to $1,700,000 for fiscal year 2003 as compared to
$1,396,000 for fiscal year 2002. As a percentage of sales, research and development expenses were 10.0% for fiscal year 2003 as compared to 7.9% for fiscal year 2002. The increase in the overall level of expenditures in fiscal year 2003 is a result
of increased efforts to complete the design and development of several products and is consistent with the Companys operational plans.



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Amortization of Goodwill.    As a result of the Companys early adoption of
Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, goodwill, as well as certain other intangible assets determined to have an indefinite life, are no longer amortized. These assets are subject to
an annual assessment for impairment by applying a fair-value based test.



Amortization of Acquired Intangibles.    Amortization of acquired intangibles was $239,000 in fiscal years 2003 and 2002. The amortization of acquired intangibles relates to the purchased technology in the
Datasonics acquisition in fiscal year 1999.



Goodwill
Impairment.    In the fourth quarter of fiscal year 2002, the Company completed an evaluation of its goodwill by comparing the fair value of its reporting units, as determined by an independent appraiser, to the reporting
units book value. This evaluation determined that an impairment of goodwill existed. As a result, an impairment charge of $2,081,000 was recorded in fiscal year 2002. The Company performed another valuation of its goodwill as of September 30,
2003 and determined that no further impairment existed.



Interest
Income.    Interest income decreased to $3,000 for fiscal year 2003 as compared to $4,000 for fiscal year 2002.



Interest Expense.    Interest expense was $208,000 for fiscal year 2003 as compared to $248,000 for fiscal year 2002. The decrease in
interest expense was a result of reduced principal on the variable rate term loan used to finance the Datasonics acquisition and reduced borrowings under the line of credit.



Gain on Sale of Real Estate.    In September 2003, the Company completed the sale of two parcels of real
estate for a total sales price of $2,500,000. The real estate had a net book value of $171,000, which resulted in a gain of $2,208,000.



Provision (Benefit) for Income Taxes.    The provision for income taxes was $831,000 for fiscal year 2003 as compared to a benefit of
$415,000 for fiscal year 2002. The effective tax rate for fiscal year 2003 was 59.2%. The effective tax rate for 2002 was (10.6%). The rate in 2003 is higher than the statutory rate primarily due to the Companys providing a non-deductible
valuation reserve of approximately $352,000 to reduce its deferred tax assets to zero. See Note 4 to Notes to Consolidated Financial Statements.



Years ended September 30, 2002 and 2001



Sales.    Total Sales decreased 3.2% to $17,720,000 for fiscal year 2002 as compared to $18,308,000 for fiscal year 2001. Sales by the
Package Inspection Systems Division increased by 19.9% to $6,109,000 for fiscal year 2002 as compared to $5,094,000 for fiscal year 2001. This increase was attributable to increased market penetration and new product introductions. Sales of the
Undersea Systems Division decreased by 12.1% to $11,611,000 for fiscal year 2002 as compared to $13,214,000 for fiscal year 2001. This decrease was experienced in the majority of the product lines within the Undersea Systems Division and is a result
of fewer large product orders, decreased demand for geophysical hydrophones for use in exploration by the oil and gas industries, transition from a distributor of locator products in the Underwater Acoustics line and the effects of the tragic events
of September 11, 2001 on purchases of these products by the airline industry. The decrease was partially offset by a multi-million dollar sale of remotely operated vehicles (ROVs).



Gross Profit.    Gross Profit decreased by 4.0% to $4,976,000 for fiscal year 2002 as compared to
$5,184,000 for fiscal year 2001. As a percentage of sales, gross profit for fiscal year 2002 was 28.1% as compared to 28.3% for fiscal year 2001. The decrease in the gross profit percentage is a result of unabsorbed overhead resulting from a lower
sales volume, product mix within the Undersea Systems Division and the Package Inspection Systems Division, an increase of $100,000 in the general product



11



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warranty reserve, and an incremental increase of $165,000 in the inventory reserves for excess and obsolescence, partially offset by a $405,000 reduction in a warranty
reserve related to an older model hydrophone that had been recorded in the prior fiscal year. The reduction in warranty reserve was the result of a lower return rate and lower repair and replacement costs for this older model hydrophone.



Selling, General, and Administrative
Expenses.    Selling, general, and administrative expenses decreased 16.4% to $4,944,000 for fiscal year 2002 as compared to $5,916,000 for fiscal year 2001. As a percentage of sales, selling, general and administrative
expenses decreased to 27.9% for fiscal year 2002 and compared to 32.3% for fiscal year 2001. The decrease in these expenses was a result of decreased commissions expenses ($358,000), write-offs and legal expenses related to an accounts receivable
balance from a former distributor ($354,000) and expenses related to the resignation of the former CEO, such as search fees for a successor and severance costs ($210,000) in fiscal year 2001 that were not repeated in fiscal year 2002.



Research and Development Expenses.    Research and
development expenses decreased 17.6% to $1,396,000 for fiscal year 2002 as compared to $1,695,000 for fiscal year 2001. As a percentage of sales, research and development expenses were 7.9% for fiscal year 2002 as compared to 9.3% for fiscal year
2001. The decrease in the overall level of expenditures is a result of the completion in fiscal year 2001 of several development projects that were active in fiscal year 2001, the elimination of certain outside costs that existed in fiscal year
2001, and the temporary reassignment of engineering resources.



Amortization of Goodwill.    As a result of the Companys early adoption of Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, goodwill, as well as
certain other intangible assets determined to have an indefinite life, are no longer amortized. These assets are subject to an annual assessment for impairment by applying a fair-value based test.



Amortization of Acquired Intangibles.    Amortization of
acquired intangibles was $239,000 in fiscal years 2002 and 2001. The amortization of acquired intangibles relates to the purchased technology in the Datasonics acquisition in fiscal year 1999.



Goodwill Impairment.    The Company performed its initial
valuation of its goodwill as of October 1, 2001 and determined that no impairment existed. In the fourth quarter of fiscal year 2002, the Company completed an evaluation of its goodwill by comparing the fair value of its reporting units, as
determined by an independent appraiser, to the reporting units book value. This evaluation determined that an impairment of goodwill existed. As a result, an impairment charge of $2,081,000 was recorded.



Interest Income.    Interest income decreased to $4,000 for
fiscal year 2002 as compared to $28,000 for fiscal year 2001. The decrease resulted from lower invested cash balances.



Interest Expense.    Interest expense was $248,000 for fiscal year 2002 as compared to $368,000 for fiscal year 2001. The decrease in
interest expense was a result of reduced principal on the variable rate term loan used to finance the Datasonics acquisition, reduced borrowings under the line of credit, and lower interest rates.



Provision (Benefit) for Income Taxes.    The benefit for
income taxes was $415,000 for fiscal year 2002 as compared to a benefit of $982,000 for fiscal year 2001. The effective tax rate for fiscal year 2002 was (10.6%). The effective tax rate for 2001 was (30.0%). The lower effective rate in 2002 was a
result of the Companys providing a valuation reserve of approximately $1.0 million in that fiscal year. This valuation reserve has reduced the Companys deferred tax asset to an amount which management believes is realizable based on
projected pre-tax income for fiscal 2003 which includes a projected gain on its sale of excess real estate in fiscal 2003. The tax rate in 2001 was lower than the statutory rate due primarily to benefits from the Companys foreign sales
corporation and state tax credits.



12



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Liquidity and Capital Resources



The Companys cash and cash equivalents increased $128,000 from September 30, 2002 to September 30, 2003. Cash of $1,234,000 was provided by operating
activities, primarily the result of the net income realized during fiscal year 2003, depreciation and amortization, deferred income taxes, and decreases in accounts receivable, inventory, and refundable income taxes. The Company received $959,000
from investing activities resulting from the receipt of $1,231,000 from the sale of real estate, and $330,000 from other investing activities (including $457,000 from the surrender of a life insurance policy on an officer), offset by $602,000 used
for purchase of capital equipment. The Company also used $2,065,000 of cash in its financing activities which represents the payment of the installment payments on the term note, principal reduction of $650,000 related to the sale of excess real
estate and reduced borrowings under the line of credit.



The Company has
a credit facility with a bank. This facility, as amended, provides for loans under two notes: a $5,500,000 variable rate term note and a $600,000 variable rate secured line of credit note. The term note was originally payable in 84 consecutive equal
monthly installments of principal with interest at the greater of 7.0% per annum, or prime (4.0% at September 30, 2003) plus 2.0%. The term note matures in August 2006. During August 2003, the Company used $229,000 of the proceeds of the surrender
of a life insurance policy on an officer to repay a portion of the term loan. On September 29, 2003, the Company completed the sale of its excess real estate for $2,500,000. The Company received $1,300,000 on September 30, 2003 and used $650,000 to
repay another portion of the principal on the term loan. In October 2003, the Company received the balance from the transaction and used $600,000 to repay another portion of the term loan. The bank agreed to reset the principal payments over the
remainder of the original term. As a result, principal payments under this note will be $879,000 in fiscal year 2004, $279,000 in fiscal year 2005, and $255,000 in fiscal year 2006. The line of credit expires on January 31, 2005. Advances are
limited to 45% of eligible accounts receivable; the availability under the line of credit on September 30, 2003 was $600,000. Advances under the line of credit are payable as follows: monthly payments of interest only and unpaid principal and
accrued and unpaid interest at maturity. The interest rate under the line of credit is the greater of 7.0% per annum or prime (4.0% at September 30, 2003) plus 2.0%. There were no advances outstanding under the line of credit as of September 30,
2003. The credit facility is secured by substantially all of the assets of the Company and requires the Company to meet certain covenants, including debt service coverage.



During the year ended September 30, 2003, the Company did not satisfy all of the financial covenants under its line of credit and term
loan agreement with its bank. The Company has obtained a waiver of these defaults and the financial covenants have been reset based upon the Companys projections for the year ending September 30, 2004.



Management believes that its projections for profitability in fiscal 2004 are
attainable. While there can be no guarantee that the Company will attain these projections, which largely rest on successful new product introductions, management believes that the Company will have sufficient cash flows from operations (based on
sales projections, cost reduction measures, and efficiencies), cash balances, availability from its line of credit, and other potential financing techniques to continue operating for at least the next twelve months. If the Company does not meet its
revised loan covenants or its projections, it may need to seek alternative financing. In such event, there can be no guarantee that the Company will be able to obtain alternative financing on commercially acceptable terms.



Critical Accounting Policies.



The preparation of financial statements requires management to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. On an on-going basis, management evaluates the Companys estimates and assumptions, including but not limited to those related to
revenue recognition, inventory valuation, warranty reserves and the impairment of long-lived assets, goodwill and other intangible assets. Management bases its estimates on historical experience and various other assumptions that it believes to be
reasonable under the circumstances, the



13



---

results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual
results may differ from these estimates under different assumptions or conditions.



1.Revenue Recognition.    The Company recognizes revenue from product sales upon shipment,
provided that title has passed, a purchase order has been received or a contract has been executed, there are no uncertainties regarding customer acceptance, the sales price is fixed or determinable and collection is deemed probable. If
uncertainties regarding customer acceptance exist, the Company recognizes revenue when those uncertainties are resolved. Amounts collected or billed prior to satisfying the above revenue recognition criteria are recorded as deferred revenue. The
Company follows EITF No. 00-21, Revenue Arrangements with MultipleDeliverables. This includes arrangements that provide for the delivery and performance of multiple products, services and/or rights to use assets where performance may
occur at different points in time or over different periods of time. The Company generally enters into arrangements for multiple deliverables when it contracts to provide installation services. Revenue is allocated to the multiple elements based
upon the relative fair values of the elements. The Company generally recognizes revenue from each of these elements as each element is delivered or performed.



2.    Inventory Valuation.    The Company values its inventory at the lower of actual cost or the
current estimated market value. It regularly reviews inventory quantities on hand and inventory commitments with suppliers and records a provision for excess and obsolete inventory based primarily on historical usage for the prior twelve to
twenty-four month period. Although the Company makes every effort to ensure the accuracy of its forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the
value of its inventory and its reported operating results.



3.    Warranty Reserves.    The Companys warranties require it to repair or replace defective products returned to it during such warranty period at no cost to the customer. It records an
estimate for warranty-related costs based on actual historical return rates, anticipated return rates, and repair costs at the time of sale. A significant increase in product return rates, or a significant increase in the costs to repair products,
could have a material adverse impact on future operating results for the period or periods in which such returns or additional costs materialize and thereafter. During fiscal 2003, the Company reversed approximately $50,000 of a warranty reserve
related to a specific warranty issue on an older model hydrophone. The reduction in warranty reserve was the result of a lower return rate and lower repair and replacement costs for this older model hydrophone.



4.    Goodwill    The
goodwill associated with the Datasonics acquisition is subject to an assessment for impairment by applying a fair-value based test on at least an annual basis. In the fourth quarter of fiscal 2003, the Company completed its annual valuation of its
goodwill by comparing the fair value of its reporting units, as determined by an independent appraiser, to the reporting units book value. The valuation indicated that goodwill for the Undersea Systems business segment was not impaired. In
fiscal 2002, the Company completed its annual valuation of the goodwill for the Undersea Systems business segment and recorded a non-cash goodwill impairment charge of $2,081,000 for the year ended September 30, 2002.



These valuations were based upon estimates of future income from the
reporting units and estimates of the market value of the units, based on comparable recent transactions. These estimates of future income are based upon historical results, adjusted to reflect managements best estimate of future market and
operating conditions, and are continuously reviewed based on actual operating trends. Actual results may differ from these estimates. In addition, the relevancy of recent transactions used to establish market value for the Companys reporting
units is based upon managements judgment.



14



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5.    Income Taxes



The Company accounts for income taxes under the liability method in accordance with SFAS No. 109, Accounting
for Income Taxes.Deferred tax assets and liabilities are determined based on differences between the financial reporting and income tax bases of assets and liabilities as well as net operating loss and tax credit carry-forwards and are measured
using the enacted tax rates and laws that will be in effect when the differences reverse. Deferred tax assets may be reduced by a valuation allowance to reflect the uncertainty associated with their ultimate realization.



Prospects for the Future



The Company will continue to pursue opportunities for growth. These include investments in product development, acquisition of
compatible product lines and companies, licensing arrangements and geographical market development.



Undersea Systems Division



The Company serves several segments of the undersea market, including oceanographic research, oil and gas exploration and production, hydrographic survey, and
underwater location, marking and navigation. These market segments experience periodic expansion and contraction as a result of economic cycles, market fluctuation in oil prices, changes in government funding, etc.



Package Inspection Systems Division



The Package Inspection Systems Division serves the food, pharmaceutical, dairy,
chemical, personal care, beer and both alcoholic and non-alcoholic beverage markets. There are common trends in these markets that are favorable to the future growth of the Package Inspection Systems Division. These include a focus on quality
control, the need to improve process yield and efficiency, and an increased awareness of product liability exposure.



The Company has maintained a steady investment in new product development in the package inspection market. As a result, the Company has introduced new products
that expand the capabilities of its existing inspection systems and open up new markets. The Company intends to continue this strategy of product line expansion and extension and development of new package inspection market segments.



The Company expends a significant amount of funds on new product research and
development. During the fiscal years ended September 30, 2003, 2002 and 2001, the Company spent $1,700,000, $1,396,000 and $1,695,000, respectively. The Company expects that this level of spending will not increase over fiscal 2003 levels as it
continues to develop new products.



The Company is not aware of any
technology trends or changes in competitive environment that would adversely affect the sales of its products within the industry segments that it serves.



Profit Margins



Overall



Overall profit margins on the
Companys products are influenced by the relative mix of sales between the Undersea Systems Division and the Package Inspection Systems Division, as well as the product mix within the Undersea Systems Division. For the fiscal year ended
September 30, 2003, sales of the Undersea Systems Division decreased to 57.0% of total Company sales as compared to 65.5% for the prior fiscal year, while sales of the Package Inspection Systems Division increased to 43.0% of total Company sales as
compared to 34.5% for the prior fiscal year. The decrease in sales from fiscal year 2002 to fiscal year 2003 was 16.5% for the Undersea Systems Division; sales for the Package Inspection Systems Division increased by 19.9%. This resulted in an
overall gross profit for the Company of 37.0% for the fiscal year ended September 30, 2003 as compared to 28.1% for the fiscal year ended September 30, 2002.



15



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Undersea Systems Division



Gross profit margins on Undersea Systems Division products averaged approximately 35.4%, 21.1% and 22.1% for fiscal years 2003, 2002
and 2001, respectively. Gross margins on this segment of the business can vary depending on the relative mix of products shipped in any time period, the effects of manufacturing overhead cost absorption and the timing of large single project
shipments. The Company expects that the relative mix of products will change, but does not expect the average gross profit margin to be adversely affected. It is possible that the startup costs associated with new products could affect gross margins
temporarily. However, the Company is not aware of other market trends, cost changes or competitive pressures that would adversely affect gross profit margins within its existing product lines.



Package Inspection Systems Division



Gross profit margins on Package Inspection Systems Division products averaged
approximately 39.1%, 41.4% and 46.4% for fiscal years 2003, 2002 and 2001, respectively. The Company expects that the sales mix of different products will not significantly change and will not adversely affect overall divisional gross margins in the
future. It is possible that increased competition will result in an overall reduction of selling prices and associated profit margins. The Company is not aware of any technological or marketplace trends that would adversely affect gross margins on
this product line.



Recently Issued Accounting Standards



In November 2002, the FASB issued FASB Interpretation (FIN) No. 45,
Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. Among other things, FIN 45 requires guarantors to recognize, at fair value, their obligations to stand ready to
perform under certain guarantees. FIN No. 45 is effective for guarantees issued or modified on or after January 1, 2003. The adoption of FIN No. 45 did not have a material effect on the Companys financial position or results of operations.



In May 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity. SFAS No. 150 is the first phase of the FASBs project on liabilities and equity. SFAS No. 150 provides guidance on how an entity classifies and measures certain
financial instruments with characteristics of both liabilities and equity. For publicly held companies, SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003. SFAS No. 150 requires companies to record the
cumulative effect of financial instruments existing at the adoption date. The adoption of SFAS No. 150 did not have an effect on the Companys operations, financial position or cash flows.



Forward-Looking Information.



The statements made in this report and in oral statements which may be made by representatives of the Company relating to plans,
strategies, economic performance and trends and other statements that are not descriptions of historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act, Section 27A of the Securities Act of
1933 and Section 21E of the Securities Exchange Act of 1934. Such information includes information relating to the Company which is based upon the beliefs of the Companys management as well as assumptions made by and information currently
available to the Companys management. When used in this report, words such as anticipate, believe, estimate, expect, intend, and similar expressions, as they relate to the
Companys management, identify forward-looking statements. Such statements reflect the current views of management with respect to future events and are subject to certain inherent risks, uncertainties and assumptions relating to the operations
and results of operations of the Company, the timing of large project orders, competitive factors, shifts in customer demand, government spending, economic cycles, availability of financing as well as the factors described in this report. Should one
or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results or outcomes may vary materially from those described herein as anticipated, believed, estimated, expected or intended.



16



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ITEM 7.    FINANCIAL STATEMENTS



The information required by this item is incorporated by reference to the Financial Statements set forth on pages F-1 through F-21
hereof.



ITEM 8.    CHANGES IN
AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE



Not Applicable.



ITEM 8A.    CONTROLS AND PROCEDURES



Evaluation of Disclosure Controls and Procedures



The Company maintains disclosure controls and procedures designed to ensure that
information required to be disclosed in its Exchange Act reports is recorded, processed, summarized and reported within the time periods specified within the Commissions rules and forms, and that such information is accumulated and
communicated to its management to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and
operated, can provide only reasonable assurance of achieving the desired control objectives, and management was necessarily required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.



As of the end of the period covered by this report, the Company carried out an
evaluation, under the supervision and with the participation of its chief executive officer and chief financial officer, of the effectiveness of the design and operation of its disclosure controls and procedures to meet the criteria referred to
above. Based on the foregoing, its chief executive officer and chief financial officer concluded that the Companys disclosure controls and procedures were effective.



17



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PART III



The information required by Part III of this report is incorporated by reference from the registrants definitive proxy statement for its 2004 annual meeting
of stockholders to be filed with the Commission in accordance with Rule 14a-101, Schedule 14A, on or before January 28, 2004.



ITEM 13.    EXHIBITS AND REPORTS ON FORM 8-K



| | (a) |  | The financial statements set forth in the Index contained on the page immediately preceding page F-1 hereof are filed herewith as a part of this report.
| | --- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------



| | (b) |  | The exhibits set forth in the Exhibit Index on the page immediately preceding the exhibits are filed herewith as a part of this report.
| | --- |  | ---------------------------------------------------------------------------------------------------------------------------------------



18



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SIGNATURES



In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.



BENTHOS, INC.By

RONALD L. MARSIGLIORonald L. Marsiglio,President




Date:
December 29, 2003



In accordance with the Exchange Act, this report has
been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.



|RONALD L. MARSIGLIORonald L. Marsiglio             |  | President, Chief Executive Officer and Director                                                    |  | December 22, 2003
|-------------------------------------------------- |  | -------------------------------------------------------------------------------------------------- |  | -----------------
|                                                   |  |                                                                                                   
|FRANCIS E. DUNNE, JR.Francis E. Dunne, Jr.         |  | Vice President, Chief Financial Officer and Treasurer (principal financial and accounting officer) |  | December 22, 2003
|                                                   |  |                                                                                                   
|STEPHEN D. FANTONEStephen D. Fantone               |  | Chairman of the Board of Directors                                                                 |  | December 27, 2003
|                                                   |  |                                                                                                   
|SAMUEL O. RAYMONDSamuel O. Raymond                 |  | Director                                                                                           |  | December 28, 2003
|                                                   |  |                                                                                                   
|A. THEODORE MOLLEGEN, JR.A. Theodore Mollegen, Jr. |  | Director                                                                                           |  | December 26, 2003
|                                                   |  |                                                                                                   
|GARY K. WILLISGary K. Willis                       |  | Director                                                                                           |  | December 29, 2003
|                                                   |  |                                                                                                   
|ARTHUR L. FATUMArthur L. Fatum                     |  | Director                                                                                           |  | December 25, 2003





19



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INDEX



|                                                                                                          |  | Page
|--------------------------------------------------------------------------------------------------------- |  | ----
|Reports of Independent Public Accountants                                                                 |  | F-1 
|                                                                                                          | 
|Consolidated Balance Sheets as of September 30, 2003 and 2002                                             |  | F-3 
|                                                                                                          | 
|Consolidated Statements of Operations for the Years Ended September 30, 2003,2002 and 2001                |  | F-4 
|                                                                                                          | 
|Consolidated Statements of Stockholders Investment for the Years Ended September 30, 2003, 2002 and 2001 |  | F-5 
|                                                                                                          | 
|Consolidated Statements of Cash Flows for the Years Ended September 30, 2003,2002 and 2001                |  | F-6 
|                                                                                                          | 
|Notes to Consolidated Financial Statements                                                                |  | F-7 



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REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS



To
the Directors and Shareholders of Benthos, Inc.:



We have audited the
accompanying consolidated balance sheets of Benthos, Inc. and subsidiaries as of September 30, 2003 and 2002 and the related consolidated statements of operations, stockholders investment and cash flows for the years then ended. These
financial statements are the responsibility of Benthos, Inc.s management. Our responsibility is to express an opinion on these financial statements based on our audits.



We conducted our audits in accordance with auditing standards generally accepted in the 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes 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, the consolidated financial
statements referred to above present fairly, in all material respects, the financial position of Benthos, Inc. and subsidiaries as of September 30, 2003 and 2002 and the results of their operations and their cash flows for the years then ended, in
conformity with accounting principles generally accepted in the United States of America.



|Boston, Massachusetts               |  | /s/ BDO SEIDMAN, LLP
|----------------------------------- |  | --------------------
|October 31, 2003 except for Note 2, |  |                     
|which is dated December 11, 2003    |  |                     



F-1



---

This is a copy of the audit report previously issued by Arthur Andersen LLP in connection with Benthos,
Inc.s filing on Form 10-KSB for the year ended September 30, 2001. This audit report has not been reissued by Arthur Andersen LLP in connection with this filing on Form 10-KSB, as Arthur Andersen LLP ceased providing audit services as of
August 31, 2002. The consolidated balance sheets as of September 30, 2000 and 2001 and the statements of operations, stockholders investment and cash flows for the year ended September 30, 2000 referred to in this report have not been included
in the accompanying financial statements.



REPORT OF INDEPENDENT
PUBLIC ACCOUNTANTS



To Benthos, Inc.:



We have audited the accompanying consolidated balance sheets of Benthos, Inc. (a
Massachusetts corporation) and subsidiary as of September 30, 2000 and 2001, and the related consolidated statements of operations, stockholders investment and cash flows for each of the three years in the period ended September 30, 2001.
These consolidated financial statements are the responsibility of Benthos, Inc.s management. Our responsibility is to express an opinion on the consolidated financial statements based on our audits.



We conducted our audits in accordance with auditing standards generally accepted in the
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. An audit includes examining, on a test basis, evidence supporting the
amounts and disclosures in the financial statements. An audit also includes 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,
the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Benthos, Inc. and subsidiary as of September 30, 2000 and 2001, and the results of their operations and their cash flows for
each of the three years in the period ended September 30, 2001, in conformity with accounting principles generally accepted in the United States.



/s/ Arthur Andersen LLP



Boston, Massachusetts

December
12, 2001



F-2



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BENTHOS, INC. AND SUBSIDIARIES



CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)



|                                                                                                                          |  | September 30, |      
|------------------------------------------------------------------------------------------------------------------------- |  | ------------- | -----
|                                                                                                                          |  | 2003          |      
|ASSETS                                                                                                                    |  |               |      
|Current Assets:                                                                                                           |  |               |      
|Cash and cash equivalents                                                                                                 |  | $             | 204  
|Accounts receivable, less reserves of $235 and $365 at September 30, 2003 and 2002, respectively                          |  |               | 2,535
|Inventories                                                                                                               |  |               | 3,076
|Refundable income taxes                                                                                                   |  |               |     
|Prepaid expenses and other current assets                                                                                 |  |               | 153  
|Deferred tax asset (Note 4)                                                                                               |  |               |     
|Note receivable and other receivablereal estate (Note 1)                                                                 |  |               | 1,150
|                                                                                                                          |  |               |      
|Total current assets                                                                                                      |  |               | 7,118
|                                                                                                                          |  |               |      
|Property, Plant and Equipment, at cost:                                                                                   |  |               |      
|Land                                                                                                                      |  |               | 32   
|Buildings and improvements                                                                                                |  |               | 2,079
|Equipment and fixtures                                                                                                    |  |               | 3,935
|Demonstration equipment                                                                                                   |  |               | 1,483
|                                                                                                                          |  |               |      
|                                                                                                                          |  |               | 7,529
|LessAccumulated depreciation                                                                                             |  |               | 5,961
|                                                                                                                          |  |               |      
|                                                                                                                          |  |               | 1,568
|                                                                                                                          |  |               |      
|Goodwill                                                                                                                  |  |               | 576  
|Acquired intangible assets, net of accumulated amortization of $974 and $735 at September 30, 2003 and 2002, respectively |  |               | 456  
|Other assets, net (Note 7)                                                                                                |  |               | 52   
|                                                                                                                          |  |               |      
|                                                                                                                          |  | $             | 9,770
|                                                                                                                          |  |               |      
|LIABILITIES AND STOCKHOLDERS INVESTMENT                                                                                  |  |               |      
|                                                                                                                          |  |              
|Current Liabilities:                                                                                                      |  |               |      
|Current maturities of long-term debt (Note 3)                                                                             |  | $             | 879  
|Line of credit (Note 2)                                                                                                   |  |               |     
|Accounts payable                                                                                                          |  |               | 2,160
|Accrued expenses (Note 10)                                                                                                |  |               | 1,161
|Customer deposits and deferred revenue                                                                                    |  |               | 261  
|                                                                                                                          |  |               |      
|Total current liabilities                                                                                                 |  |               | 4,461
|                                                                                                                          |  |               |      
|Long-term Debt, net of current maturities (Note 3)                                                                        |  |               | 534  
|                                                                                                                          |  |               |      
|Commitments and Contingencies (Notes 5 and 7)                                                                             |  |               |      
|                                                                                                                          |  |              
|Stockholders Investment: (Note 5)                                                                                        |  |               |      
|Common stock, $0.062/3par valueAuthorized7,500,000 sharesIssued1,652,831 shares at September 30, 2003 and 2002         |  |               | 110  
|Capital in excess of par value                                                                                            |  |               | 1,569
|Retained earnings                                                                                                         |  |               | 3,727
|Treasury stock, at cost269,749 shares at September 30, 2003 and 2002                                                     |  |               | (631 
|                                                                                                                          |  |               |      
|Total stockholders investment                                                                                            |  |               | 4,775
|                                                                                                                          |  |               |      
|                                                                                                                          |  | $             | 9,770
|                                                                                                                          |  |               |      



The accompanying notes are an
integral part of these consolidated financial statements.



F-3



---

BENTHOS, INC. AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except share and per share data)



|                                                                          |  | Year Ended September 30, |          
|------------------------------------------------------------------------- |  | ------------------------ | ---------
|                                                                          |  | 2003                     |          
|Net Sales                                                                 |  | $                        | 17,024   
|Cost of Sales                                                             |  |                          | 10,728   
|                                                                          |  |                          |          
|Gross profit                                                              |  |                          | 6,296    
|Selling, General and Administrative Expenses                              |  |                          | 4,956    
|Research and Development Expenses                                         |  |                          | 1,700    
|Amortization of Goodwill                                                  |  |                          |         
|Amortization of Acquired Intangibles                                      |  |                          | 239      
|Goodwill Impairment (Note 1)                                              |  |                          |         
|                                                                          |  |                          |          
|Loss from operations                                                      |  |                          | (599     
|Interest Income                                                           |  |                          | 3        
|Interest Expense                                                          |  |                          | (208     
|Gain on Sale of Real Estate (Note 1)                                      |  |                          | 2,208    
|                                                                          |  |                          |          
|Income (Loss) before provision (benefit) for income taxes                 |  |                          | 1,404    
|Provision (Benefit) for Income Taxes (Note 4)                             |  |                          | 831      
|                                                                          |  |                          |          
|Net income (loss)                                                         |  | $                        | 573      
|                                                                          |  |                          |          
|Basic Earnings (Loss) per Share (Note 6)                                  |  | $                        | .41      
|                                                                          |  |                          |          
|Diluted Earnings (Loss) per Share (Note 6)                                |  | $                        | .41      
|                                                                          |  |                          |          
|Weighted Average Number of Shares Outstanding (Note 6)                    |  |                          | 1,383,082
|                                                                          |  |                          |          
|Weighted Average Number of Shares Outstanding, assuming dilution (Note 6) |  |                          | 1,388,796
|                                                                          |  |                          |          





The accompanying notes are an integral part of these consolidated financial statements.



F-4



---

BENTHOS, INC. AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF STOCKHOLDERS INVESTMENT

(In thousands, except share and per share data)



|                            |                 | Common Stock |                   | Capital in Excess ofParValue |     | RetainedEarnings |                 |       | Treasury Stock, at cost |        |        | Total StockholdersInvestment | 
|--------------------------- | --------------- | ------------ | ----------------- | ---------------------------- | --- | ---------------- | --------------- | ----- | ----------------------- | ------ | ------ | ----------------------------- | 
|                            | Number ofShares |              | $0.062/3Par Value |                              |     |                  | Number ofShares |       |                         | Amount |        |                              
|Balance, September 30, 2000 |                 | 1,652,831    |                   | $                            | 110 |                  | $               | 1,569 |                         | $      | 8,959  |                               | 
|Sale of treasury stock      |                 |             |                   |                              |    |                  |                 |      |                         |        |       |                               | 
|Net loss                    |                 |             |                   |                              |    |                  |                 |      |                         |        | (2,292 | )                             | 
|                            |                 |              |                   |                              |     |                  |                 |       |                         |        |        |                               | 
|Balance, September 30, 2001 |                 | 1,652,831    |                   |                              | 110 |                  |                 | 1,569 |                         |        | 6,667  |                               | 
|Net loss                    |                 |             |                   |                              |    |                  |                 |      |                         |        | (3,513 | )                             | 
|                            |                 |              |                   |                              |     |                  |                 |       |                         |        |        |                               | 
|Balance, September 30, 2002 |                 | 1,652,831    |                   |                              | 110 |                  |                 | 1,569 |                         |        | 3,154  |                               | 
|Net income                  |                 |             |                   |                              |    |                  |                 |      |                         |        | 573    |                               | 
|                            |                 |              |                   |                              |     |                  |                 |       |                         |        |        |                               | 
|Balance, September 30, 2003 |                 | 1,652,831    |                   | $                            | 110 |                  | $               | 1,569 |                         | $      | 3,727  |                               | 
|                            |                 |              |                   |                              |     |                  |                 |       |                         |        |        |                               | 





The accompanying notes are an integral part of these consolidated financial statements.



F-5



---

BENTHOS, INC. AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)



|                                                                                                   |  | Year Ended September 30, |       
|-------------------------------------------------------------------------------------------------- |  | ------------------------ | ------
|                                                                                                   |  | 2003                     |       
|Cash Flows from Operating Activities:                                                              |  |                          |       
|Net income (loss)                                                                                  |  | $                        | 573   
|Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |  |                          |       
|Goodwill impairment                                                                                |  |                          |      
|Gain on sale of real estate                                                                        |  |                          | (2,208
|Depreciation and amortization                                                                      |  |                          | 838   
|Deferred income taxes                                                                              |  |                          | 1,500 
|Changes in assets and liabilities                                                                  |  |                          |       
|Accounts receivable                                                                                |  |                          | 336   
|Inventories                                                                                        |  |                          | 134   
|Refundable Income taxes                                                                            |  |                          | 393   
|Prepaid expenses and other current assets                                                          |  |                          | (5    
|Accounts Payable and accrued expenses                                                              |  |                          | (48   
|Customer deposits and deferred revenue                                                             |  |                          | (279  
|                                                                                                   |  |                          |       
|Net cash provided by (used in) operating activities                                                |  |                          | 1,234 
|                                                                                                   |  |                          |       
|Cash Flows from Investing Activities:                                                              |  |                          |       
|Purchase of property, plant and equipment                                                          |  |                          | (602  
|Other investing activities, net                                                                    |  |                          | 330   
|Proceeds from sale of real estate, net                                                             |  |                          | 1,231 
|                                                                                                   |  |                          |       
|Net cash provided by (used in) investing activities                                                |  |                          | 959   
|                                                                                                   |  |                          |       
|Cash Flows from Financing Activities:                                                              |  |                          |       
|Payments of long-term debt                                                                         |  |                          | (1,665
|Line of credit                                                                                     |  |                          | (400  
|Sale of treasury stock                                                                             |  |                          |      
|                                                                                                   |  |                          |       
|Net cash used in financing activities                                                              |  |                          | (2,065
|                                                                                                   |  |                          |       
|Net Increase (Decrease) in Cash and Cash Equivalents                                               |  |                          | 128   
|Cash and Cash Equivalents, beginning of year                                                       |  |                          | 76    
|                                                                                                   |  |                          |       
|Cash and Cash Equivalents, end of year                                                             |  | $                        | 204   
|                                                                                                   |  |                          |       
|Supplemental Disclosure of Cash Flow Information:                                                  |  |                          |       
|Interest paid during the year                                                                      |  | $                        | 210   
|                                                                                                   |  |                          |       
|Income taxes refunded during the year, net                                                         |  | $                        | (774  
|                                                                                                   |  |                          |       
|Supplemental Disclosure of Non-cash Investing Activities:                                          |  |                          |       
|Sale of real estate for note and other receivable                                                  |  | $                        | 1,150 
|                                                                                                   |  |                          |       



The accompanying notes are an
integral part of these consolidated financial statements.



F-6



---

BENTHOS, INC. AND SUBSIDIARIES



NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS



(In thousands, except share
and per share data)



(1)    Operations and Significant
Accounting Policies



Benthos, Inc. and its subsidiaries (the
Company) design, manufacture, sell and service oceanographic products and systems for underwater exploration, oil and gas development and production, research and defense, as well as electronic inspection equipment for the automated assessment of
the seal integrity of food, dairy, beverage, pharmaceutical, personal care and chemical packages. The Companys customers are located throughout the world.



On September 29, 2003, the Company completed the sale of two parcels of real estate, the South Side and the North Side, for a total sales price of $2,500. The
real estate had a net book value of approximately $171 which resulted in a gain of $2,208. The gross proceeds of $1,300 for the South Side parcel were received on September 30, 2003. The Company used $650 of these proceeds to repay a portion of the
principal on the term loan (see Note 3). The gross proceeds for the North Side parcel were $1,200. The Company received a promissory note in the amount of $300 from the buyer and an escrow agent held an additional $850 of proceeds, net of $50 of
commissions, until the recording of the deed for the North Side parcel was complete. The Company received these proceeds on October 17, 2003. The Company used $600 of these proceeds to repay an additional portion of the principal on the term loan
(see Note 3). The Company received the $300 from the promissory note on October 24, 2003.



During the years ended September 30, 2003, 2002, and 2001, the Company experienced a decrease in sales and incurred a loss from operations. As a result, the Company did not satisfy several of the financial covenants under its
line of credit and term loan agreement with its bank. The Company has obtained a waiver of these defaults and the financial covenants have been amended based upon the Companys projections for the year ending September 30, 2004. While the
Company believes that its projections for fiscal 2004 are attainable, there can be no guarantee that it will attain these projections, which largely rest on several successful new product introductions. Management believes the Company will have
sufficient cash flows from operations (based on its sales projections and cost savings measures and efficiencies) along with its cash balances and availability from its line of credit to fund operations. If the Company does not meet the covenants
under its amended credit agreement, it may need to seek alternative financing. In such event, there can be no guarantee that the Company will be able to obtain financing on commercially acceptable terms.



The accompanying consolidated financial statements reflect the application of certain
significant accounting policies as described below and elsewhere in the accompanying notes to the consolidated financial statements.



(a)  Principles of Consolidation



The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, Benthos International, Inc., a foreign sales
corporation, Leumas LLC, a single member limited liability company and Evets LLC, a single member limited liability company. All material intercompany transactions and balances have been eliminated in consolidation.



(b)  Use of Estimates



The preparation of financial statements in conformity with generally accepted
accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those estimates.



F-7



---

BENTHOS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(In thousands, except share and per share data)



(c)  Cash and Cash Equivalents



The Company considers all highly liquid securities with original maturities of three months or less to be cash equivalents.



(d)  Inventories



Inventories are stated at the lower of cost (first-in, first-out) or market, net of
obsolescence reserves. Work-in-process and finished goods inventories include materials, labor and overhead. Inventories consist of the following at September 30, 2003 and 2002:



|                |  | 2003 |       | 2002
|--------------- |  | ---- | ----- | ----
|Raw materials   |  | $    | 259   |     
|Work-in-process |  |      | 2,772 |     
|Finished goods  |  |      | 45    |     
|                |  |      |       |     
|                |  | $    | 3,076 |     
|                |  |      |       |     



The Company regularly reviews
inventory quantities on hand and inventory commitments with suppliers and records a provision for excess and obsolete inventory based primarily on historical usage for the prior twelve to twenty-four month period and forecast of future demand.
Although the Company makes every effort to ensure the accuracy of its forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of its inventory and
its reported operating results.



(e)  Depreciation and
Amortization



The Company provides for depreciation and amortization
using the straight-line method by charges to operations in amounts estimated to allocate the cost of the assets over their estimated useful lives, as follows:



|Asset Classification       |  | EstimatedUseful Life
|-------------------------- |  | --------------------
|Buildings and improvements |  | 1533 years         
|Equipment and fixtures     |  | 5 years             
|Demonstration equipment    |  | 3 years             



Depreciation expense for the
years ended September 30, 2003, 2002 and 2001 was approximately $583, $538 and $652, respectively.



(f)  Long-Lived Assets



Long-lived assets, such as intangible assets, property and equipment and certain sundry assets, are evaluated for impairment when events or changes in circumstances
indicate that the carrying amount of the assets may not be recoverable through the estimated undiscounted future cash flows from the use of these assets. When any such impairment exists, the related assets are written down to fair value.



F-8



---

BENTHOS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(In thousands, except share and per share data)



Intangible assets subject to amortization consist of developed technology purchased in the acquisition of the
assets of Datasonics, Inc. in August of 1999. The developed technology has an estimated useful life of 6 years. Amortization expense related to this asset will be $239 and $217 in fiscal 2004 and 2005, respectively.



(g)  Goodwill



In June 2001, the FASB issued Statement of Financial Accounting Standards (SFAS) No.
142, Goodwill and Other Intangible Assets. This statement supersedes APB Opinion No. 17, Intangible Assets, and applies to goodwill and intangible assets acquired after June 30, 2001, as well as goodwill and intangible assets
previously acquired. Under this statement, goodwill, as well as certain other intangible assets determined to have an indefinite life, are no longer amortized; instead these assets are reviewed for impairment on a periodic basis.



Pursuant to this statement, the Company elected early adoption effective October 1,
2001. Accordingly, the Company stopped amortizing the goodwill and the acquired assembled workforce, now jointly classified as goodwill, associated with its past acquisition. The Company has identified two reporting units under SFAS No. 142 which
are the same as the Companys operating segments.



The goodwill was
allocated to the Undersea Systems segment of the Companys business. The Company performed an evaluation of these assets as of October 1, 2001 and determined that they were not impaired at that time. During the quarter ended September 30, 2002,
as a result of disappointing sales results and a reduction in expectations of the future prospects of the Undersea Systems segment, the Company determined that a triggering event, as defined in SFAS 142, had occurred in the Undersea Systems business
segment. The Company obtained an independent appraisal of the fair market value of this reporting unit that indicated that the net book value of the Undersea Systems business segment exceeded its fair market value. As a result, the Company performed
an analysis to allocate the reporting units fair market value to its assets. This analysis indicated that goodwill was impaired. Accordingly, the Company recorded a non-cash goodwill impairment charge of $2.1 million for the year ended
September 30, 2002. The balance of goodwill represents the remaining net book value of the Undersea Systems segments goodwill.



The Company performed its annual impairment test of the goodwill allocated to the Undersea Systems segment as of September 30, 2003 and determined that there was no
further impairment at that time.



F-9



---

BENTHOS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(In thousands, except share and per share data)



The pro forma effect on prior years earnings of excluding goodwill amortization expense, net of tax, is as
follows:



|                                                       |  | 2003 |     | 2002 |   |        | 2001 | 
|------------------------------------------------------ |  | ---- | --- | ---- | - | ------ | ---- | 
|Reported net income (loss)                             |  | $    | 573 |      | $ | (3,513 | )    | 
|                                                       |  |      |    
|Add back: Amortization of goodwill                     |  |      |    |      |   |       |      | 
|                                                       |  |      |     |      |   |        |      | 
|Adjusted net income (loss)                             |  | $    | 573 |      | $ | (3,513 | )    | 
|                                                       |  |      |     |      |   |        |      | 
|                                                       |  |      |    
|Basic income (loss) per common share:                  |  |      |     |      |   |        |      | 
|                                                       |  |      |    
|Reported net income (loss)                             |  | $    | .41 |      | $ | (2.54  | )    | 
|                                                       |  |      |    
|Amortization of goodwill                               |  |      |    |      |   |       |      | 
|                                                       |  |      |     |      |   |        |      | 
|Adjusted net income (loss)                             |  | $    | .41 |      | $ | (2.54  | )    | 
|                                                       |  |      |     |      |   |        |      | 
|                                                       |  |      |    
|Income (loss) per common share assuming full dilution: |  |      |     |      |   |        |      | 
|                                                       |  |      |    
|Reported net income (loss)                             |  | $    | .41 |      | $ | (2.54  | )    | 
|                                                       |  |      |    
|Amortization of goodwill                               |  |      |    |      |   |       |      | 
|                                                       |  |      |     |      |   |        |      | 
|Adjusted net income (loss)                             |  | $    | .41 |      | $ | (2.54  | )    | 
|                                                       |  |      |     |      |   |        |      | 



(h)  Revenue
Recognition



Revenue is recognized when products are shipped to
customers, provided that title has passed, there are no uncertainties regarding customer acceptance, there is persuasive evidence of an arrangement, the sales price is fixed or determinable and collection of the related receivable is probable. The
Company generally enters into arrangements for multiple deliverables when it contracts to provide installation services. The Company follows EITF No. 00-21, Revenue Arrangements with Multiple Deliverables. This includes arrangements that
provide for the delivery or performance of multiple products, services and/or rights to use assets where performance may occur at different points in time or over different periods of time. Revenue is allocated to the multiple elements based upon
the relative fair values of the elements. The Company generally recognizes revenue from each of these elements as each element is delivered or performed. Amounts received from customers for future delivery are shown as customer deposits in the
accompanying consolidated balance sheets. The Company accounts for shipping and handling fees passed on to customers as sales. The corresponding costs are recorded as cost of sales.



(i)  Concentration of Credit Risk



The Company has no significant off-balance-sheet concentration of credit risk such as foreign exchange contracts, options contracts or
other foreign hedging arrangements. Financial instruments, which potentially subject the Company to concentrations of credit risk, are principally cash, cash equivalents and accounts receivable. The Company places its cash and cash equivalents in
highly rated financial institutions.In 2003, there were no customers who accounted for more than 10% of net sales. In 2002, one customer of the Undersea Systems Division accounted for $2,368 (13%) of net sales. In 2001, there were no
customers who accounted for more than 10% of net sales. As of September 30, 2003, no customers accounted for more than 10% of accounts receivable. As of September 30, 2002, one customer accounted for 13% of accounts receivable. As of September 30,
2001, no customer accounted for more than 10% of accounts receivable.



F-10



---

BENTHOS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(In thousands, except share and per share data)



The Company reviews accounts receivable on a monthly basis to determine if any receivables will be potentially
uncollectable. The Company includes any accounts receivable balances that are determined to be uncollectable, along with a general reserve, in the overall allowance for doubtful accounts. After all attempts to collect a receivable have failed, the
receivable is written off against the allowance. Based on the information available, the Company believes the allowance for doubtful accounts is adequate. However, actual write-offs may exceed the recorded allowance.



(j)  Reclassifications



The Company has reclassified certain prior-year information to conform to the current
years presentation.



(k)  Financial Instruments



The carrying amounts of cash and cash equivalents, note receivable,
accounts receivable, other receivablereal estate, accounts payable and accrued expenses are reasonable estimates of their fair value because of the short maturity of those items.



The carrying amount of the term loan approximates fair market value as the loan bears interest at the current market rate.



(l)  New Accounting Standards



In November 2002, the FASB issued FASB Interpretation (FIN) No. 45,
Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. Among other things, FIN 45 requires guarantors to recognize, at fair value, their obligations to stand ready to
perform under certain guarantees. FIN No. 45 is effective for guarantees issued or modified on or after January 1, 2003. The adoption of FIN No. 45 did not have a material effect on the Companys financial position or results of operations.



In May 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity. SFAS No. 150 is the first phase of the FASBs project on liabilities and equity. SFAS No. 150 provides guidance on how an entity classifies and measures certain
financial instruments with characteristics of both liabilities and equity. For publicly held companies, SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003. SFAS No. 150 requires companies to record the
cumulative effect of financial instruments existing at the adoption date. The adoption of SFAS No. 150 did not have an effect on the Companys operations, financial position or cash flows.



(m)  Comprehensive Income (Loss)



Comprehensive income (loss) is defined as the change in equity of a business
enterprise during a period from transactions and other events and circumstances from non-owner sources. Comprehensive income (loss) is the same as net income (loss) for all periods presented.



(n)  Stock-Based Compensation



The Company accounts for its stock-based compensation plans under APB Opinion No. 25,
Accounting for Stock Issued to Employees, and related interpretations. FIN No. 44, Accounting for Certain



F-11



---

BENTHOS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(In thousands, except share and per share data)



Transactions Involving Stock CompensationAn Interpretation of APB Opinion No. 25clarifies the application of APB Opinion No. 25 in certain situations, as
defined.SFAS No. 123, Accounting for Stock-Based Compensation, establishes a fair value method of accounting for stock-based compensation plans. The Company has adopted the disclosure-only alternative under SFAS No. 123, which requires
disclosures of the pro forma effects on earnings and earnings per share as if SFAS No. 123 had been adopted, as well as certain other information.



In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based CompensationTransition and Disclosure. SFAS No. 148 requires the disclosure
of the effects of a Companys accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. SFAS No. 148 amends SFAS No. 123 by providing
alternative methods of transition to the fair-value method of accounting for stock-based employee compensation under SFAS No. 123. SFAS No. 148 also amends the disclosure provisions of SFAS No. 123 and APB Opinion No. 28, Interim Financial
Reportingto require disclosure of the effects of a Companys accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. In accordance with
SFAS No. 148, the Company has adopted the disclosure-only provision of SFAS No. 123 and the enhanced disclosures as required by SFAS No. 148.



Had compensation cost for the Companys stock option plans been determined consistent with SFAS No. 123, pro forma net income (loss) and net income (loss) per
share would have been the following:



|                                   |  | September 30, |    
|---------------------------------- |  | ------------- | ---
|                                   |  | 2003          |    
|Net income (loss)                 |  |               |    
|As reported                        |  | $             | 573
|Pro forma                          |  |               | 429
|                                   |  |               |    
|Basic earnings (loss) per share   |  |               |    
|As reported                        |  | $             | .41
|Pro forma                          |  |               | .31
|                                   |  |               |    
|Diluted earnings (loss) per share |  |               |    
|As reported                        |  | $             | .41
|Pro forma                          |  |               | .31



(o)  Income Taxes



The Company accounts for income taxes under the liability method in
accordance with SFAS No. 109, Accounting for Income Taxes.Deferred tax assets and liabilities are determined based on differences between the financial reporting and income tax bases of assets and liabilities as well as net operating loss
and tax credit carry-forwards and are measured using the enacted tax rates and laws that will be in effect when the differences reverse. Deferred tax assets may be reduced by a valuation allowance to reflect the uncertainty associated with their
ultimate realization.



(p)  Research and Development



All costs of research and development activities are expensed as
incurred.



F-12



---

BENTHOS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(In thousands, except share and per share data)



(q)  Advertising Costs



Advertising costs are expensed as incurred and are included as a component of selling, general, and administrative expenses in the
accompanying Consolidated Statements of Operations. Advertising costs were $133, $141, and $136 for the years ended September 30, 2003, 2002, and 2001, respectively.



(r)  Guarantees



The Companys products generally carry a standard one-year warranty. The Company sets aside a reserve based on anticipated warranty claims at the time product
revenue is recognized. Actual warranty claims incurred are charged to the warranty accrual. Factors that affect the Companys product warranty liability include the number of units sold, the anticipated cost of warranty repairs, and both
historical and anticipated rates of warranty claims.



(2)    Line
of Credit



As of September 30, 2003, the Company has a $600 line of
credit with a bank expiring on January 31, 2004. No amounts were outstanding under this line of credit at September 30, 2003. Borrowings under this agreement are payable on demand and bear interest at the Wall Street Journals
reported prime rate (4.0% at September 30, 2003) plus 2.0%, or 7.0%, whichever is higher. The line of credit is secured by substantially all of the assets of the Company. The Company is required to maintain certain covenants, including debt service
coverage. The Company was not in compliance with one of the covenants at September 30, 2003 and received a waiver from the bank with respect to the noncompliance. On December 11, 2003, the bank extended the secured line of credit through January 31,
2005 and amended the financial covenants under the agreement. The Company expects to meet the amended financial covenants throughout the fiscal year ending September 30, 2004.



(3)    Note Payable



The Company has a note payable with a bank. The note is secured by substantially all of the assets of the Company, accrues interest at prime (4.0% at September 30,
2003) plus 2.0%, or 7.0%, whichever is higher, and had an outstanding balance of $1,413 at September 30, 2003. In connection with the land sale discussed in Note 1, the Company paid down the principal balance on this term loan by $600 on October 17,
2003. Subsequent to this payment, the bank and the Company amended the term loan to amortize the remaining term loan balance on a monthly basis through August 2006, thereby reducing the monthly principal payment from $64 to $23. The Company is
required to meet certain covenants, including debt service coverage. The Company was not in compliance with one of the covenants at September 30, 2003 and received a waiver from the bank with respect to the noncompliance and amended the financial
covenants under the agreement. Principal payments under this note will be $879, $279, and $255 in fiscal years 2004, 2005, and 2006, respectively.



F-13



---

BENTHOS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(In thousands, except share and per share data)



(4)    Income Taxes



The components of the provision (benefit) for income taxes for each of the three years ended September 30, 2003 are as follows:



|                                |  | 2003 |     | 2002 |   |        | 2001 | 
|------------------------------- |  | ---- | --- | ---- | - | ------ | ---- | 
|Federal                        |  |      |     |      |   |        |      | 
|Current                         |  | $    |    |      | $ | (565   | )    | 
|Deferred                        |  |      | 477 |      |   | (820   | )    | 
|                                |  |      |     |      |   |        |      | 
|                                |  |      | 477 |      |   | (1,385 | )    | 
|                                |  |      |    
|State                          |  |      |     |      |   |        |      | 
|Current                         |  |      |    |      |   |       |      | 
|Deferred                        |  |      | 215 |      |   | (71    | )    | 
|                                |  |      |     |      |   |        |      | 
|                                |  |      | 215 |      |   | (71    | )    | 
|Increase in valuation Allowance |  |      | 139 |      |   | 1,041  |      | 
|                                |  |      |     |      |   |        |      | 
|                                |  | $    | 831 |      | $ | (415   | )    | 
|                                |  |      |     |      |   |        |      | 



The Companys effective tax
rate differed from the statutory rate for the reasons set forth below:



|                                               |  | 2003  |   |  | 2002   |    |  | 2001   |   
|---------------------------------------------- |  | ----- | - |  | ------ | -- |  | ------ | --
|Federal statutory rate                         |  | 34.00 | % |  | (34.00 | )% |  | (34.00 | )%
|State income taxes, net of federal tax benefit |  | 4.70  |   |  | (1.81  | )  |  | (4.71  | ) 
|Tax (benefit) provision of foreign sales       |  | (0.36 | ) |  | 1.02   |    |  | 0.31   |   
|Tax credits                                    |  | (0.00 | ) |  | (3.56  | )  |  | (5.64  | ) 
|Change in valuation allowance                  |  | 25.00 |   |  | 26.50  |    |  | 12.37  |   
|Permanent differences                          |  | .85   |   |  | 1.27   |    |  | 1.67   |   
|Elimination of tax contingency reserves        |  | (5.00 | ) |  | 0.0    |    |  | 0.0    |   
|                                               |  |       |   |  |        |    |  |        |   
|Effective tax rate                             |  | 59.19 | % |  | (10.58 | )% |  | (30.00 | )%
|                                               |  |       |   |  |        |    |  |        |   



The components of the net
deferred tax asset and liability recognized in the accompanying consolidated balance sheets are as follows:



|                                          |  | 2003 |        |   | 2002 |  
|----------------------------------------- |  | ---- | ------ | - | ---- | -
|Deferred Tax Assets:                      |  |      |        |   |      |  
|Acquisition related intangibles           |  | $    | 266    |   |      | $
|Inventory reserves                        |  |      | 517    |   |      |  
|Tax credits and net operating losses      |  |      | 771    |   |      |  
|Other nondeductible reserves and accruals |  |      | 628    |   |      |  
|Valuation allowance                       |  |      | (1,798 | ) |      |  
|                                          |  |      |        |   |      |  
|Deferred tax asset                        |  | $    | 384    |   |      | $
|                                          |  |      |        |   |      |  
|Deferred Tax Liabilities:                 |  |      |        |   |      |  
|Installment sale gain on real estate sale |  | $    | 384    |   |      | $
|                                          |  |      |        |   |      |  
|Net deferred tax asset                    |  | $    |       |   |      | $
|                                          |  |      |        |   |      |  



F-14



---

BENTHOS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(In thousands, except share and per share data)



Under SFAS No. 109, the Company recognizes a deferred tax asset for the future benefit of its temporary
differences if it concludes that it is more likely than not that the deferred tax asset will be realized. During the year ended September 30, 2003, the Company has increased its valuation reserve by approximately $352 to eliminate all of its net
deferred tax assets. Tax credits of approximately $320, state net operating losses of approximately $4,300, and federal net operating losses of approximately $620 expire at various dates through 2023.



(5)    Employee Benefit Plans



(a)  Stock Option Plans



The Company has granted to certain directors nonqualified stock options to purchase
shares of the Companys common stock at a price not less than the fair market value of the shares at the date of grant. The options are exercisable ratably over a three-year period, commencing one year from the date of grant, and expire not
more than 10 years from the date of grant. At September 30, 2002, 150,000 shares of common stock were reserved for issuance upon exercise of the nonqualified stock options. At September 30, 2003, 37,500 shares were available for future grant.



The Companys 1990 and 2000 Stock Option Plans (the Employee Plans)
each authorize 300,000 shares of the Companys common stock for issuance. The Employee Plans are administered by the Compensation and Stock Option Committee of the Board of Directors and provide for the granting of incentive stock options and
nonqualified stock options. The options are exercisable ratably over a four-year period, commencing one year from the date of grant, and expire not more than 10 years from the date of grant. The purchase price applicable to incentive stock options
granted may not be less than the fair market value of the shares at the date of grant. At September 30, 2003, 72,700 shares were available for future grant.



Stock option activity is summarized as follows:



|                                |  | Employee Options |   | Director Options
|------------------------------- |  | ---------------- | - | ----------------
|                                |  | Numberof Shares  |   |                 
|Outstanding, September 30, 2000 |  | 195,625          |   |                 
|Granted                         |  | 113,400          |   |                 
|Terminated                      |  | (77,950          | ) |                 
|                                |  |                  |   |                 
|Outstanding, September 30, 2001 |  | 231,075          |   |                 
|Granted                         |  | 30,000           |   |                 
|Terminated                      |  | (15,950          | ) |                 
|                                |  |                  |   |                 
|Outstanding, September 30, 2002 |  | 245,125          |   |                 
|Granted                         |  | 70,000           |   |                 
|Terminated                      |  | (38,450          | ) |                 
|                                |  |                  |   |                 
|Outstanding, September 30, 2003 |  | 276,675          |   |                 
|                                |  |                  |   |                 
|Exercisable, September 30, 2003 |  | 140,425          |   |                 
|                                |  |                  |   |                 
|Exercisable, September 30, 2002 |  | 106,325          |   |                 
|                                |  |                  |   |                 
|Exercisable, September 30, 2001 |  | 57,563           |   |                 
|                                |  |                  |   |                 



F-15



---

BENTHOS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(In thousands, except share and per share data)



The range of exercise prices for options outstanding and options exercisable at September 30, 2003 for the
Employee Plans is as follows:



|                        |  |                    |  | Options Outstanding                      |  | Options Exercisable          
|----------------------- |  | ------------------ |  | ---------------------------------------- |  | -----------------------------
|Range ofExercise Prices |  | OptionsOutstanding |  | WeightedAverageRemainingContractual Life |  | WeightedAverage ExercisePrice
|$  2.65                 |  | 15,000             |  | 9.5                                      |  | $                            
|$  3.78                 |  | 12,000             |  | 8.3                                      |  |                              
|$  4.33                 |  | 3,375              |  | 2.5                                      |  |                              
|$  4.62                 |  | 47,500             |  | 9.1                                      |  |                              
|$  5.00  5.65          |  | 115,800            |  | 7.7                                      |  |                              
|$  6.25                 |  | 17,000             |  | 5.3                                      |  |                              
|$  8.00  8.75          |  | 42,000             |  | 6.4                                      |  |                              
|$10.1711.50            |  | 19,500             |  | 3.3                                      |  |                              
|$17.54                  |  | 4,500              |  | 4.1                                      |  |                              
|                        |  |                    |  |                                          |  |                              
|                        |  | 276,675            |  | 7.31                                     |  | $                            
|                        |  |                    |  |                                          |  |                              



The range of exercise prices for
options outstanding and options exercisable at September 30, 2003 for director stock options is as follows:



|Range of Exercise Prices |  | OptionsOutstanding                       |  | Options Outstanding           |  | Options Exercisable
|------------------------ |  | ---------------------------------------- |  | ----------------------------- |  | -------------------
|                         |  | WeightedAverageRemainingContractual Life |  | WeightedAverage ExercisePrice |  | OptionsExercisable 
|$  2.86                  |  | 6,000                                    |  | 9.3                           |  | $                  
|$  3.78                  |  | 26,500                                   |  | 8.3                           |  |                    
|$  8.00  8.50           |  | 50,000                                   |  | 6.1                           |  |                    
|$13.3814.25             |  | 30,000                                   |  | 4.4                           |  |                    
|                         |  |                                          |  |                               |  |                    
|                         |  | 112,500                                  |  | 6.4                           |  | $                  
|                         |  |                                          |  |                               |  |                    



SFAS No. 123 requires the
measurement of the fair value of stock options or warrants to be included in the statement of operations or disclosed in the notes to financial statements. The Company has determined that it will continue to account for stock-based compensation for
employees under APB Opinion No. 25 and elect the disclosure-only alternative under SFAS No. 123 for stock-based compensation awarded in 2003, 2002 and 2001 using the Black-Scholes option-pricing model prescribed by SFAS No. 123. The underlying
assumptions used are as follows:



|                         |  | September 30, |  
|------------------------ |  | ------------- | -
|                         |  | 2003          |  
|Risk-free interest rate  |  | 3.56          | %
|Expected dividend yield  |  |              |  
|Expected life (in years) |  | 7             |  
|Expected volatility      |  | 40            | %



The weighted average fair value
of options granted during the years ended September 30, 2003, 2002 and 2001 under these plans is $1.93, $2.10 and $2.89, respectively.



F-16



---

BENTHOS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(In thousands, except share and per share data)



(b)  Employee Stock Ownership Plan



The Company has an Employee Stock Ownership Plan (ESOP) covering all eligible
employees, as defined. Contributions to the plan are made at the discretion of the Board and in an amount determined by the Board, provided that the total amount contributed for any plan year does not exceed the maximum amount allowable by the
Internal Revenue Code (IRC). These contributions vest to a participants account over five years based on completed service, as defined. There were no provisions for contributions for the years ended September 30, 2003, 2002, and 2001,
respectively.



(c)  401(k) Retirement Plan



The Company has a 401(k) retirement plan covering all eligible employees, as
defined. Contributions to the plan are made at the discretion of the Board and in an amount determined by the Board, provided that the total amount contributed for any plan year does not exceed the maximum amount allowable by the IRC. These
contributions vest to a participants account over five years based on completed service, as defined. Additionally, each participant may elect to contribute up to 100% of his or her compensation for the plan year, but not more than $12,000 (for
calendar year 2003), to the plan. There were no provisions for contributions for the years ended September 30, 2003, 2002, and 2001. The Company also made matching contributions to the plan of $98, $102, and $97 for the years ended September 30,
2003, 2002, and 2001, respectively.



(d)  Supplemental
Executive Retirement Plan



The Company has a Supplemental Executive
Retirement Plan for the benefit of certain management and highly compensated executive employees. Under the plan, participants may elect to defer a portion of their compensation paid by the Company for supplemental retirement benefits. The Company
also established the Supplemental Executive Retirement Trust (the Trust Fund) and shall regularly transfer to the Trust Fund amounts equal to the elective deferrals made by participants under the plan. No such elective deferrals have been made by
participants during the three years ended September 30, 2003.



(6)    Earnings Per Share



Basic
earnings per share were computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted earnings per share were computed by dividing net income (loss) by the weighted average number of
diluted common and common equivalent shares outstanding during the period. All common equivalent shares have been excluded in 2002 and 2001 due to the net loss, as the effect would be antidilutive. The weighted average number of common equivalent
shares outstanding has been determined in accordance with the treasury-stock method. Common stock equivalents consist of common stock issuable upon the exercise of outstanding options.



A reconciliation of basic and diluted shares outstanding is as follows:



|                                                              |  | 2003      |  | 2002      |  | 2001     
|------------------------------------------------------------- |  | --------- |  | --------- |  | ---------
|Weighted average common shares outstanding                    |  | 1,383,082 |  | 1,383,082 |  | 1,381,745
|Effect of dilutive securities                                 |  | 5,714     |  |          |  |         
|                                                              |  |           |  |           |  |          
|Weighted average common shares outstanding, assuming dilution |  | 1,388,796 |  | 1,383,082 |  | 1,381,745
|                                                              |  |           |  |           |  |          



F-17



---

BENTHOS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(In thousands, except share and per share data)



For the years ended September 30, 2003, 2002 and 2001, 350,875, 365,165 and 250,450 weighted average options,
respectively, were outstanding but not included in the diluted weighted average common share calculation as the effect would have been antidilutive.



(7)    Employment and Noncompetition Agreements



The Company has an employment and noncompetition agreement, as amended, with a director/stockholder. In connection with the employment agreement, the Company had
agreed to provide a $1,500 split-dollar life insurance policy on the director/stockholder. In 2003, as a result of provisions of the Sarbanes-Oxley Act, the employment agreement was amended to remove the requirement that the Company provide the
split-dollar life insurance policy. The existing split-dollar life insurance was surrendered in August 2003 and the Company received proceeds of $457. Of this amount, the Company used $229 to reduce the principal balance on its term loan.



If the Company makes a discretionary contribution to its ESOP, the
Company may be obligated to repurchase from the director/stockholder the number of shares that are contributed to or purchased by the Companys ESOP each year. The director/stockholder may make this decision annually. The Company has not made
any discretionary contributions to the ESOP during the past three fiscal years; accordingly, the director/stockholder has not elected to have any shares purchased from him. The Company also has the right of first refusal at fair market value on any
future sales of common stock by the director/stockholder other than sales made in routine open market brokerage transactions and certain sales through an over-the-counter market maker. In addition, a change in the control of the Company, as defined,
will result in certain payments to the director/stockholder, as outlined under the employment agreement. Compensation expense of approximately $103, $86 and $85 related to this agreement is included in the accompanying 2003, 2002 and 2001
consolidated statements of operations, respectively.



The Company also
has employment agreements with its CEO, CFO, and Vice President, General Manager, Package Inspection Systems Division. These agreements are for two-year periods and provide for minimum salary during their term and a Company severance obligation
should the employee be terminated without cause.



F-18



---

BENTHOS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(In thousands, except share and per share data)



(8)    Segment Reporting



The Company has viewed its operations and manages its business as two segments, Undersea Systems and Package Inspection Systems, as
being strategic business units that offer different products. Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision maker, or
decision-making group, in making decisions on how to allocate resources and assess performance. The Companys chief decision maker is a combination of the president, the chief financial officer and other operating officers. The Company
evaluates the performance of its operating segments based on revenues from external customers, income from operations and identifiable assets.



|                                                                          |  | Year Ended September 30, |       
|------------------------------------------------------------------------- |  | ------------------------ | ------
|                                                                          |  | 2003                     |       
|Sales to unaffiliated customers:                                          |  |                          |       
|Undersea systems                                                          |  | $                        | 9,699 
|Package inspection systems                                                |  |                          | 7,325 
|                                                                          |  |                          |       
|Total                                                                     |  | $                        | 17,024
|                                                                          |  |                          |       
|Loss from operations:                                                     |  |                          |       
|Undersea systems                                                          |  | $                        | (473  
|Package inspection systems                                                |  |                          | (126  
|                                                                          |  |                          |       
|Total                                                                     |  | $                        | (599  
|                                                                          |  |                          |       
|Goodwill impairment for fiscal 2002 was in the Undersea Systems Division. |  |                          |       
|                                                                          |  |                          |       
|Identifiable assets:                                                      |  |                          |       
|Undersea systems                                                          |  | $                        | 5,411 
|Package inspection systems                                                |  |                          | 2,247 
|Corporate assets                                                          |  |                          | 2,112 
|                                                                          |  |                          |       
|Total                                                                     |  | $                        | 9,770 
|                                                                          |  |                          |       
|Depreciation:                                                             |  |                          |       
|Undersea systems                                                          |  | $                        | 315   
|Package inspection systems                                                |  |                          | 227   
|Corporate assets                                                          |  |                          | 41    
|                                                                          |  |                          |       
|Total                                                                     |  | $                        | 583   
|                                                                          |  |                          |       
|Tax (benefit) expense:                                                    |  |                          |       
|Undersea systems                                                          |  | $                        | (142  
|Package inspection systems                                                |  |                          | (38   
|Corporate assets                                                          |  |                          | 1,011 
|                                                                          |  |                          |       
|Total                                                                     |  | $                        | 831   
|                                                                          |  |                          |       
|Purchases of fixed assets:                                                |  |                          |       
|Undersea systems                                                          |  | $                        | 145   
|Package inspection systems                                                |  |                          | 342   
|Corporate assets                                                          |  |                          | 115   
|                                                                          |  |                          |       
|Total                                                                     |  | $                        | 602   
|                                                                          |  |                          |       
|The net sales of each product line of the Undersea Systems Division were: |  |                          |       
|Underwater Acoustics                                                      |  | $                        | 5,089 
|Geophysical Exploration Equipment                                         |  |                          | 3,315 
|Other Undersea Products                                                   |  |                          | 1,295 
|                                                                          |  |                          |       
|Total                                                                     |  | $                        | 9,699 
|                                                                          |  |                          |       



F-19



---

BENTHOS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(In thousands, except share and per share data)



The Package Inspection Systems Division has only one product line.



Net sales by geographic area for the years ended September 30, 2003, 2002 and 2001
were:



|Geographic Area |  | 2003 |        | 2002 |   | 2001  
|--------------- |  | ---- | ------ | ---- | - | ------
|United States   |  | $    | 11,870 |      | $ | 10,966
|Malaysia        |  |      |       |      |   | 2,299 
|Other           |  |      | 5,154  |      |   | 4,455 
|                |  |      |        |      |   |       
|                |  | $    | 17,024 |      | $ | 17,720
|                |  |      |        |      |   |       



(9)    Related Party
Transactions



Prior to fiscal year 2003, the Company paid patent
license fees to an entity controlled by the Companys Chairman of the Board. The Company expensed approximately $20 annually for these fees in fiscal 2002 and 2001. In 2002, the Company elected to discontinue payment of this minimum annual
license fee to the entity controlled by the Companys Chairman of the Board. As a consequence, the Companys rights under this license were converted from exclusive rights to nonexclusive rights, effective as of November 30, 2002.
Additionally, during fiscal 2001, the Company paid the Chairman of the Board $48 for providing services as interim President and Chief Executive Officer.



(10)    Certain Balance Sheet Accounts



(a)  Accrued Expenses:



Accrued expenses consist of the following at September 30, 2003 and 2002:



|                                    |  | 2003 |       | 2002
|----------------------------------- |  | ---- | ----- | ----
|Accrued salary and related expenses |  | $    | 524   |     
|Accrued warranty                    |  |      | 200   |     
|Accrued taxes                       |  |      | 100   |     
|Other accrued expenses              |  |      | 337   |     
|                                    |  |      |       |     
|                                    |  | $    | 1,161 |     
|                                    |  |      |       |     



(b)  Accounts
Receivable Reserve



The changes in the accounts receivable reserve
are as follows:



|For the year ended September 30, |  | Balance, Beginning of Period |  | Charged to Costs and Expenses |  | Deductions |  | Balance, End of Period
|-------------------------------- |  | ---------------------------- |  | ----------------------------- |  | ---------- |  | ----------------------
|2001                             |  | $220                         |  | $389                          |  | $144       |  | $465                  
|2002                             |  | 465                          |  | 30                            |  | 130        |  | 365                   
|2003                             |  | 365                          |  | (98)                          |  | 32         |  | 235                   



F-20



---

BENTHOS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(In thousands, except share and per share data)



(c)  Warranty Reserve



The changes in the warranty reserve are as follows:



|For the year ended September 30, |  | Balance, Beginning of Period |  | Charged to Costs and Expenses |  | Deductions |  | Balance, End of Period
|-------------------------------- |  | ---------------------------- |  | ----------------------------- |  | ---------- |  | ----------------------
|2001                             |  | $302                         |  | $874                          |  | $361       |  | $815                  
|2002                             |  | 815                          |  | (97)                          |  | 468        |  | 250                   
|2003                             |  | 250                          |  | 107                           |  | 157        |  | 200                   



During fiscal 2002, the Company
reversed approximately $405 of warranty reserve related to a specific warranty issue on an older model hydrophone. During fiscal 2003, the Company reversed approximately $50 of warranty reserve related to the same issue. The reduction in warranty
reserve in both years was the result of a lower return rate and lower repair and replacement costs for this older model hydrophone.



F-21



---

BENTHOS, INC.



EXHIBIT INDEX



|Exhibit |  |                                                                                                         
|------- |  | --------------------------------------------------------------------------------------------------------
|        | 
|3.1     |  | Restated Articles of Organization (1)                                                                   
|        | 
|3.2     |  | Articles of Amendment dated April 28, 1997 (2)                                                          
|        | 
|3.3     |  | Articles of Amendment dated April 20, 1998 (5)                                                          
|        | 
|3.4     |  | By-Laws (1)                                                                                             
|        | 
|3.5     |  | By-Law Amendments adopted January 23, 1998 (4)                                                          
|        | 
|4.1     |  | Common Stock Certificate (1)                                                                            
|        | 
|10.1    |  | Employment Contract with Samuel O. Raymond (1)                                                          
|        | 
|10.2    |  | Amendment to Employment Contract with Samuel O. Raymond (2)                                             
|        | 
|10.3    |  | Fourth Amendment to Employment Agreement with Samuel O. Raymond                                         
|        | 
|10.4    |  | Employment Contract with John L. Coughlin (1)                                                           
|        | 
|10.5    |  | Amended and Restated Employment Agreement with John L. Coughlin (10)                                    
|        | 
|10.6    |  | Severance Agreement with John L. Coughlin (13)                                                          
|        | 
|10.7    |  | Employment Agreement with Ronald L. Marsiglio dated May 21, 2001 (15)                                   
|        | 
|10.8    |  | Employment Agreement with Francis E. Dunne, Jr. (11)                                                    
|        | 
|10.9    |  | Employment Agreement with James R. Kearbey dated as of January 1, 2003 (20)                             
|        | 
|10.10   |  | Employee Stock Ownership Plan (1)                                                                       
|        | 
|10.11   |  | First Amendment to Employee Stock Ownership Plan (2)                                                    
|        | 
|10.12   |  | Second Amendment to Employee Stock Ownership Plan (8)                                                   
|        | 
|10.13   |  | Third Amendment to Employee Stock Ownership Plan (8)                                                    
|        | 
|10.14   |  | Fourth Amendment to Employee Stock Ownership Plan (11)                                                  
|        | 
|10.15   |  | Fifth Amendment to Employee Stock Ownership Plan (11)                                                   
|        | 
|10.16   |  | Benthos, Inc. Employee Stock Ownership Plan as Amended and Restated Effective as of October 1, 2002 (19)
|        | 
|10.17   |  | 401(k) Retirement Plan (1993)(1)                                                                        
|        | 
|10.18   |  | First Amendment to 401(k) Retirement Plan (2)                                                           
|        | 
|10.19   |  | Second Amendment to 401(k) Retirement Plan (2)                                                          
|        | 
|10.20   |  | Third Amendment to 401(k) Retirement Plan (3)                                                           
|        | 
|10.21   |  | 401(k) Retirement Plan (1999)(8)                                                                        
|        | 
|10.22   |  | First Amendment to 1999 401(k) Retirement Plan (11)                                                     
|        | 
|10.23   |  | Second Amendment to 1999 401(k) Retirement Plan (11)                                                    
|        | 
|10.24   |  | Third Amendment to 1999 401(k) Retirement Plan (14)                                                     
|        | 
|10.25   |  | Supplemental Executive Retirement Plan (1)                                                              
|        | 
|10.26   |  | 1990 Stock Option Plan (1)                                                                              
|        | 
|10.27   |  | Stock Option Plan for Non-Employee Directors (1)                                                        
|        | 
|10.28   |  | 1998 Non-Employee Directors Stock Option Plan (4)                                                      
|        | 
|10.29   |  | Benthos, Inc. 2000 Stock Incentive Plan (9)                                                             
|        | 
|10.30   |  | License Agreement between the Company and The Penn State Research Foundation dated December 13, 1993 (1)



---

|Exhibit |  |                                                                                                                                                                                 
|------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|        | 
|10.31   |  | Technical Consultancy Agreement between the Company and William D. McElroy dated July 12, 1994 (1)                                                                              
|        | 
|10.32   |  | Technical Consultancy Agreement between the Company and William D. McElroy dated October 1, 1996 (3)                                                                            
|        | 
|10.33   |  | General Release and Settlement Agreement between the Company and Lawrence W. Gray dated February 8, 1996 (1)                                                                    
|        | 
|10.34   |  | Line of Credit Loan Agreement between the Company and Cape Cod Bank and Trust Company dated September 24, 1990, as amended (1)                                                  
|        | 
|10.35   |  | Commercial Mortgage Loan Extension and Modification Agreement between the Company and Cape Cod Bank and Trust Company, dated July 6, 1994 (1)                                   
|        | 
|10.36   |  | Credit Agreement between the Company and Cape Cod Bank and Trust Company dated August 18, 1999 (8)                                                                              
|        | 
|10.37   |  | First Amendment to Credit Agreement dated March 23, 2001 (14)                                                                                                                   
|        | 
|10.38   |  | Second Amendment to Credit Agreement dated December 12, 2001 (17)                                                                                                               
|        | 
|10.39   |  | Third Amendment to Credit Agreement dated January 29, 2003 (20)                                                                                                                 
|        | 
|10.40   |  | Fourth Amendment to Credit Agreement dated November 3, 2003                                                                                                                     
|        | 
|10.41   |  | License Agreement between the Company and Optikos Corporation dated July 29, 1997 (3)                                                                                           
|        | 
|10.42   |  | Hydrophone License Agreement between the Company and Sercel, Inc. (formerly Syntron, Inc.) dated December 5, 1996 (6)                                                           
|        | 
|10.43   |  | Amendment Number 1 to Hydrophone License Agreement between the Company and Sercel, Inc. (formerly Syntron, Inc.) dated September 11, 1998 (6)                                   
|        | 
|10.44   |  | Asset Purchase Agreement among Benthos, Inc., Datasonics, Inc., and William L. Dalton and David A. Porta (7)                                                                    
|        | 
|10.45   |  | Settlement Agreement and Mutual Release dated October 18, 2001 between the Company and RJE International, Inc (16)                                                              
|        | 
|10.46   |  | Amendment of Settlement Agreement and General Release dated June 10, 2002. (19)                                                                                                 
|        | 
|10.47   |  | Amendment and Termination of Consulting Agreement between the Company and William D. McElroy dated February 15, 2002 (18)                                                       
|        | 
|10.48   |  | Standard Form Purchase and Sale Agreement among the Company and certain of its subsidiaries and Falmouth Economic Development & Industrial Corporation dated March 21, 2003
(20)
|        | 
|10.49   |  | Amendment of Purchase and Sale Agreement dated as of June 30, 2003 (21)                                                                                                         
|        | 
|10.50   |  | Second Amendment of Purchase and Sale Agreement dated as of August 11, 2003                                                                                                     
|        | 
|10.51   |  | Agreement among the Company, Samuel O. Raymond and the Samuel O. Raymond 1996 Irrevocable Insurance Trust dated July 24, 2003                                                   
|        | 
|21      |  | Subsidiaries of the Registrant (19)                                                                                                                                             
|        | 
|31.1    |  | Certification of Chief Executive Officer Pursuant to the Securities Exchange Act                                                                                                
|        | 
|31.2    |  | Certification of Chief Financial Officer Pursuant to the Securities Exchange Act                                                                                                
|        | 
|32      |  | Statement Pursuant to 18 U.S.C. §1350                                                                                                                                           

---

|(1) |  | Previously filed as an exhibit to Registrants Registration Statement on Form 10-SB filed with the Commission on December 17, 1996 (File No. 0-29024) and incorporated herein by this
reference.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) |  | Previously filed as an exhibit to Registrants Quarterly Report on Form 10-QSB for the quarterly period ended March 30, 1997 (File No. 0-29024) and incorporated herein by this reference.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



---

|(3) |  | Previously filed as an exhibit to Registrants Quarterly Report on Form 10-QSB for the quarterly period ended June 29, 1997 (File No. 0-29024) and incorporated herein by this reference.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) |  | Previously filed as an exhibit to the Registrants Quarterly Report on Form 10-QSB for the quarterly period ended December 31, 1997 (File No. 0-29024) and incorporated herein by this
reference.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) |  | Previously filed as an exhibit to the Registrants Quarterly Report on Form 10-QSB for the quarterly period ended March 31, 1998 (File No. 0-29024) and incorporated herein by this
reference.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) |  | Previously filed as an exhibit to the Registrants Quarterly Report on Form 10-QSB for the quarterly period ended December 31, 1998 (File No. 0-29024) and incorporated herein by this
reference.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(7) |  | Previously filed as an exhibit to Registrants Current Report on Form 8-K filed on or about August 27, 1999 (File No. 0-29024) and incorporated herein by this reference.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(8) |  | Previously filed as an exhibit to Registrants Annual Report on Form 10-KSB for the fiscal year ended September 30, 1999 (File No. 0-29024) and incorporated herein by this reference.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(9) |  | Previously filed as an exhibit to the Registrants definitive proxy statement filed on Schedule 14A on or about January 18, 2000 and incorporated herein by this reference.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(10) |  | Previously filed as an exhibit to the Registrants Quarterly Report on Form 10-QSB for the quarterly period ended December 31, 1999 (File No. 0-29024) and incorporated herein by this
reference.
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(11) |  | Previously filed as an exhibit to the Registrants Quarterly Report on Form 10-QSB for the quarterly period ended June 30, 2000 (File No. 0-29024) and incorporated herein by this
reference.
|---- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(12) |  | Previously filed as an exhibit to the Registrants Annual Report on Form 10-KSB for the fiscal year ended September 30, 2000 (File No. 0-29024) and incorporated herein by this reference.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(13) |  | Previously filed as an exhibit to Amendment No. 1 to the Registrants Annual Report on Form 10-KSB for the fiscal year ended September 30, 2000 (File No. 0-29024) and incorporated herein
by this reference.
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(14) |  | Previously filed as an exhibit to the Registrants Quarterly Report on Form 10-QSB for the quarterly period ended March 31, 2001 (File No. 0-29024) and incorporated herein by this
reference.
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(15) |  | Previously filed as an exhibit to the Registrants Quarterly Report on Form 10-QSB for the quarterly period ended June 30, 2001 (File No. 0-29024) and incorporated herein by this
reference.
|---- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(16) |  | Previously filed as an exhibit to the Registrants Annual Report on Form 10-KSB for the fiscal year ended September 30, 2001 (File No. 0-29024) and incorporated herein by this reference.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(17) |  | Previously filed as an exhibit to the Registrants Quarterly Report on Form 10-QSB for the quarterly period ended December 31, 2001 (File No. 0-29024) and incorporated herein by this
reference.
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(18) |  | Previously filed as an exhibit to the Registrants Quarterly Report on Form 10-QSB for the quarterly period ended March 31, 2002 (File No. 0-29024) and incorporated herein by this
reference.
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(19) |  | Previously filed as an exhibit to the Registrants Annual Report on Form 10-KSB for the fiscal year ended September 30, 2002 (File No. 0-29024) and incorporated herein by this reference.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(20) |  | Previously filed as an exhibit to the Registrants Quarterly Report on Form 10-QSB for the quarterly period ended March 31, 2003 (File No. 0-29024) and incorporated herein by this
reference.
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(21) |  | Previously filed as an exhibit to the Registrants Quarterly Report on Form 10-QSB for the quarterly period ended June 30, 2003 (File No. 0-29024) and incorporated herein by this
reference.
|---- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------