##### Table of Contents









SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549




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Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934


For the fiscal year ended December 31,
2003

Commission file number: 001-11376



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The Allied Defense Group, Inc.

(Exact name of registrant as specified in its
charter)


|                         |  |                                     
|------------------------ |  | ------------------------------------
|Delaware                 |  | 04-2281015                          
|(State of incorporation) |  | (I.R.S. Employer Identification No.)

8000 Towers Crescent Drive,
Suite 260

Vienna, Virginia 22182


(Address of principal executive offices,
including zip code)


(703) 847-5268

(Registrants telephone number, including
area code)




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Securities registered pursuant to
Section 12(b) of the Act:

|                              |  |                        
|----------------------------- |  | -----------------------
|Title of Class                |  | Name of Exchange       
|                              |  |                        
|Common Stock, $0.10 Par Value |  | American Stock Exchange

Securities registered pursuant to
Section 12(g) of the Act: None

Indicate by check mark whether the registrant
(1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the
past
90 days.     Yes þ          No o

Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of
Regulation S-K (Section 229.405 of this chapter) is
not contained herein, and will not be contained, to the best of
registrants knowledge, in definitive proxy or information
statements incorporated by reference in Part II of this
Form 10-K or any amendment to this
Form 10-K.     Yes þ

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

State the aggregate market value of the voting
stock of the registrant held by non-affiliates as of
June 30, 2003, the last day of the registrants most
recently completed second fiscal quarter (For purposes of this
determination, only our directors and executive officers have
been deemed affiliates):

|                              |  |            
|----------------------------- |  | -----------
|Common Stock  Par Value $.10 |  | $94,368,779

The number of shares of registrants Common
Stock outstanding as of March 1, 2004, was 5,551,373.



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INDEX

|                  |  |                                                                                                        |    |  |    | 
|----------------- |  | ------------------------------------------------------------------------------------------------------ | -- |  | -- | 
|PART I           
|Item 1.           |  | Business                                                                                               |    |  | 2  | 
|Item 2.           |  | Properties                                                                                             |    |  | 8  | 
|Item 3.           |  | Legal Proceedings                                                                                      |    |  | 9  | 
|Item 4.           |  | Submission of Matters to a
    Vote of Security Holders                                                |    |  | 9  | 
|PART II          
|Item 5.           |  | Market for Stock and Related
    Stockholder Matters                                                   |    |  | 9  | 
|Item 6.           |  | Selected Financial Data                                                                                |    |  | 10 | 
|Item 7.           |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations              |    |  | 10 | 
|Item 7A.          |  | Quantitative and Qualitative
    Disclosures About Market Risk                                         |    |  | 20 | 
|Item 8.           |  | Financial Statements and
    Supplementary Data                                                        |    |  | 21 | 
|Item 9.           |  | Changes in and Disagreements
    with Accountants on Accounting and Financial Disclosure               |    |  | 21 | 
|Item 9A.          |  | Controls and Procedures                                                                                |    |  | 21 | 
|PART III         
|Item 10.          |  | Directors and Executive
    Officers of Allied                                                         |    |  | 22 | 
|Item 11.          |  | Executive Compensation                                                                                 |    |  | 24 | 
|Item 12.          |  | Security Ownership of
    Certain Beneficial Owners and Management and Related Stockholder
    Matters |    |  | 27 | 
|Item 13.          |  | Certain Relationships and
    Related Transactions                                                     |    |  | 29 | 
|Item 14.          |  | Principal Accounting Fees
    and Service                                                              |    |  | 29 | 
|PART IV          
|Item 15.          |  | Exhibits, Financial
    Statement Schedules, and Reports on Form 8-K                                   |    |  | 30 | 
|                  |  |                                                                                                        |    |  |    | 
|Signatures        |  |                                                                                                        | 32 | 
|EX-21            
|EX-23            
|CEO Certification
|CFO Certification
|EX-32            



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##### Table of Contents



PART I




Item 1.     Business

The Allied Defense Group, Inc.
(Allied or the Company) owns and manages
a strategic portfolio of defense and security businesses, with
presence in worldwide markets.

Allied was incorporated as a Delaware corporation
in 1961 under the name Allied Research Associates, Inc. Allied
changed its corporate name to Allied Research Corporation in
1988 and subsequently changed its name to The Allied Defense
Group, Inc. effective January 2, 2003. Allieds
strategic defense and security businesses are conducted through
MECAR S.A. (MECAR), a group of Belgian corporations
acquired in 1994, 1995 and 1999 consisting of VSK Electronics
N.V., Télé Technique Générale, S.A.,
Intelligent Data Capturing Systems, S.A. and VIGITEC, S.A.
(collectively, the VSK Group), News/ Sports
Microwave Rental Inc. (NS Microwave), Titan Dynamics
Systems, Inc. (Titan Dynamics), and SeaSpace
Corporation (SeaSpace). In late 2003, the Company
organized MECAR USA, Inc., a Delaware corporation (MECAR
USA).

The following table summarizes the Companys
significant acquisitions and divestitures:

|                      |  |                                    |  |         
|--------------------- |  | ---------------------------------- |  | --------
|Date                  |  | Company Involved                   |  | Event   
|                      |  |                                    |  |         
|May 26, 1987          |  | Barnes & Reinecke, Inc.            |  | Acquired
|May 31, 1994 and 1995 |  | The VSK Group                      |  | Acquired
|March 6, 2000         |  | Barnes & Reinecke, Inc.            |  | Sold    
|December 31, 2001     |  | News/ Sports Microwave Rental Inc. |  | Acquired
|June 6, 2002          |  | Titan Dynamics Systems, Inc.       |  | Acquired
|July 31, 2002         |  | SeaSpace Corporation               |  | Acquired

In order to continue building a strong worldwide
strategic portfolio of defense and security businesses and to
improve profitability, Allied has adopted a growth strategy that
focuses on the following objectives:



| |   |                                                                                                                                
| | - | -------------------------------------------------------------------------------------------------------------------------------
| |  | Strategic acquisitions that complement existing
    operating divisions                                                        
|
| |  | Organic growth by expanding product offerings,
    increasing market share in existing markets, and penetrating new
    markets
|
| |  | Enhance marketing and business development
    efforts between each subsidiary to increase sales and backlog                   
|
| |  | Successfully integrate new subsidiaries to ensure
    profitability and accretion                                              

Description of Business

Allied.Allied
provides management, marketing services and government relations
for its subsidiaries. In addition, Allied also provides export
licensing, procurement and logistic support services for its
subsidiaries.

MECAR.MECAR
develops, designs, manufactures and sells ammunition and light
weapons for military use. Substantially all of MECARs
revenues are derived from the sale of ammunition which is used
with weapons that are generally considered defensive weapons.
From time to time, MECAR provides system integration services
pursuant to which it purchases and resells weapon systems and/or
ammunition manufactured by others. MECAR designs, develops and
manufactures a wide variety of ammunition and grenades in the
medium caliber, artillery, anti-tank and anti-personnel
categories. The following are the principal products produced
and sold by MECAR:

Mortar AmmunitionThe 120mm family is state of the art
ammunition for standard field mortars and for the increased
performance turreted Automatic Mortar System (AMS). The current
version of this ammunition has successfully completed
qualification with the U.S. Army, together with the 120mm AMS
LAV-M(S) system. This system is capable of direct as well as
indirect fire. The MECAR ammunition is the only one so far
developed that has been qualified in the AMS weapon high
pressure and acceleration environment. The 81mm family of mortar

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ammunition has been modernized to compete with
the latest generation of this product line. Production
quantities of this latest version have already been manufactured
and delivered to MECAR customers.


90mm AmmunitionMECAR has developed and produces
complete families of ammunition that include Armor Piercing Fin
Stabilized Discarding Sabot (APFSDS), High Explosive (HE), Smoke
(SMK) and High Explosive Squash Head (HESH) rounds for
the COCKERILL Mk II and III and ENGESA EC-90, and DEFA F1 guns.
Over 2,000 of these guns are standard equipment on light Armored
Personnel Carriers (APCs) in the Far East and South America
alone. In the last five years, these families of ammunition have
been improved to meet the highest standards of safety and
performance. The 90mm KENERGA Weapon System has been jointly
developed by Cockerill Mechanical Systems (CMI) and
MECAR to provide the modern A..P..C.. (APC) with anti-tank
punch similar to that of tanks equipped with 105mm guns, without
sacrifice to the range, mobility and maintainability of the
light APC. In this partnership, CMI is responsible for the
weapon and MECAR for the ammunition. The ammunition family
includes the APFSDS, HESH and SMK versions with their
corresponding training rounds. This system is currently
completing its final phase of qualification by the U.S. Army.

Tank AmmunitionMECAR produces the entire range of
105mm rounds of its own design and which perform to NATO
requirements, for use in the US M68, UK L7 and French CN105F1
guns. These include the APFSDS, HEAT, HESH and SMK, with their
corresponding training rounds. Additionally, it has produced
under license the US Army M393A2 HEP-T and M724A1 TPDS-T rounds
for the Belgian Army. MECAR has produced 100mm APFSDS rounds for
friendly pro western clients in the Far East.

Artillery AmmunitionMECAR has produced 155mm HE, SMK(WP)
and ILLUMINATING rounds for various customers.

Medium Caliber RoundThe 25mm APFSDS-T ammunition round is
MECARs entry into the medium caliber arena.

76mm L23 AmmunitionMECAR manufactures HE, HESH and
HESH-PRAC ammunition for the L23 guns, which are in service with
armored vehicles in several countries in Europe, South America,
Africa and the Far East. Even though this is an established
weapon, requirements for this ammunition are expected to
continue for the next several years.

84mm SAKR Recoilless RifleMECAR develops and manufactures this
recoilless rifle and its associated family of ammunition. The
SAKR fills the gap between rifle grenades and the 90mm family of
guns and ammunition. The SAKR ammunition (HEAT, HE-T and
HE-TP-T) is also interoperable with existing 84mm systems.

GrenadesMECAR
manufactures two types of grenades: the M72 controlled
fragmentation hand grenade and the universal bullet trap rifle
grenade. The universal bullet trap rifle grenade is designed to
be light, effective, accurate and simple to use. It is fitted
over the muzzle of any standard military rifle with a muzzle
outer diameter of 22mm and fired from the shoulder in the normal
manner. MECAR manufactures several different bullet trap
grenades including high explosive fragmentation, anti-personnel,
armor piercing, smoke generating, white phosphorus, and
parachute flare (night illuminating).

VSK Group.The VSK
Group designs, manufactures, sells, installs and services
security systems for government and private industry. The VSK
Group consists of four firms: VSK Electronics, N.V.,
Télé Technique Générale, S.A., Intelligent
Data Capturing Systems (IDCS) S.A., and VIGITEC S.A. VSK
Electronics, N.V. manufactures access control and fire detection
systems; Télé Technique Générale, S.A.
installs security systems; IDCS S.A. manufacturers integrated
video systems; and VIGITEC S.A. installs networked video
surveillance systems. These firms combine to create a wealth of
technical knowledge in hardware and software development and
closed circuit monitoring, along with the latest trends in data
transmission and communication protocols for a host of
protection and detection security systems. The VSK Groups
systems offer total integration with all aspects of data
collection and management, surveillance, protection and
detection with either direct and/or remote programming options
for maximum control. The latest technological systems include
biometric verification, asset tracking and digital closed
circuit television distribution.

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NS Microwave.NS
Microwave develops sophisticated microwave surveillance systems
used in law enforcement, port security, border security, airport
security, high-end commercial security, and citywide
surveillance applications. The companys products and
services are used for gathering, transmitting, receiving and
processing multiple signals from remote locations. The company
develops, assembles and sells electronic technology products and
systems for users to operate through the companys
proprietary hardware, software and communication links. NS
Microwaves systems and products include cameras,
command/control systems, video concealments, microwave link
solutions, and other sensors. NS Microwave offers fixed
observation/transmit surveillance installations in addition to
mobile command centers and airborne camera/tracking/transmit
packages.

Titan Dynamics.Titan Dynamics designs, manufactures
and sells an extensive line of battlefield effects simulators.
These systems provide military personnel with real time,
thermal, audio/visual battlefield effects commonly experienced
in wartime to enhance training realism. The simulators fire
pyrotechnic cartridges that simulate the flash, smoke and sound
of fired or exploding ammunition and ordnance systems. Titan
Dynamics principal product lines are Omega 36/ B2 and
Omega 60/ B1 battlefield effects simulators (BES), the Multi Air
Defense Simulator System (MADSS), the Rocket Propelled Grenade
System (RPGS) and the E-Pryo Simulator devices. The Omega
36/ B2 and the Omega 60/ B1 BES are 36 shot and
60 shot programmable dispensers which discharge multiple
Titan-produced cartridges that produce various pyrotechnic
effects such as flash/bang, colored smokes, air burst, star
clusters and missile firing signatures. The MADSS and the RPGS
are multi-spectrum training systems used to simulate
aircrews and ground crews internal attack warning
systems while also providing the real-time thermal/audio/visual
battlefield effects related to the attack. The companys
focus for the future is to design and manufacture innovative new
products for the military training environment and exploit its
revolutionary patented initiation technologies to a wide variety
of applicable commercial fields.

SeaSpace.SeaSpace
designs, manufactures, distributes and services weather and
environmental satellite ground reception systems. Its
proprietary TeraScan® software processes earth remote
sensing satellite data for mission-critical applications
requiring timely and accurate weather and environmental
information. Founded in 1982, SeaSpace pioneered the development
of cost-effective, easily deployed systems, and has built a
worldwide base of over 450 military, commercial, and academic
customers. SeaSpace has also established market leadership in
development and deployment of ground stations supporting the
newest generation of X-Band satellites being
launched by NASA and other organizations.

MECAR USA.MECAR USA
will initially pursue contracts from the U. S. Government and
others for ammunition and pyrotechnics devices. MECAR USA is
expected to be operational in the latter portion of 2004.

Geographic Areas and Industry
Segments

See Note U to Allieds consolidated
financial statements for information concerning the geographic
areas and industry segments of Allied which information is
incorporated herein by reference. The Company operates in four
principal segments: the Ordnance & Manufacturing segment
which consists of MECAR; the Electronic Security segment which
consists of the VSK Group and NS Microwave; the Environmental
Safety & Security segment which consists of SeaSpace; the
Software, Training & Simulation segment which consists of
Titan Dynamics.

Market and Customers

Allied derives the principal portion of its
revenue in the Ordnance and Manufacturing segment from direct
and indirect sales to foreign governments and prime contractors,
primarily on fixed price contracts. Two foreign governments
accounted for approximately 56% and 4% in 2003, 65% and 1% in
2002, and 77% and 1% in 2001, of Allieds revenue as
detailed in Note P to Allieds consolidated financial
statements, the provisions of which are incorporated herein.
Ordnance and Manufacturing sales to its principal foreign
government customers are made via an independent marketing
representative. Commencing in early 2000, MECAR designated an
affiliate of this representative as its independent
distributor/value added reseller (the Distributor).
The Distributor obtains a contract from the end user customer
and subcontracts a portion of the work to MECAR. The products
that MECAR produces are sold to the Distributor for resale to
the foreign government agencies end users.

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Ordnance and Manufacturing products are sold
either directly or indirectly to the defense departments of
governments. MECAR is regulated by Belgian law regarding the
foreign governments with which it may do business. The sales by
MECAR in any given period and its backlog at any particular time
may be significantly influenced by one or a few large orders. An
order for MECARs products is typically for a large
quantity and/or a substantial aggregate price, primarily because
materials required for the manufacture of the products cannot be
economically purchased in small quantities and because of the
favorable economies of large volume production. Most of the
contracts received by MECAR require delivery in approximately
one year. Accordingly, MECARs business is dependent upon
its ability to obtain such large orders. MECAR frequently
accepts smaller orders in an attempt to increase its customer
base and efficiently use its manufacturing capacity.

When MECAR obtains a contract for the sale of its
products, it generally receives down payment(s) and/or letter(s)
of credit to be applied to the purchase price upon shipment of
the products. In such cases, MECAR is generally required to
provide advance payment guarantees and performance bonds issued
by its bank syndicate.

MECAR has from time-to-time received foreign
military sale (FMS) contracts from the U.S.
Government for the manufacture of ammunition for the benefit of
a foreign government customer. Such contracts may be terminated
for convenience by the government or upon default by the
manufacturer. The contracts received by MECAR through the FMS
system do not require down payments, letters of credit, advance
payment guarantees or performance bonds.

In the Electronic Security segment, the VSK Group
derives substantially all of its revenue from sales and services
to private industry such as banks, hospitals, commercial
businesses, office buildings and to local governments. The VSK
Group sells some of its products/services directly to the end
users; in other instances it sells its systems to independent
distributors and resellers for resale to the end users. The
customers of the VSK Group are located in Belgium and in
neighboring countries. While most of the orders received by the
VSK Group are for work which can be completed within one year,
it has received multi-year orders for its products and services.
VSK Electronics and IDCS sell their products principally in
European markets. VIGITEC and Télé Technique
Générale sell their products in Belgium and in other
European markets. NS Microwaves customers include U.S.
Government agencies as well as state and local law enforcement
agencies. The U.S. Government agencies have historically
accounted for a majority of NS Microwaves revenues. The
Electronic Security segment is not dependent upon any single
customer or a few customers.

In the Environmental Safety and Security segment,
customers include numerous users with need for mission-critical
weather and environmental information, including
scientists/researchers, universities, military forces and
commercial users. The Environmental Safety and Security segment
is not dependent upon any single customer or a few customers.

In the Software, Training & Simulation
segment, customers include a number of Army, National Guard and
Marine Corps ranges and training centers.

Principal Customers

MECAR has historically received a large
percentage of its revenue from agencies of a foreign government.
See Note P to Allieds consolidated financial
statements. MECAR receives contracts for the benefit of this
customer via the Distributor and has received contracts for the
benefit of these customers via the FMS program.

Raw Materials and Suppliers

In the Ordnance and Manufacturing segment,
production of ammunition requires an ample supply of chemicals,
pyrotechnic materials, metal component parts and casings. MECAR
generally attempts to ensure that several vendors will be
available in the open market to compete for all supply
contracts. However, once the development phase is complete and
the design has been stabilized for certain products, the
continued availability of supplies can become critical to its
ability to perform a particular contract. MECAR seeks to protect
itself against shortages and similar risks by planning
alternative means of production, by producing internally, and by
monitoring the availability and sources of supplies. MECAR
depends upon major suppliers to provide a continuous flow of
such components and materials where in-house capability does not
exist, and has generally

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found such materials and supplies to be readily
available. In 2003, MECAR acquired certain assets of a
pyrotechnics supplier to mitigate future supply issues.


In the Electronic Security segment, each of the
VSK Group and NS Microwave relies upon a number of select
subcontractors to supply the requisite electronic hardware for
its security systems. To date, each entity has found such
subcontract materials to be readily available.

In the Environmental Safety & Security
segment, SeaSpace uses a variety of high quality vendors to
produce various hardware components and subsystems. Adequate
numbers of vendors exist for all significant components and
subsystems. Software is developed in-house with existing
technical staff.

In the Software, Training & Simulation
segment, Titan has adequate numbers of suppliers for most
components. If a vendor change or addition is required,
additional time and funds may be required to evaluate and
certify vendors prior to use. In the past, this has not been a
critical problem.

Prolonged disruptions in the supply of any of the
Companys raw materials, difficulty completing
qualification of new sources of supply, or implementing use of
replacement materials or new sources of supply could have a
material adverse effect on the Companys business,
financial condition, or results of operations.

Marketing

Most of the marketing activities of the Ordnance
and Manufacturing segment are handled by MECARs staff of
sales engineers and executive personnel. In addition, MECAR
advertises in trade journals and participates in trade shows.
MECAR is also represented by marketing representatives in
different markets and has designated a Distributor for indirect
sales to its principal end user customers.

Electronic Security segment markets its products
principally through its executive management and the staff of
sales personnel of the VSK Group and NS Microwave. Marketing
activities of the VSK Group outside of Belgium are conducted by
independent distributors. In addition, the Electronic Security
segment advertises in trade journals and participates in trade
shows.

Environmental Safety & Security markets its
products in the United States principally through its executive
management and its sales personnel. Marketing activities outside
of the United States are conducted by independent distributors,
supported by SeaSpace executive management and sales personnel.

Software, Training & Simulation markets its
products principally through its executive management.

Research and Development

In the Ordnance and Manufacturing segment, the
development of ammunition and weapon systems requires knowledge
and experience in aerodynamics, mechanical engineering,
chemistry, combustion, materials behavior and ballistics. MECAR
maintains an active research and development staff, including a
staff of design engineers, in order to determine how materials
can be used or combined in new ways to improve performance or to
solve new problems. In 2003, 2002, and 2001, MECAR expended
$1,075, $292, and $501, respectively, for research and
development activities. MECAR designed most of the products
which it currently manufactures. MECAR designs and develops most
of its special tooling, fixtures and special explosive loading
and testing systems.

The Electronic Security business requires
continuous investment in research and development to update and
enhance its security systems. The VSK Group and NS Microwave
employ staffs of design engineers specialized in the field of
both electronic hardware and software. During 2003, 2002, and
2001, the Electronic Security segment expended $2,452, $1,329
and $1,003, respectively, on research and development.

The Environmental Safety & Security and
Software, Training & Simulation Segments expended minimal
amounts for research and development.

Backlog

As of December 31, 2003 and
December 31, 2002, Allied had backlog orders believed to be
firm, after giving effect to the percentage of completion method
of accounting, of approximately $115.4 million and

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$156.8 million, respectively. A substantial
portion of the backlog of orders as of December 31, 2003 is
expected to be filled in 2004. The December 31, 2003
backlog was as follows:


|                                |  |              
|------------------------------- |  | -------------
|Ordnance and Manufacturing      |  | $88.8 million
|Electronic Security             |  | 24.4 million 
|Environmental Safety & Security |  | 1.7 million  
|Software, Training & Simulation |  | 0.5 million  

Electronic Security backlog includes an unfunded
portion of $12 million from a federal contract.

Competition

The munitions business is highly competitive.
MECAR has a number of competitors throughout the world,
including the United States. Many of its competitors are
substantially larger companies with greater capital resources
and experience. Many of its competitors have existing
relationships with governments and countries in which MECAR
markets its products. For example, many countries will only
acquire ammunition and other military items from vendors located
in said countries. In many other countries, it is important to
have an independent marketing representative. Competition is
mainly based upon accessibility to potential markets, technical
expertise, quality, capabilities of the product, price and
ability to meet delivery schedules. The downsizing of the
munitions industrial base has resulted in a reduction in the
number of competitors through consolidations and departures from
the industry. This has reduced the number of competitors in some
programs, but has strengthened the capabilities of some of the
remaining competitors. In addition, it is possible that there
will be increasing competition from the remaining competitors in
business areas area they do not currently compete.

The nature of the competition encountered by the
Electronic Security segment depends upon the sub-segment of the
security systems business. In the development and manufacturing
area, there are a number of larger competitors, many with
greater financial resources than the VSK Group. In the
installation and services area, the VSK Group competes with a
number of smaller, local competitors. NS Microwave competes with
niche suppliers of specialized security products as well as much
larger companies with substantially greater financial and other
resources.

Competition in the Environmental Safety &
Security segment is vigorous but usually limited to fewer than a
dozen suppliers, some of which are substantially larger than
SeaSpace. Barriers to entry are significant and competition
often hinges on customer satisfaction, risk associated with
trying a new supplier on mission-critical applications,
technical capability and price.

The U. S. battlefield effects simulator market
where Titan Dynamics competes is relatively small and served by
an entrenched, substantially larger competitor. Historically,
the market does not attract new entrants. Titan Dynamics
believes that it has superior technology that should permit it
to gain a substantially larger share once required government
testing and certification is completed.

Seasonal Nature of Business

The Companys business in general is not
seasonal, although the summer and winter holiday seasons affect
Company revenue because of the impact of holidays and vacations
on the Companys product and service sales by the
Companys international operations. Variations in the
Companys business may also occur at the expiration of
major contracts until such contracts are renewed or new
businesses obtained.

The U.S. Governments fiscal year ends on
September 30 of each year. It is not uncommon for
government agencies to award extra tasks or complete other
contract actions in the weeks before the end of the fiscal year
in order to avoid the loss of unexpected fiscal year funds.
Moreover, in the years when the U.S. Government does not
complete its budget process before the end of its fiscal year,
government operations typically are funded pursuant to a
continuous resolution that authorizes agencies of
the government to continue to operate but traditionally does not
authorize new spending initiatives. When the government operates
pursuant to a continuing

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resolution, delays can occur in procurement of
products and services, and such delays can affect the
Companys revenue and profit during the period of delay.


Personnel

As of December 31, 2003, Allied, MECAR, the
VSK Group, NS Microwave, SeaSpace and, Titan Dynamics had 577
full and part-time employees as follows:

|               |  |                    |     |         |  |           |     |             |  |       |   |  |  |  |   |  |  |  |     | 
|-------------- |  | ------------------ | --- | ------- |  | --------- | --- | ----------- |  | ----- | - |  |  |  | - |  |  |  | --- | 
|               |  | Technical &        |     | Hourly  |  | Part-time |     | Technical   |  |      
|               |  | salaried employees |     | workers |  | employees |     | consultants |  | Total
|               |  |                    |     |         |  |           |     |             |  |      
|Allied         |  |                    | 7   |         |  |           |    |             |  |       |  |  |  |  |  |  |  |  | 7   | 
|MECAR          |  |                    | 50  |         |  |           | 265 |             |  |       |  |  |  |  | 2 |  |  |  | 317 | 
|VSK Group      |  |                    | 120 |         |  |           | 23  |             |  |       | 5 |  |  |  |  |  |  |  | 148 | 
|NS Microwave   |  |                    | 34  |         |  |           | 23  |             |  |       |  |  |  |  |  |  |  |  | 57  | 
|SeaSpace       |  |                    | 32  |         |  |           | 6   |             |  |       |  |  |  |  |  |  |  |  | 38  | 
|Titan Dynamics |  |                    | 2   |         |  |           | 8   |             |  |       |  |  |  |  |  |  |  |  | 10  | 

The classification of employees noted above for
MECAR and the VSK Group is in accordance with Belgian law.

Patents and Trademarks

NS Microwave holds a patent on a mechanical mast
that is a key component of certain security systems it supplies
to law enforcement agencies. The patent was granted in 1997.
Titan holds patents on its weapon discharge simulation system
(granted in 1993), its electrostatically dischargeable primer
(granted in 1999), its electric impulse cartridge (granted in
2001) and an electric gun (granted in 2002). SeaSpace has the
TERASCAN and SEASPACE trademarks. Neither Allied nor any of its
other subsidiaries holds any other significant patents and
trademarks. The Companys operations are not dependent to
any significant extent upon its patents or trademarks.

Environmental Regulations

Allied does not anticipate that compliance with
any laws or regulations relating to environmental protection
will have a material effect on its capital expenditures,
earnings or competitive position.

Available Information

Our principal Internet address is
www.allieddefensegroup.com. We make available free of
charge on www.allieddefensegroup.com our annual,
quarterly and current reports, and amendments to those reports,
as soon as reasonably practicable after we electronically file
such material with, or furnish it to, the SEC. In addition, you
may request a copy of these filings (excluding exhibits) at no
cost by writing or telephoning us at the following address or
telephone number:



| |                               
| | ------------------------------
| | The Allied Defense Group, Inc.
| | 8000 Towers Crescent Drive    
| | Suite 260                     
| | Vienna, Virginia 22182        
| | (703) 847-5268                




Item 2.     Properties

Allieds principal executive offices are
located in Vienna, Virginia, where it leases approximately 3,900
square feet of office space. The lease expires in September,
2007.

MECARs principal factory is located
approximately 25 miles south of Brussels near Nivelles, Belgium.
The factory principally consists of a manufacturing and
administrative complex which was occupied by MECAR in

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1989. The manufacturing area is approximately
112,000 square feet and the administration facility is
approximately 28,000 square feet. There are a number of older
buildings on the property that are still used in conjunction
with the new complex. A small test firing range is maintained on
this property. MECAR also owns 600 acres in the vicinity of the
Village of Marche in the Ardennes region of Belgium, which was
previously used as a test range. MECAR ceased its use of the
Ardennes firing range in 2001. MECAR is now utilizing other test
ranges, including a test range owned by the Belgian Army,
although it is also exploring the prospects of securing the use
of a new test range. Throughout 2003, MECAR operated using one
full and two partial shifts. MECAR is currently operating near
its productive capacity.


The VSK Group operates from owned facilities
throughout Belgium containing approximately 49,400 square feet.
Such facilities are currently operating at approximately 75% of
productive capacity.

NS Microwave operates from a leased office,
production and warehouse facility consisting of approximately
8,400 square feet in Spring Valley, California. The facility is
leased on a month to month basis and is currently operating at
approximately 80% of productive capacity.

SeaSpace operates from a leased office consisting
of 14,000 square feet in Poway, CA. The lease expires in June,
2009 and the facility is currently operating at approximately
70% of productive capacity.

Titan Dynamics operates from a leased office and
manufacturing facility consisting of approx 3,800 square feet in
Marshall, TX. The facility is currently operating at
approximately 80% of productive capacity.

MECAR USA will operate from a leased facility in
Marshall, Texas, which is being constructed by the local
development authority.

Capital expenditure programs for facilities and
equipment planned in 2004 will require funding of approximately
$3.8 million.




Item 3.     Legal
Proceedings

There are no material pending legal proceedings,
other than ordinary routine litigation incidental to
Allieds business, to which Allied or any of its
subsidiaries is a party or to which any of their property is
subject. See Note L to Allieds consolidated financial
statements for a description of one pending suit against the VSK
Group and one pending suit against SeaSpace.




Item 4.     Submission
of Matters to a Vote of Security Holders

No matter was submitted to a vote of security
holders during the fourth quarter of 2003, through the
solicitation of proxies or otherwise.

PART II




Item 5.     Market
for Stock and Related Stockholder Matters

Market Information.Allieds Common Stock has been
listed for trading on the American Stock Exchange
(AMEX) since September 15, 1992. Its AMEX
trading symbol is ADG. Its media listing is under the symbol
Allied Defense. The table below shows the high and low sales
prices of Allieds Common Stock during 2003 and 2002 (as
reported by AMEX):

|            |  |      |       |      |  |      |       |     |  |   |       |  |  |   |       | 
|----------- |  | ---- | ----- | ---- |  | ---- | ----- | --- |  | - | ----- |  |  | - | ----- | 
|            |  |      |       |     
|            |  | 2003 |       | 2002
|            |  |      |       |     
|            |  | High |       | Low  |  | High |       | Low
|            |  |      |       |      |  |      |       |    
|1st Quarter |  | $    | 18.99 |      |  | $    | 14.86 |     |  | $ | 24.99 |  |  | $ | 13.58 | 
|2nd Quarter |  |      | 19.00 |      |  |      | 14.75 |     |  |   | 28.04 |  |  |   | 19.55 | 
|3rd Quarter |  |      | 22.00 |      |  |      | 18.25 |     |  |   | 25.37 |  |  |   | 18.60 | 
|4th Quarter |  |      | 24.04 |      |  |      | 20.00 |     |  |   | 20.75 |  |  |   | 14.20 | 

Stockholders.The
number of holders of record of the Common Stock at March 1,
2004 was 1,119.

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Dividends.Allied
paid a 5% stock dividend in November, 1992 to holders of record
of its Common Stock on October 15, 1992. Cash was paid in
lieu of the issuance of fractional shares. There have been no
subsequent dividends declared or paid by Allied. The payment of
dividends is within the discretion of Allieds Board of
Directors and any decision to pay dividends in the future will
depend upon an evaluation of a number of factors, including
earnings, capital requirements, operating and financial
condition, and any contractual limitation then in effect. In
this regard, MECARs bank syndicate agreement requires the
maintenance by MECAR of minimum financial covenants, which
effectively restricts the amount of dividends we may pay from
MECARs assets.




Item 6.     Selected
Financial Data

The selected consolidated financial data below
have been derived from our audited financial statements. You
should read the following table in conjunction with
Managements Discussion and Analysis of Financial Condition
and Results of Operations and our consolidated financial
statements and notes thereto included elsewhere in the annual
report on Form 10-K. The historical results presented below
are not indicative of any future results. The following selected
financial data relates to Allieds consolidated financial
position and results of operations for 2003, 2002, 2001, 2000,
and 1999:

|                                                         |                          |                                          |              |       |       |         |         |        |        |         |        |        |        |        |         |       |       |        |        |        |        |        | 
|-------------------------------------------------------- | ------------------------ | ---------------------------------------- | ------------ | ----- | ----- | ------- | ------- | ------ | ------ | ------- | ------ | ------ | ------ | ------ | ------- | ----- | ----- | ------ | ------ | ------ | ------ | ------ | 
|                                                         |                          | 2003                                     |              | 2002  |       | 2001    |         | 2000   |        | 1999   
|                                                         |                          |                                          |              |       |       |         |         |        |        |        
|                                                         |                          |                                         
|                                                         |                          | (000s omitted except per share amounts)
|Revenues                                                 |                          | $                                        | 171,407      |       |       | $       | 130,866 |        |        | $       | 96,947 |        |        | $      | 107,743 |       |       | $      | 59,033 |       
|Earnings (loss) from                                     |                          |                                          |              |       |       |         |         |        |        |         |        |        |        |        |         |       |       |        |        |       
|                                                         |  continuing operations  |                                          |              | 8,821 |       |         |         | 10,672 |        |         |        | 10,367 |        |        |         | 8,705 |       |        |        | (3,282 | )     
|                                                         |  discontinued operation |                                          |              |      |       |         |         |       |        |         |        |       |        |        |         | 517   |       |        |        | (746   | )     
|                                                         |                          |                                          |              |       |       |         |         |        |        |         |        |        |        |        |         |       |       |        |        |       
|                                                         |                          | Net earnings (loss)                      |              |       | 8,821 |         |         |        | 10,672 |         |        |        | 10,367 |        |         |       | 9,222 |        |        |        | (4,028 | )     
|                                                         |                          |                                          |              |       |       |         |         |        |        |         |        |        |        |        |         |       |       |        |        |       
|Earnings (loss) per share Basic:                         |                          |                                          |              |       |       |         |         |        |        |         |        |        |        |        |         |       |       |        |        |       
|                                                         |  continuing operations  |                                          |              | 1.60  |       |         |         | 2.01   |        |         |        | 2.11   |        |        |         | 1.79  |       |        |        | (0.68  | )     
|                                                         |  discontinued operation |                                          |              |      |       |         |         |       |        |         |        |       |        |        |         | 0.11  |       |        |        | (0.16  | )     
|                                                         |                          |                                          |              |       |       |         |         |        |        |         |        |        |        |        |         |       |       |        |        |       
|                                                         |                          | Net earnings (loss)                      |              |       | 1.60  |         |         |        | 2.01   |         |        |        | 2.11   |        |         |       | 1.90  |        |        |        | (0.84  | )     
|                                                         |                          |                                          |              |       |       |         |         |        |        |         |        |        |        |        |         |       |       |        |        |       
|Diluted:                                                 |                          |                                          |              |       |       |         |         |        |        |         |        |        |        |        |         |       |       |        |        |       
|                                                         |  continuing operations  |                                          |              | 1.54  |       |         |         | 1.92   |        |         |        | 2.10   |        |        |         | 1.79  |       |        |        | (0.68  | )     
|                                                         |  discontinued operation |                                          |              |      |       |         |         |       |        |         |        |       |        |        |         | 0.11  |       |        |        | (0.16  | )     
|                                                         |                          |                                          |              |       |       |         |         |        |        |         |        |        |        |        |         |       |       |        |        |       
|                                                         |                          | Net earnings (loss)                      |              |       | 1.54  |         |         |        | 1.92   |         |        |        | 2.10   |        |         |       | 1.90  |        |        |        | (0.84  | )     
|                                                         |                          |                                          |              |       |       |         |         |        |        |         |        |        |        |        |         |       |       |        |        |       
|                                                         |                          |                                          | Total assets |       |       | 227,237 |         |        |        | 168,168 |        |        |        | 86,784 |         |       |       | 87,636 |        |        |        | 60,131 | 
|Long-term obligations and redeemable preferred
    stock |                          |                                          | 9,731        |       |       |         | 7,422   |        |        |         | 3,110  |        |        |        | 3,529   |       |       |        | 3,081  |       
|Cash dividends declared per common share                 |                          |                                          |             |       |       |         |        |        |        |         |       |        |        |        |        |       |       |        |       |       






|        |                                                                                                                                
|------- | -------------------------------------------------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations (amounts in
    thousands of dollars)

Overview

Allied is a strategic portfolio of defense and
security businesses, with presence in worldwide markets,
offering both government and commercial customers leading edge
products and services. Allied operates in four principal
segments: MECARs development and production of ammunition
and weapon systems (Ordnance & Manufacturing);
VSK Groups and NS Microwaves manufacture,
distribution and service of industrial security products
(Electronic Security); Titan Dynamics
development and sale of Battlefield Effects Simulators
(Software, Training & Simulation); and
SeaSpaces production and sale of weather and environmental
satellite ground reception systems (Environmental Safety
& Security).

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Due to the historic volatility in MECARs
business, in the mid-1990s Allied acquired the VSK Group
with a goal of attempting to diversify its operations. The
Company continued its diversification efforts in late 2001 and
into mid-2002 with the acquisitions of NS Microwave, Titan
Dynamics and SeaSpace.

In 2003, MECAR and the VSK Group continued to
provide excellent revenues and net profits. MECAR achieved
above-average net profits due in large part to continued work on
a large FMS contract for the benefit of one of its principal
customers. The VSK Group reported record revenues and net
profits based on increased export sales of its security services
products via its distribution system. The excellent European
results were amplified by the increased value of the Euro versus
the U.S. Dollar but offset by losses incurred by the most recent
domestic acquisitions.

Allied earned net profits of $8,821 ($1.60 per
share  basic and $1.54 per share-diluted) in 2003
compared to net profits of $10,672 ($2.01 per share 
basic and $1.92 per share-diluted) in 2002 and net profits of
$10,367 ($2.11 per share-basic and $2.10 per share 
diluted) in 2001.

Allied anticipates that 2004 will be another
profitable year. The European subsidiaries have healthy backlogs
and are expected to deliver substantial profits, although
perhaps not at the same levels as in recent years. Allied
anticipates that its domestic subsidiaries should perform
considerably better in 2004 than in 2003.

In late 2003, Allied organized MECAR USA, INC., a
Delaware corporation, to pursue ammunition and related
opportunities from U.S. and other markets. MECAR USA will
initially focus on contracts for ammunition and pyrotechnics
devices. MECAR USA will operate from Marshall, Texas. It will
commence operations in the fourth quarter of 2004.

Allied enters 2004 with substantial cash reserves
and anticipates no liquidity concerns in 2004. The Company
continues to pursue a domestic lending facility in order to
continue its acquisitions program.

Results of Operations

The following table sets forth, for the years
ended December 31, 2003, 2002 and 2001, certain items from
Allieds consolidated statements of operations expressed as
a percentage of revenue:

|                                       |                            |                                  |         |        |        |      |       |      |      |   |         |        |        |  |       |      |      |   |        |        |        |  |       |      |      | 
|-------------------------------------- | -------------------------- | -------------------------------- | ------- | ------ | ------ | ---- | ----- | ---- | ---- | - | ------- | ------ | ------ |  | ----- | ---- | ---- | - | ------ | ------ | ------ |  | ----- | ---- | ---- | 
|                                       |                            | For the years ended December 31,
|                                       |                            |                                 
|                                       |                            |                                  |         |       
|                                       |                            | 2003                             |         | 2002   |        | 2001
|                                       |                            |                                  |         |        |        |     
|Revenue                                |                            | $                                | 171,407 |        |        |      | 100.0 | %    |      | $ | 130,866 |        |        |  | 100.0 | %    |      | $ | 96,947 |        |        |  | 100.0 | %   
|Cost and expenses Cost of sales        |                            |                                  | 124,558 |        |        |      | 72.7  |      |      |   | 91,509  |        |        |  | 69.9  |      |      |   | 63,253 |        |        |  | 65.2  |     
|                                       | Selling and administrative |                                  |         | 24,987 |        |      |       | 14.6 |      |   |         | 17,497 |        |  |       | 13.4 |      |   |        | 12,109 |        |  |       | 12.5 |     
|                                       | Research and development   |                                  |         | 3,543  |        |      |       | 2.0  |      |   |         | 1,629  |        |  |       | 1.2  |      |   |        | 1,504  |        |  |       | 1.6  |     
|                                       |                            |                                  |         |        |        |      |       |      |      |   |         |        |        |  |       |      |      |   |        |        |        |  |       |     
|                                       |                            | Operating income                 |         |        | 18,319 |      |       |      | 10.7 |   |         |        | 20,231 |  |       |      | 15.5 |   |        |        | 20,081 |  |       |      | 20.7 | 
|Other income (expense) Interest income |                            |                                  | 459     |        |        |      | 0.3   |      |      |   | 506     |        |        |  | 0.4   |      |      |   | 645    |        |        |  | 0.7   |     
|                                       | Interest expense           |                                  |         | (2,490 | )      |      |       | (1.5 | )    |   |         | (2,087 | )      |  |       | (1.6 | )    |   |        | (1,666 | )      |  |       | (1.7 | )   
|                                       | Other  net                |                                  |         | 255    |        |      |       | 0.2  |      |   |         | 1,300  |        |  |       | 1.0  |      |   |        | (316   | )      |  |       | (0.3 | )   
|                                       |                            |                                  |         |        |        |      |       |      |      |   |         |        |        |  |       |      |      |   |        |        |        |  |       |     
|                                       |                            | Earnings before income taxes     |         |        | 16,543 |      |       |      | 9.7  |   |         |        | 19,950 |  |       |      | 15.3 |   |        |        | 18,744 |  |       |      | 19.3 | 
|Income tax expense                     |                            |                                  | 7,722   |        |        |      | 4.5   |      |      |   | 9,278   |        |        |  | 7.1   |      |      |   | 8,377  |        |        |  | 8.6   |     
|                                       |                            |                                  |         |        |        |      |       |      |      |   |         |        |        |  |       |      |      |   |        |        |        |  |       |     
|                                       |                            | Net earnings                     |         | $      | 8,821  |      |       |      | 5.2  |   |         | $      | 10,672 |  |       |      | 8.2  |   |        | $      | 10,367 |  |       |      | 10.7 | 
|                                       |                            |                                  |         |        |        |      |       |      |      |   |         |        |        |  |       |      |      |   |        |        |        |  |       |     

Revenues.Allieds consolidated revenues
for 2003 increased $40,541, or 31%, over the prior year
principally due to higher production activities at MECAR and the
VSK Group. Revenues for 2002 increased $33,919, or 35%, over
2001 revenues, again based upon increased activity at MECAR and
the VSK Group during the period.

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|                                |  |        |         |                                  |  |        |       |   |  |        |         |   |  |  |       |   |  |   |        |  |  |  |       |  
|------------------------------- |  | ------ | ------- | -------------------------------- |  | ------ | ----- | - |  | ------ | ------- | - |  |  | ----- | - |  | - | ------ |  |  |  | ----- | -
|                                |  |        |         |                                  |  |       
|                                |  |        |         | Revenues By Segment ($ Millions) |  |       
|                                |  |        |         |                                  |  |       
|                                |  |        |         |                                  |  |       
|                                |  | 2003   |         | 2002                             |  | 2001  
|                                |  |        |         |                                  |  |       
|                                |  | Amount |         | %                                |  | Amount |       | % |  | Amount |         | %
|                                |  |        |         |                                  |  |        |       |   |  |        |         |  
|Ordnance & Manufacturing        |  | $      | 129,710 |                                  |  |        | 75.7  | % |  | $      | 95,279  |   |  |  | 73    | % |  | $ | 77,071 |  |  |  | 80    | %
|Electronic Security             |  |        | 33,303  |                                  |  |        | 19.4  | % |  |        | 31,302  |   |  |  | 24    | % |  |   | 19,876 |  |  |  | 20    | %
|Environmental Safety & Security |  |        | 7,065   |                                  |  |        | 4.1   | % |  |        | 4,032   |   |  |  | 3     | % |  |   |       |  |  |  |      |  
|Software, Training & Simulation |  |        | 1,329   |                                  |  |        | 0.8   | % |  |        | 253     |   |  |  |      |   |  |   |       |  |  |  |      |  
|                                |  |        |         |                                  |  |        |       |   |  |        |         |   |  |  |       |   |  |   |        |  |  |  |       |  
|                                |  | $      | 171,407 |                                  |  |        | 100.0 | % |  | $      | 130,866 |   |  |  | 100.0 | % |  | $ | 96,947 |  |  |  | 100.0 | %
|                                |  |        |         |                                  |  |        |       |   |  |        |         |   |  |  |       |   |  |   |        |  |  |  |       |  

Ordinance & Manufacturing segment revenues
increased in 2003 due to continued performance of the multi-year
FMS contract as well as work on additional orders secured from
non-traditional customers. Notwithstanding MECARs success
in obtaining orders from new customers, approximately 60% of
2003 revenues were derived from MECARs traditional
customer base.

The positive fluctuation in 2002 over 2001
Ordnance & Manufacturing segment revenues was caused by work
on the FMS contract awarded in early 2002.

Electronic Security segment revenue increased by
7% in 2003, although the mix was substantially different. The
VSK Group contributed $27,234, a 29% increase over 2002, largely
due to increased sales to non-Belgian customers. The VSK Group
makes sales to such customers via independent sales
distributors. NS Microwaves 2003 revenues decreased to
$6,069. Many of NS Microwaves traditional U.S. Government
agency customers were reorganized into the Department of
Homeland Security. The organization and startup of the
Department of Homeland Security was marked by a delay in award
of contracts by these agencies. While NS Microwave began to
receive some orders in the fourth quarter of 2003, it was too
late to realize meaningful revenues from some of these orders in
2003.

Electronic Security segment revenues increased by
$11,426 in 2002. NS Microwave was added to the Electronic
Security segment in 2002 and contributed $10,248 to this amount.

In each of 2003 and 2002, Ordnance &
Manufacturing and Electronic Security segment revenues were
positively impacted by the stronger Euro. In 2003 and 2002,
these revenues were so benefited by approximately 20% and 6%,
respectively.

Environmental Safety & Security segment
revenue increased in 2003 over 2002 revenues as a result of only
five months of activity in 2002. This segments revenue in
2003 was less than expected due to increased competition by
domestic and foreign competitors.

Software, Training & Simulation segment
revenues increased in 2003 inasmuch as 2002 revenues included
only six (6) months of operations following the June, 2002
acquisition of Titan Dynamics. Revenues continue to be
constrained due to the lack of safety certification for the
OMEGA 36/ B2 battlefield effects simulator. Testing by the
Marine Corps is substantially complete and Titan Dynamics is
optimistic that it will receive Marine Corps certification of
this product by the end of the third quarter of 2004.
Certification should also accelerate penetration in foreign
markets. Further, Marine Corps certification should facilitate
and accelerate certification by the U.S. Army. In 2003, the
sales of cartridges represented the majority of Titan
Dynamics sales.

Cost of Sales.Cost
of sales as a percentage of revenue for 2003 was approximately
73% compared with 70% in 2002. The increase during 2003 was
driven by higher costs within the Ordnance and Manufacturing
Segment. The costs were primarily related to the FMS contract
which dominated the production process in the current year.
Additionally, MECAR incurred higher than anticipated labor costs
due to production delays surrounding a 90MM production order.
The delay has been resolved and should not affect activity in
future periods. Electronic Security segment cost of sales
decreased from 2002 primarily due to the VSK Groups
production efficiencies realized as it expanded its distribution
channel throughout Europe. In particular, the VSK Group incurred
lower material costs on its export sales to its distributors.
Environmental Safety & Security Segment cost of sales
increased over 2002 as a result of higher X band sales, which
traditionally have lower margins. Over the past twelve months,
the X band market has become much more competitive. While selling

12



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##### Table of Contents



prices were reduced to meet the competition in
order to maintain market share, cost of materials remained
unchanged. Accordingly, while the number of X band orders is
greater this year, the gross margins are lower. This trend is
expected to continue in future years.


Cost of sales as a percentage of revenue for 2002
was approximately 70% compared with 65% for 2001. The increase
in production costs relative to those incurred in 2001 was
primarily the result of a very favorable development contract in
2001 with above-average margins. The majority of the margins
generated by this one contract were recognized during the third
and fourth quarters of 2001.

Selling and Administrative Expenses.Selling and administrative expenses as
a percentage of sales for 2003 was slightly higher than 2002.
The Ordnance & Manufacturing segment incurred higher
administrative compensation costs. In the Electronic Security
segment, the VSK Group also incurred higher costs that were
driven by the increased sales volume. NS Microwave was affected
by the funding issues surrounding homeland security spending by
the federal government. Administrative costs were also burdened
with compensation charges associated with production personnel
who had been reassigned to administrative support functions
since the beginning of the year. Additionally, the consolidated
results were affected by full year contributions by Titan
Dynamics and SeaSpace. The Company expects Selling and
administrative expense to continue to increase in proportion to
the increase in sales.

Selling and administrative expenses in 2002
increased by $5,388 from the prior year. The increase was due
primarily to the additions of NS Microwave, Titan Dynamics and
SeaSpace. Administrative costs at MECAR and VSK only increased
by approximately $400 from 2001. NS Microwave was consolidated
on a full-year basis while Titan Dynamics and SeaSpace were
second and third quarter 2002 additions.

Research and Development.Research and development costs
increased between 2001 and 2003. The total dollar increases were
primarily attributed to increased research conducted at MECAR,
the VSK Group and NS Microwave. This trend is expected to
continue.

Interest Income.Interest income decreased between 2001
and 2003. Income earned on interest bearing accounts throughout
the Company has been affected by the lower interest rates being
earned on such accounts.

Interest expense.Interest expense increased between
2001 and 2003 due principally to the costs associated with a
convertible debenture issued in the second quarter of 2002. The
interest charges on that debenture will continue, on a monthly
basis, until the earlier of the instrument being converted into
common stock or until the debenture is liquidated. The debenture
is repayable in ten monthly payments commencing on June 28,
2004, and terminating on March 28, 2005.

Other  Net.Other-Net income for 2003 decreased by
$1,045 from 2002, while Other-Net income for 2002 increased by
$1,616 over 2001. The fluctuations stemmed primarily from the
currency fluctuations at MECAR and the VSK Group. In particular,
MECAR had currency gains in 2002 on its U.S. bank accounts.
Subsequently, MECAR incurred currency losses in 2003 on its U.S.
bank accounts due the strength of the Euro over the past twelve
months. Other expense includes bank charges related to
MECARs performance bonds and advance payment guarantees.

Pre-Tax Profit.

|                                |  |                                  |        |      |  |      |        |   |  |   |        |  
|------------------------------- |  | -------------------------------- | ------ | ---- |  | ---- | ------ | - |  | - | ------ | -
|                                |  |                                 
|                                |  | Pre-Tax Profit (Loss) By Segment
|                                |  |                                 
|                                |  | 2003                             |        | 2002 |  | 2001
|                                |  |                                  |        |      |  |     
|Ordnance & Manufacturing        |  | $                                | 16,487 |      |  | $    | 16,439 |   |  | $ | 17,379 |  
|Electronic Security             |  |                                  | 2,618  |      |  |      | 3,903  |   |  |   | 3,498  |  
|Environmental Safety & Security |  |                                  | (528   | )    |  |      | 550    |   |  |   |       |  
|Software, Training & Simulation |  |                                  | (208   | )    |  |      | (181   | ) |  |   |       |  
|Corporate and Other             |  |                                  | (1,826 | )    |  |      | (761   | ) |  |   | (2,133 | )
|                                |  |                                  |        |      |  |      |        |   |  |   |        |  
|                                |  | $                                | 16,543 |      |  | $    | 19,950 |   |  | $ | 18,744 |  
|                                |  |                                  |        |      |  |      |        |   |  |   |        |  

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MECAR has enjoyed several consecutive years of
above-average profitability. In 2003, MECAR continued to reap
the benefits of a large multi-year FMS contract for the benefit
of one of its principal customers. This contract was also a
prime contributor to MECARs 2002 profits. While some work
remains on this FMS contract, it is not expected to be a
substantial contributor to 2004 profits. In 2001, a substantial
portion of MECARs profits was earned on a high margin
product development contract. While MECAR has a substantial
backlog of orders for 2004, it does not have any above-average
margin contracts similar to those enjoyed in 2001  2003.
Accordingly, MECARs profitability for 2004 will likely be
less than the amounts earned in the preceding time periods.

2003 profits within the Electronic Security
segment decreased from 2002 levels despite record performance by
the VSK Group. The VSK Group reported $5,519 of pre-tax profits,
which amount was favorably impacted by increased sales to
non-Belgian customers via the VSK Groups distribution
network. NS Microwaves performance suffered due to
continuing delays in award of orders caused in part by the
organization of the Department of Homeland Security. Some orders
began to be received in the fourth quarter of 2003. NS Microwave
has right-sized its workforce for its 2004 operations.

The Environmental Safety & Security segment
results in 2003 were disappointing due to increased competitive
pressures, both home and abroad. The Company has appointed a new
President at SeaSpace and SeaSpace has taken efforts to
right-size its organization and reduce its cost of goods sold in
light of the competitive environment.

Titan Dynamics continues to be adversely impacted
since its principal product lacks U.S. Government safety
certification. Titan Dynamics anticipates receipt of Marine
Corps certification in the second or third quarter of 2004.

The losses incurred by the Corporate and Other
segment increased in 2003 due to increased taxes, intercompany
management fee adjustments and reduced currency gains.

Income Taxes.The
effective income tax expense in 2003, 2002 and 2001 was 46%, 46%
and 45%, respectively, primarily due to foreign rate
differentials and permanent tax differences. In 2003, the
statutory tax rate for the European subsidiaries was reduced by
the Belgium parliament from 40.17% to 33.99%. The 2003 effective
tax rate was adversely affected as a result of increased
permanent differences and benefits impacted by the repatriation
of dividends by Allied from its foreign subsidiaries.

Net Earnings.2003
net earnings of $8,821 decreased from 2002 levels due to losses
incurred by Allieds domestic subsidiaries.

Liquidity and Capital Resources

Balance Sheet.All
items on the Companys December 31, 2003 consolidated
balance sheet were positively affected by the increased value of
the Euro in 2003. All European values were converted at the
December 31, 2003 and 2002 conversion ratios of 1.2557 and
1.0483 U.S. Dollar to 1 Euro, respectively. The following sets
forth additional reasons for the fluctuations in the balance
sheet items from December 31, 2002 to December 31, 2003.

Historically, the Companys positive cash
flow from operations and available credit facilities have
provided adequate liquidity and working capital to fully fund
the Companys operational needs. Working capital, which
includes restricted cash, was $76,880 at December 31, 2003,
which is an increase of $16,698 over the December 31, 2002,
level. Working capital has remained strong since 2002 due to
profitable operations and the $7,500 convertible debenture
issued by the Company on June 28, 2002.

Cash (including restricted cash) increased by
$36,386 in 2003 due to profitable operations and cash
collections by MECAR and the VSK Group, borrowings from
short-term debt and improved cash flow from operations. Accounts
receivable at December 31, 2003, was consistent with the
amount at December 31, 2002. Costs and accrued earnings on
uncompleted contracts increased from year-end 2002 primarily as
a result of work on the FMS contract at MECAR. Inventories
increased $2,659 primarily from higher raw material purchases.
The inventory buildup will give the subsidiaries the ability to
deliver products with the shortest possible lead times. Fair
value of foreign exchange contracts was $9,378 at
December 31, 2003, compared to $13,595 at

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December 31, 2002. MECAR uses foreign
currency hedge contracts to minimize the foreign currency
exposures that arise from sales contracts with certain foreign
customers. Prepaid and other current assets increased $1,982
primarily from payment of quarterly taxes at MECAR.


Property, Plant & Equipment, net of
accumulated depreciation, increased primarily from equipment
purchases at MECAR and the VSK Group. Intangibles and Goodwill,
net of accumulated amortization, increased primarily from the
strength of the Euro and adjustment of deferred tax related to
intangibles purchased in 2002.

Notes Payable increased $7,683 over 2002 as a
result of MECAR funding its working capital needs. Accounts
payable increased $22,318 over 2002 which is related to the
increase in costs on uncompleted contracts. Accrued liabilities
increased $8,627 due primarily to the costs associated with
higher production levels and deferred gains related to forward
exchange contracts at MECAR. Customer deposits decreased $154
primarily at MECAR as a result of shipments during the period
and other new contracts in 2003 not requiring deposits. Income
taxes decreased $1,772 due to the tax benefits at NS Microwave,
SeaSpace, Titan Dynamics and Corporate, offset by the tax
provisions at MECAR and the VSK Group.

Convertible-subordinated debenture, current and
long-term, was only impacted by amortization between
December 31, 2003 and December 31, 2002. However, the
current and long-term allocations changed. The initial terms
called for monthly principal payments, in the amount of $750, to
begin on June 28, 2003, and continue for a period of ten
(10) months or until March 28, 2004. Additionally, the
monthly principal payments were to include interest on the
outstanding note balance. On June 27, 2003, the lender
exercised its right to extend the terms of the debenture by
twelve (12) months, which impacted the Companys
current maturity schedule.

Stockholders equity at December 31,
2003, was positively affected by 2003 profits and increase in
the value of the Euro versus the U.S. dollar during the year
2003 by approximately 20%, resulting in accumulated other
comprehensive income of $13,383 at December 31, 2003.

Cash Flows.The
table below highlights Allieds cash flows for the periods
listed:

|                                                        |  |                                 |        |      |  |      |         |   |  |   |        |  
|------------------------------------------------------- |  | ------------------------------- | ------ | ---- |  | ---- | ------- | - |  | - | ------ | -
|                                                        |  |                                
|                                                        |  | For the years ended December 31
|                                                        |  |                                
|                                                        |  | 2003                            |        | 2002 |  | 2001
|                                                        |  |                                 |        |      |  |     
|Net cash provided by operating activities               |  | $                               | 30,157 |      |  | $    | 1,350   |   |  | $ | 13,531 |  
|Net cash used in investing activities                   |  |                                 | (6,342 | )    |  |      | (10,100 | ) |  |   | (3,535 | )
|Net cash provided by (used in) financing
    activities |  |                                 | 536    |      |  |      | 11,353  |   |  |   | (6,250 | )

The increase in cash provided by operating
activities between 2003 and 2002 is attributed primarily to
growth in earnings, collection of receivables and decreased cash
outlays for cost and accrued earnings on uncompleted contracts,
which are mainly from MECARs and the VSK Groups
customer base. The decrease in cash provided by operating
activities between 2002 and 2001 stems primarily from the
expenditures for work related to the FMS contract which was
awarded in early 2002. Cash paid for interest was $1,492, $535
and $1,692 for the years ended December 31, 2003, 2002 and
2001, respectively. Cash paid for income taxes was $9,455,
$9,510 and $6,939 for the years ended December 31, 2003,
2002 and 2001, respectively, and includes federal, international
and state taxes.

Cash used in investing activities decreased by
$3,758 between 2003 and 2002. This stemmed from cash paid for
the Titan Dynamics and SeaSpace acquisitions in 2002, with no
related acquisition activity in 2003. This decrease was offset
by a slight increase in capital expenditures due primarily to
higher outlays for production equipment and leasehold
improvements at the Belgian business units. The 2002
acquisitions were the main reason for the $6,565 increase in
cash used in investing activities between 2002 and 2001. In
addition, capital expenditures were higher in 2002. The Company
anticipates that cash generated from operations and capital
leases will be sufficient to support any further capital
expenditures in the foreseeable future. Future expenditures will
be primarily incurred at MECAR for machinery and equipment.

Cash provided by financing activities decreased
between 2003 and 2002 and increased between 2002 and 2001.
During 2002, the primary source of cash provided by financing
activities was the $7,500 proceeds realized from the sale of the
convertible debenture and warrant.

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Allied.The parent
company continues to operate based on fees and dividends
received from its subsidiaries. Allied has made cash infusions
to NS Microwave and Titan to support working capital
requirements. To implement its acquisition program, Allied has
secured dividends from its subsidiaries and in 2002 sold a
$7.5 million convertible debenture. The debenture is
repayable in ten (10) monthly installments commencing in
June 2004. The Company anticipates repayment of the debenture
from existing cash reserves.

MECAR.MECAR
continues to operate from internally generated cash and funds
provided by its bank syndicate and financing from capital
leases. MECAR typically obtains orders for its ammunition and
weapon systems that require credit facilities to provide import
letters of credit, advance payment guarantees and performance
bonds. These needs have been met in the last few years via
agreements with a five member international bank syndicate of
which the lead bank is based in Belgium. While the bank
syndicate agreement provides that MECAR is responsible to repay
the syndicate for amounts paid by the banks pursuant to the
guarantees/bonds, the financial terms stipulate that all such
obligations be secured, in part, by a cash pledge.

The bank syndicate agreement provides the banks
the right to review and approve each proposed MECAR contract
before agreeing to provide the necessary letters of credit,
guarantee and/or bond. While management believes that it will be
able to finance additional MECAR contracts using the bank
syndicate structure, there can be no assurance that such
financing will be unconditionally and permanently provided.

The bank syndicate agreement provides
(i) lines of credit for tax prepayments and working capital
and (ii) a facility for guarantees/bonds to support
customer contracts. The financial lending terms and fees are
denominated in Euros and the dollar equivalents will fluctuate
according to global economic conditions.

The revised bank agreement, as executed in March
2002, eliminates most restrictions on cash transfers by MECAR to
Allied or other Allied group companies. However, the agreement
imposes two financial covenants requiring MECAR to maintain
minimum net worth and working capital levels. As of December 31,
2003, MECAR was in compliance with both of these bank covenants.
MECARs obligations under the bank syndicate agreement
continue to be collateralized by a pledge of MECARs assets
and a mortgage on MECARs facility. The agreement includes
Allieds pledge to support MECAR so that it remains in
compliance with its total borrowing obligations.

VSK Group.The VSK
Group operated throughout 2003 solely from cash generated from
business operations. The VSK Group is obligated on several
mortgages and other long-term obligations.

Other Subsidiaries.NS Microwave and Titan Dynamics
operated in 2003 from cash generated from operations and cash
infusions by Allied. SeaSpace operated in 2003 from cash
generated from operations and cash reserves.

Stock Repurchases.The Company did not repurchase any
shares of its common stock in 2003, 2002 or 2001 and does not
anticipate repurchasing shares of Company stock in calendar year
2004.

Contractual Obligations and Commercial
Commitments.As described herein and
in the notes to the consolidated financial statements, Allied
has contractual obligations and commercial commitments that may
affect its financial condition. However, based on
managements assessment of the underlying provisions and
circumstances of the material contractual obligations and
commercial commitments of Allied, there is no known trend,
demand, commitment, event or uncertainty that is reasonably
likely to occur which would have a material adverse effect on
Allieds financial condition or results of operations.

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The following table identifies material
contractual obligations as of December 31, 2003:

|                           |                               |                                         |       |             |  |       |       |       |  |           |       |       |  |   |       |       |  |   |     |     | 
|-------------------------- | ----------------------------- | --------------------------------------- | ----- | ----------- |  | ----- | ----- | ----- |  | --------- | ----- | ----- |  | - | ----- | ----- |  | - | --- | --- | 
|                           |                               |                                        
|                           |                               | Payments due by period (amount in 000s)
|                           |                               |                                        
|                           |                               |                                         |       | Less than 1 |  | 1  3 |       | 3  5 |  | More than
|                           |                               | Total                                   |       | year        |  | years |       | years |  | 5 years  
|                           |                               |                                         |       |             |  |       |       |       |  |          
|Long-Term Debt Obligations |                               | $                                       | 1,094 |             |  | $     | 675   |       |  | $         | 274   |       |  | $ | 128   |       |  | $ | 17  |    
|Capital Lease Obligations  |                               |                                         | 6,517 |             |  |       | 2,034 |       |  |           | 3,257 |       |  |   | 1,223 |       |  |   | 3   |    
|Convertible Debenture      |                               |                                         | 7,500 |             |  |       | 5,250 |       |  |           | 2,250 |       |  |   |      |       |  |   |    |    
|Operating Leases           |                               |                                         | 2,270 |             |  |       | 360   |       |  |           | 746   |       |  |   | 791   |       |  |   | 373 |    
|Purchase Obligations       |                               |                                         |      |             |  |       |      |       |  |           |      |       |  |   |      |       |  |   |    |    
|                           |                               |                                         |       |             |  |       |       |       |  |           |       |       |  |   |       |       |  |   |     |    
|                           | Total Contractual Obligations |                                         | $     | 17,381      |  |       | $     | 8,319 |  |           | $     | 6,527 |  |   | $     | 2,142 |  |   | $   | 393 | 
|                           |                               |                                         |       |             |  |       |       |       |  |           |       |       |  |   |       |       |  |   |     |    

Future Liquidity.The Company continues to explore
alternate methods of securing the necessary financial capacity
to implement its growth plans. At times, the Company has
utilized the services of an investment banker in an attempt to
secure a senior credit facility for its U.S. based operations.

Funds for the build out of the initial MECAR USA
infrastructure are being provided by the Marshall Economic
Development Corporation of Marshall, Texas. This is a state
funded organization with the initial proceeds directed at
creating roads and a manufacturing plant on the grounds.

The Companys ability to cover its
anticipated future operating and capital requirements is
dependent upon its continued ability to generate positive cash
flow from the operations of its subsidiaries, particularly the
operations of MECAR and the VSK Group, and its ability to
successfully integrate its acquisitions. The Company expects its
acquisitions to be accretive to operations within
24 months, although this cannot be assured. This will
depend upon many factors including the successful release of new
product offerings, successful research and development efforts,
and increased market share. There is no assurance that this goal
will be achieved.

Completed Acquisitions.See Note B to Allieds
consolidated financial statements for a discussion of completed
acquisitions which have affected our liquidity.

Off-Balance Sheet Arrangements.As part of our ongoing business, we do
not participate in transactions that generate relationships with
unconsolidated entities or financial partnerships, such as
entities often referred to as structured finance or special
purpose entities (SPEs), which would have been
established for the purpose of facilitating off-balance sheet
arrangements or other contractually narrow or limited purposes.
As of December 31, 2003, we are not involved in any
material unconsolidated SPE transactions. MECAR is required to
provide performance bonds and advance payment guarantees for
certain contracts, which are provided by MECARs bank
syndicate. At December 31, 2003, MECARs bank
syndicate had provided $18,079 of such bonds/ guarantees. MECAR
is obligated to repay the bank syndicate any amounts it pays as
a result of any demands on the bonds or guarantees. To date,
there have never been any such demands.

Recent Accounting Pronouncements.See Note A to Allieds
consolidated financial statements for a description of recently
issued accounting pronouncements. Allied does not anticipate
that any of such pronouncements will have a material impact on
its financial results.

Critical Accounting Policies

The Companys discussion and analysis of its
financial condition and results of operations are based upon the
Companys consolidated financial statements, which have
been prepared in accordance with accounting principles generally
accepted in the United States. The preparation of these
financial statements requires the Company to make estimates and
judgments that affect the reported amounts of assets,
liabilities, sales, and expenses, and related disclosure of
contingent assets and liabilities. The Company re-evaluates its
estimates on an on-going basis. The Companys estimates are
based on historical experience and on various other assumptions
that are believed to be reasonable under the circumstances.
Actual results may differ from these estimates under different
assumptions or conditions.

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The Company believes the following are its
critical accounting policies which affect its more significant
judgments and estimates used in the preparation of its
consolidated financial statements:



| |   |                                                                
| | - | ---------------------------------------------------------------
| |  | Revenue recognition via the percentage of
    completion method
|
| |  | Goodwill and intangible asset valuation                        
|
| |  | Inventory reserves and allowance for doubtful
    accounts     
|
| |  | Valuation of deferred income taxes and income tax
    reserves.

Revenue Recognition via the Percentage of
Completion Method.We
believe our most critical accounting policies include revenue
recognition and cost estimation on fixed price contracts for
which we use the percentage of completion method of accounting.
The percentage of completion method is used by MECAR, NS
Microwave, and SeaSpace for substantially all of their fixed
price sales contracts. Approximately 83%, 92% and 80% of
consolidated revenue was recognized under the percentage of
completion method during 2003, 2002, and 2001, respectively.

Under the percentage of completion method,
revenue is recognized on these contracts as work progresses
during the period, based on the amount of actual cost incurred
during the period compared to total estimated cost to be
incurred for the total contract (cost-to-cost method).
Management reviews these estimates as work progresses and the
effect of any change in cost estimates is reflected in cost of
sales in the period in which the change is identified. If the
contract is projected to create a loss, the entire estimated
loss is charged to operations in the period such loss first
becomes known.

Accounting for the profit on a contract requires
estimates of (1) the total contract value, (2) the
total costs at completion, which is equal to the sum of the
actual incurred costs to date on the contract and the estimated
costs to complete the contracts scope of work, and
(3) the measurement of progress towards completion. The
estimated profit or loss on a contract is equal to the
difference between the contract value and the estimated total
cost at completion. Adjustments to original estimates are often
required as work progresses under a contract, as experience is
gained and as more information is obtained, even though the
scope of work required under the contract may not change, or if
contract modifications occur. A number of internal and external
factors affect our cost of sales estimates, including labor
rates and efficiency variances, material usage variances,
revised estimates of warranty costs, delivery schedules and
testing requirements. Additionally, as inventory items increase
in age, obsolete and excess items are charged to cost of sales
if the economic conditions of the future sales potential of that
inventory warrant a charge. While we believe that the systems
and procedures used by the subsidiaries, coupled with the
experience of their management teams, provide a sound basis for
our estimates, actual result will differ from managements
estimates. The complexity of the estimation process and issues
related to the assumptions, risks and uncertainties inherent
with the application of the percentage of completion method
affect the amounts reported in our financial statements.

Goodwill and intangible asset valuation.The Company adopted the Financial
Accounting Standards Board (FASB) Statements of
Financial Accounting Standards (SFAS) No. 141,
Business Combinations and SFAS No. 142,
Goodwill and Other Intangible Assets on accounting
for business combinations and goodwill as of the beginning of
fiscal year 2002. Accordingly, the Company no longer amortizes
goodwill from acquisitions, but continues to amortize other
acquisition-related intangibles with definitive lives and other
costs. As of December 31, 2003, the Company has
$13.8 million of goodwill recorded in Other assets on the
Consolidated Balance Sheet.

In conjunction with the implementation of the new
accounting rules for goodwill, the Company completed a goodwill
impairment analysis in the fourth quarter of 2003 and did not
determine that an impairment charge to earnings was required. As
required by the new rules, the Company will perform a similar
review each year, or earlier if indicators of potential
impairment exist. The impairment review is based on a discounted
cash flow approach that uses estimates of future cash flows
discounted at the Companys weighted average cost of
capital. The estimates used are consistent with the plans and
estimates that the Company uses to manage the underlying
businesses. If market conditions in these business units fail to
meet expectations, it could negatively impact revenue or cost,
and could result in charges for the impairment of goodwill in
future periods.

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For intangible assets with definitive lives, the
Company amortizes the cost over the estimated useful life and
assesses any impairment by estimating the future cash flow from
the associated asset. As of December 31, 2003, the Company
had $4.1 million of intangible assets with definitive lives
recorded in Other assets, which includes patents,
customer lists, trademarks, etc. If the estimated undiscounted
cash flow related to these assets decreases in the future or the
useful life is shorter than originally estimated, the Company
may incur charges to reflect the impairment of these assets.
Impairment could also result if the underlying technology fails
to gain market acceptance, if the products fail to gain expected
market acceptance or if the market conditions in the related
businesses are unfavorable.

Inventory reserves and allowance for doubtful
accounts.Inventories are
stated at the lower of cost or market. Cost is determined based
on a first-in, first-out basis. The Companys inventory
includes raw materials, work-in process and finished goods of
$12.1 million as of December 31, 2003. The Company
reviews its recorded inventory and estimates a write-down for
obsolete or slow-moving items to their net realizable value. The
write-down is based on current and forecasted demand and the age
of the item, and therefore, if actual demand and market
conditions are less favorable than those projected by
management, additional write-downs may be required. Allowances
for doubtful accounts are evaluated based upon detailed analysis
and assessment of receivables that may not be collected in the
normal course of operations.

Valuation of deferred income taxes and income
tax reserves.The Company
is subject to taxation by federal, state and international
jurisdictions. The Companys annual provision for income
taxes and the determination of the resulting deferred tax assets
and liabilities involve a significant amount of management
judgment and are based on the best information available at the
time. The Company believes that it has recorded adequate
liabilities and reviews those balances on a quarterly basis.

Judgment is also applied in determining whether
deferred tax assets will be realized in full or in part. When it
is more likely than not that all or some portion of specific
deferred tax assets such as foreign tax credit carryovers will
not be realized, a valuation allowance is established for the
amount of the deferred tax assets that are determined not to be
realizable.

Forward-Looking Statements

This Managements Discussion and Analysis of
Financial Condition and Results of Operations contains
forward-looking statements that are based on current
expectations, estimates and projections about the Company and
the industries in which it operates. These statements are not
guarantees of future performance and involve certain risks,
uncertainties and assumptions (Future Factors) which
are difficult to predict. Therefore, actual outcomes and results
may differ materially from what is expressed or forecast in such
forward-looking statements. The Company undertakes no obligation
to update publicly any forward-looking statements, whether as a
result of new information, future events or otherwise.

Future Factors include substantial reliance on
MECARs principal customers to continue to acquire
MECARs products on a regular basis; the cyclical nature of
the Companys military business; rapid technological
developments and changes and the Companys ability to
continue to introduce competitive new products and services on a
timely, cost effective basis; the ability of the Company to
successfully continue to expand its business base; the mix of
products/services; domestic and foreign governmental fiscal
affairs and public policy changes which may affect the level of
purchases made by customers; changes in environmental and other
domestic and foreign governmental regulations; general risks
associated with doing business outside the United States
including, without limitation, import duties, tariffs, quotas
and political and economic instability, the effects of terrorist
actions on business activities, customer orders and
cancellations, and the United States and international
governments responses to these terrorist actions; changes
in government regulations; liability and other claims assorted
against us; the ability to attract and retain qualified
personnel; and continued availability of financing, financial
instruments and financial resources in the amounts, at the times
and on the terms required to support the Companys future
business. These are representative of the Future Factors that
could affect the outcome of the forward-looking statements. In
addition, such statements could be affected by general industry
and market conditions and growth rates; general domestic and
international economic conditions including

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interest rate and currency exchange rate
fluctuations; increasing competition by foreign and domestic
competitors, including new entrants; and other Future Factors.





Item
7A.     Quantitative and Qualitative
Disclosures About Market Risk

In the normal course of business, we are exposed
to market risk, including foreign currency fluctuations
and interest rates changes. From time to time, we use
derivatives to manage some portion of these risks. Our
derivatives are agreements with independent third parties that
provide for payments based on a notional amount. As of
December 31, 2003 and 2002, all of the derivatives were
related to actual or anticipated exposures of our transactions.
We are exposed to credit riskin the event of
non-performance by counterparties to derivatives. However, we
monitor our derivative positions by regularly evaluating our
positions and the creditworthiness of the counterparties, all of
whom we either consider credit worthy, or who have issued
letters of credit to support their performance.

We have performed sensitivity analyses to
determine how market rate changes might affect the fair value of
our market risk sensitive derivatives and related positions.
This analysis is inherently limited because it represents a
singular, hypothetical set of assumptions. Actual market
movements may vary significantly from our assumptions. The
effects of market movements may also directly or indirectly
affect our assumptions and rights and obligations not covered by
sensitivity analysis. Fair value sensitivity is not necessarily
indicative of the ultimate cash flow or the earnings effect from
the assumed market rate movements.

Interest Rate Sensitivity.Allied manages its debt and its
available cash considering available investment opportunities
and risks, tax consequences and overall financing strategies. At
December 31, 2003, Allied had approximately
$15.0 million of fixed-rate indebtedness. Allied has not
entered into any interest rate swaps or other derivatives with
respect to its indebtedness. Cash available for investment is
typically invested in short term funds, which generally mature
in 30 days or money-market funds. In general, such funds
are not subject to market risk because the interest paid on such
funds fluctuates with the prevailing interest rate. The carrying
amounts approximate market value. It is the Companys
practice to hold these investments to maturity. Assuming
year-end cash available for investment (including restricted
cash), a 1% change in interest rates would impact net interest
income for the years ended December 31, 2003 and 2002 by
$0.4 million and less than $0.1 million, respectively.

Exchange Rate Sensitivity.Allied maintains operations in several
foreign countries. Approximately 92% of the Companys
revenue was derived from operations outside the United States.
Accordingly, exposure exists to potentially adverse movement in
foreign currency rates. Allied uses foreign exchange forward
contracts to hedge the risk of change in foreign currency
exchange rates associated with some, but not all, of its
contracts in which the expenses for providing services are
incurred in currency other than the functional currency of
Allieds foreign subsidiaries or payments on contracts are
made by the customer in another currency. The objective of these
contracts is to hedge fixed obligations to reduce the effect of
foreign currency exchange rate fluctuations on Allieds
foreign subsidiaries operating results. The notional value
of foreign exchange forward contracts outstanding at December
31, 2003 and 2002 was $50 million and $93 million,
respectively. A 10% change in the exchange rate of the
currencies hedged would change the fair market value of the
contracts by approximately $7.2 million and
$11.2 million as of December 31, 2003 and 2002,
respectively.

Additionally, Allieds consolidated
financial statements are denominated in U.S. dollars and,
accordingly, changes in the exchange rates between the Allied
subsidiaries local currency and the U.S. dollar will
affect the translation of such subsidiaries financial
results into U.S. dollars for purposes of reporting the
consolidated financial results. Allied does not hedge these
matters because cash-flows from international operations are
generally re-invested locally. It is estimated that a 10% change
in the value of the Euro would impact reported net earnings for
the years ending December 31, 2003 and 2002 by
approximately $1.4 million and $1.2 million,
respectively. See Note N to the financial statements for
more information on financial instruments.

Allied does not use derivative financial
instruments for speculative trading purposes, nor does Allied
hedge its foreign currency exposure in a manner that entirely
offsets the effects of changes in foreign exchange rates. Allied
regularly reviews its hedging program and may as part of this
review determine at any time to change its hedging program.

20



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##### Table of Contents








|        |                                                
|------- | -----------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data

The financial statements and supplementary
financial information and data required by this Item are set
forth in the pages indicated in Item 15(a) (1) and (2).

See Note V to Allieds consolidated
financial statements for supplementary quarterly financial data
required by this item.






|        |                                                                                              
|------- | ---------------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with
    Accountants on Accounting and Financial
    Disclosures

There were no disagreements on any matter of
accounting principles, financial statement disclosure or
auditing scope or procedure to be reported under this item.






|         |                        
|-------- | -----------------------
|Item 9A. | Controls and Procedures

Under the direction and with the participation of
the Companys management, including the Companys
Chief Executive Officer and Chief Financial Officer, the Company
carried out an evaluation of the effectiveness of the design and
operation of its disclosure controls and procedures pursuant to
Exchange Act Rule 13a-15 as of the end of the period
covered by the report. Based on that evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that the
Companys disclosure controls and procedures are effective
to ensure that information required to be disclosed by the
Company in reports that it files or submits under the Exchange
Act of 1934 (i) is recorded, processed, summarized and
reported within the time periods specified in the Securities and
Exchange Commissions rules and forms and (ii) is
accumulated and communicated to the Companys senior
management to allow timely decisions regarding required
disclosure.

There have been no significant changes in our
internal controls over financial reporting or, to our knowledge,
in other factors that could significantly affect our internal
control over financial reporting subsequent to the date we
conducted the above-described evaluation. We are currently
reviewing the new internal controls documentation and
attestation requirements regarding Rule 404 of the Sarbanes
Oxley Act of 2002. We have retained an independent consulting
firm to assist us in evaluating and improving our internal
controls. We are confident that we will fully comply with such
requirements by December 31, 2004.

21



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##### Table of Contents



PART III



Item
10.     Directors and Executive
Officers of Allied

Directors.The
following are the directors of Allied:

J. H. Binford Peay,
III, age 64, became a director in
April, 2000 and was elected Chairman of the Board, President and
Chief Executive Officer in January, 2001. General Peay retired
in 1997 as Commander in Chief, United States Central Command,
with responsibility for operations in some 20 countries
throughout Africa, the Middle East, Persian Gulf and South Asia.
Previously, he was Vice Chief of Staff, U.S. Army. General Peay
is currently a director of United Defense Industries, Inc., and
a Trustee of the National Defense University. Previously, he had
also been a trustee of Virginia Military Institute Foundation
and the George C. Marshall Foundation. General Peay resigned as
Chief Executive Officer as of June 1, 2003 to become
Superintendent of the Virginia Military Institute. He remains
the Chairman of the Board.

John G. Meyer, Jr.,
age 59, became a director in January, 2003 when he was also
elected as President of the Company. He succeeded General Peay
as the CEO on June 1, 2003. He previously served as
Executive Vice President and Chief Operating Officer since
January, 2001. Mr. Meyer previously retired from the U.S.
Army having served as its most senior Public Affairs Officer
during his last four (4) years of military service.

J. R. Sculley,
age 63, became a director of Allied in 1991 and currently serves
as Chairman Emeritus. He served as Chairman of the Board and
Chief Executive Officer from December, 1992 until September,
1999; from April 1992 until December 1992 he served as President
and Chief Operating Officer of Allied. Between 1989 and April,
1992, Mr. Sculley was Director of Advanced Studies and
Technologies of Grumman Corporation, a defense company, and,
prior thereto, was Assistant Secretary of the Army (Research,
Development and Acquisition).

Clifford C. Christ,
age 56, became a director of Allied in 1993. He has been the
President and Chief Executive Officer of NavCom Defense
Electronics, Inc., a defense electronics company, since 1988.

Harry H. Warner, age
68, became a director of Allied in early 1996. He is president
of the George C. Marshall Foundation and is also a director of
Chesapeake Corporation and Virginia Management Investment
Corporation, a registered investment advisor. Throughout the
last five years, Mr. Warner has been a self-employed
financial consultant, investor and real estate developer.

Ronald H. Griffith,
age 65, became a director of Allied in April, 2000.
Mr. Griffith is Executive Vice President and Chief
Operating Officer of MPRI, Inc., a professional services
company, since 1998. Formerly, he served as Vice Chief of Staff
of the U.S. Army.

Gilbert F. Decker,
age 66, became a director of Allied in June, 2002. Mr. Decker is
a consultant to companies in the defense and aerospace
industries. He previously served as Executive Vice President of
Engineering and Production at Walt Disney Imagineering as well
as Assistant Secretary of the Army for Research, Development and
Acquisitions. Mr. Decker is currently on the board of
directors of Alliant Techsystems, Inc. and Anteon International
Corporation.

Executive Officers.The following are the executive
officers of Allied:

John G. Meyer, Jr.was elected President in January, 2003 and subsequently became
the Chief Executive Officer. He previously served as Executive
Vice President and Chief Operating Officer.

Monte Pickenswas
elected Executive Vice President and Chief Operating Officer in
May 2003. Previously, Mr. Pickens was the Vice President of
T. Marzetti Company. Mr. Pickens retired from the U.S. Army
as a Colonel in 1992.

Charles A. Hasper,
age 48, was elected Treasurer and Chief Financial Officer in
August, 2001. Previously, Mr. Hasper served as a partner in
CK Capital Partners, an investment banking firm.

22



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##### Table of Contents



Audit Committee Financial Expert.The Board of Directors of Allied has
determined that each of Clifford C. Christ and
Gilbert F. Decker is an audit committee financial expert as
defined by Item 401(h) of Regulation S-K of the
Securities Exchange Act of 1934, as amended (the Exchange
Act) and is independent within the meaning of
Item 7(d)(3)(iv) of Schedule 14A of the Exchange Act.

Audit Committee.Allied has a separately-designated
standing Audit Committee established in accordance with
Section 3(a)(58)(A) of the Exchange Act. The members of the
Audit Committee are Clifford C. Christ, Harry H. Warner, Ronald
H. Griffith and Gilbert F. Decker.

Code of Ethics.Allied has adopted a code of business
conduct and ethics for directors, officers (including
Allieds principal executive officer, principal financial
officer and controller) and employees. The code of ethics is
available on the Companys website at
http://www.allieddefensegroup.com. Stockholders may
request a free copy of the code of ethics from:



| |                                      
| | -------------------------------------
| | Allied Defense Group, Inc.           
| | 8000 Towers Crescent Drive, Suite 260
| | Vienna, Virginia 22182               
| | (703) 847-5268                       
| | Attn: Investor Relations             

23



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##### Table of Contents






Item
11.     Executive
Compensation

Compensation of Directors and Executive
Officers.

The following table sets forth information
concerning all compensation accrued for services rendered in all
capacities to the Company and its subsidiaries during the years
ended December 31, 2003, 2002 and 2001, to the chief
executive officer of Allied and to other executive officers of
Allied whose total annual salary and bonus exceed $100,000:

Summary Compensation Table

|                            |                                                   |      |      |                     |  |              |         |                 |  |              |        |                 |  |   |         |        |  |  |        |         |  |  |   |        | 
|--------------------------- | ------------------------------------------------- | ---- | ---- | ------------------- |  | ------------ | ------- | --------------- |  | ------------ | ------ | --------------- |  | - | ------- | ------ |  |  | ------ | ------- |  |  | - | ------ | 
|                            |                                                   |      |      |                     |  |              |         |                 |  | Long-Term    |        |                
|                            |                                                   |      |      |                     |  |              |         |                 |  | Compensation |        |                
|                            |                                                   |      |      |                     |  |              |         |                 |  | Awards       |        |                
|                            |                                                   |      |      |                     |  |              |         |                
|                            |                                                   |      |      | Annual Compensation |  | Securities   |         |                
|                            |                                                   |      |      |                     |  | Underlying   |         |                
|                            |                                                   |      |      |                     |  | Other Annual |         | Options/        |  | All Other   
|Name and Principal Position |                                                   | Year |      | Salary(1)           |  | Bonus(2)     |         | Compensation(3) |  | SARs (#)     |        | Compensation(4)
|                            |                                                   |      |      |                     |  |              |         |                 |  |              |        |                
|J. H. Binford Peay, III     |                                                   |      | 2003 |                     |  | $            | 153,583 |                 |  | $            | 69,792 |                 |  | $ | 107,960 |        |  |  | 6,500  |         |  |  |  |       
|                            | Chairman of the Board;                            |      |      | 2002                |  |              | $       | 312,500         |  |              | $      | 150,637         |  |   | $       | 69,007 |  |  |        | 100,000 |  |  |   |       | 
|                            | Chief Executive Officer                           |      |      | 2001                |  |              | $       | 300,000         |  |              | $      | 150,000         |  |   | $       | 67,685 |  |  |        | 100,000 |  |  | $ | 86,250 | 
|                            | until June, 2003                                  |      |      |                     |  |              |         |                 |  |              |        |                 |  |   |         |        |  |  |        |         |  |  |   |        | 
|John G. Meyer, Jr.          |                                                   |      | 2003 |                     |  | $            | 243,333 |                 |  | $            | 85,167 |                 |  | $ | 2,322   |        |  |  | 70,000 |         |  |  |  |       
|                            | Chief Executive Officer                           |      |      | 2002                |  |              | $       | 196,667         |  |              | $      | 58,625          |  |   | $       | 2,322  |  |  |        | 40,000  |  |  |   |       | 
|                            | since June, 2003                                  |      |      | 2001                |  |              | $       | 160,000         |  |              | $      | 76,000          |  |   | $       |       |  |  |        | 40,000  |  |  | $ | 21,563 | 
|Monte L. Pickens,           |                                                   |      | 2003 |                     |  | $            | 116,667 |                 |  | $            | 28,583 |                 |  | $ | 31,548  |        |  |  | 40,000 |         |  |  |  |       
|                            | Executive Vice President since May, 2003          |      |      |                     |  |              |         |                 |  |              |        |                 |  |   |         |        |  |  |        |         |  |  |   |        | 
|Charles A. Hasper           |                                                   |      | 2003 |                     |  | $            | 165,000 |                 |  | $            | 40,425 |                 |  | $ | 810     |        |  |  |       |         |  |  |  |       
|                            | Treasurer and Chief                               |      |      | 2002                |  |              | $       | 160,000         |  |              | $      | 49,008          |  |   | $       | 810    |  |  |        | 40,000  |  |  |   |       | 
|                            | Financial Officer                                 |      |      | 2001                |  |              | $       | 66,667          |  |              | $      | 48,000          |  |   | $       |       |  |  |        | 40,000  |  |  | $ | 22,525 | 
|Bruce W. Waddell            |                                                   |      | 2003 |                     |  | $            | 163,500 |                 |  | $            | 40,058 |                 |  | $ | 2,322   |        |  |  |       |         |  |  |  |       
|                            | Vice President for                                |      |      | 2002                |  |              | $       | 158,750         |  |              | $      | 48,672          |  |   | $       | 2,322  |  |  |        | 40,000  |  |  |   |       | 
|                            | Strategic Planning and                            |      |      | 2001                |  |              | $       | 145,000         |  |              | $      | 69,000          |  |   | $       |       |  |  |        | 40,000  |  |  | $ | 21,563 | 
|                            | Corporate Development
    until December, 2003(5) |      |      |                     |  |              |         |                 |  |              |        |                 |  |   |         |        |  |  |        |         |  |  |   |        | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Mr. Peays salary includes compensation
    as Chief Executive Officer through June 1, 2003.
    Mr. Peay resigned as the Chief Executive Officer but
    remains the Chairman of the Board and his salary includes
    $14,000 paid to him in that capacity in 2003.                                                                                                                                                                                            
|   
|(2) | Cash and stock bonuses approved, on an annual
    basis, by the Compensation Committee. My Peay was awarded a
    stock grant in 2002 in the amount of $33,450. In 2001, the
    Compensation Committee awarded Messrs. Meyer, Waddell and
    Hasper with a stock grant based on performance objectives issued
    during the year of $20,000. Stock grants were not awarded to
    these same officers in 2003 or 2002 as part of the annual bonus
    program.
|   
|(3) | The costs include premiums on life insurance
    policies and a one-time payment to Mr. Peay upon his
    resignation as Chief Executive Officer.                                                                                                                                                                                                                                                                                                                
|   
|(4) | Stock grants were awarded to Messrs. Peay,
    Meyer, Waddell and Hasper as part of the employment agreements
    each executed in 2001.                                                                                                                                                                                                                                                                                                                         
|   
|(5) | Mr. Waddell resigned as Vice President for
    Strategic Planning and Corporate Development of the Company
    effective December 1, 2003, when he accepted the position
    of President of SeaSpace Corporation, a wholly-owned subsidiary
    of the Company.                                                                                                                                                                                                 

24



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##### Table of Contents



Options Grants in Last Fiscal Year

The following table contains information
concerning the stock option grants made to each of the named
executive officers for the fiscal year ended December 31,
2003.

|                        |  |                   |        |                      |  |             |    |                        |  |                |       |        |  |  |          |  |  |  |         |  |  |  |         | 
|----------------------- |  | ----------------- | ------ | -------------------- |  | ----------- | -- | ---------------------- |  | -------------- | ----- | ------ |  |  | -------- |  |  |  | ------- |  |  |  | ------- | 
|                        |  |                   |        |                     
|                        |  | Individual Grants |        | Potential Realizable
|                        |  |                   |        | Value at Assumed    
|                        |  | Number of         |        | % of Total           |  |             |    | Annual Rates of Stock 
|                        |  | Securities        |        | Options              |  |             |    | Price Appreciation for
|                        |  | Underlying        |        | Granted to           |  | Exercise or |    |                        |  | Option Term(1)
|                        |  | Options           |        | Employees in         |  | Base Price  |    | Expiration             |  |               
|Name                    |  | Granted           |        | Fiscal Year          |  | ($/Sh)      |    | Date                   |  | 5%($)          |       | 10%($)
|                        |  |                   |        |                      |  |             |    |                        |  |                |       |       
|J. H. Binford Peay, III |  |                   | 6,500  |                      |  |             | 4  | %                      |  | $              | 18.50 |        |  |  | 06/30/08 |  |  |  | 29,524  |  |  |  | 64,401  | 
|John G. Meyer, Jr.      |  |                   | 70,000 |                      |  |             | 47 | %                      |  | $              | 17.19 |        |  |  | 12/31/08 |  |  |  | 332,450 |  |  |  | 734,627 | 
|Monte L. Pickens        |  |                   | 40,000 |                      |  |             | 27 | %                      |  | $              | 14.90 |        |  |  | 04/30/08 |  |  |  | 139,123 |  |  |  | 301,914 | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Potential gains are net of exercise price, but
    before taxes associated with exercise. These amounts represent
    certain assumed rates of appreciation only, in accordance with
    the SECs rule. Actual gains, if any, on stock option
    exercises are dependent on the future performance of the common
    stock, overall market conditions and the option holders
    continued employment through the vesting period. The amounts
    reflected in this table may not necessarily be achieved.

Aggregated Options Exercised in Last Fiscal
Year and Fiscal Year-End Values

The following table sets forth information
concerning option exercises and option holdings by each of the
named executive officers for the fiscal year ended
December 31, 2003.

|                        |  |             |        |             |  |                                  |         |                              |  |             |         |               |  |  |         |  |  |   |           |  |  |   |           | 
|----------------------- |  | ----------- | ------ | ----------- |  | -------------------------------- | ------- | ---------------------------- |  | ----------- | ------- | ------------- |  |  | ------- |  |  | - | --------- |  |  | - | --------- | 
|                        |  |             |        |             |  |                                  |         |                              |  |            
|                        |  |             |        |             |  |                                  |         | Value of Unexercised In-the-
|                        |  |             |        |             |  | Number of Securities Underlying/ |         | Money Options/SARs at FY-   
|                        |  | Shares      |        |             |  | Unexercised Options/SARs Value   |         | End($)(2)                   
|                        |  | Acquired on |        | Value       |  |                                  |         |                             
|Name                    |  | Exercise(#) |        | Realized(1) |  | Exercisable(#)                   |         | Unexercisable(#)             |  | Exercisable |         | Unexercisable
|                        |  |             |        |             |  |                                  |         |                              |  |             |         |              
|J. H. Binford Peay, III |  |             |       |             |  |                                  |        |                              |  |             | 106,333 |               |  |  | 106,667 |  |  | $ | 1,306,524 |  |  | $ | 1,111,869 | 
|John G. Meyer, Jr.      |  |             |       |             |  |                                  |        |                              |  |             | 51,333  |               |  |  | 98,667  |  |  | $ | 560,931   |  |  | $ | 821,069   | 
|Monte L. Pickens        |  |             |       |             |  |                                  |        |                              |  |             | 8,000   |               |  |  | 32,000  |  |  | $ | 72,080    |  |  | $ | 288,320   | 
|Charles A. Hasper       |  |             | 5,000  |             |  | $                                | 56,200  |                              |  |             | 32,333  |               |  |  | 42,667  |  |  | $ | 383,231   |  |  | $ | 438,669   | 
|Bruce W. Waddell        |  |             | 42,000 |             |  | $                                | 451,990 |                              |  |             | 3,333   |               |  |  | 26,667  |  |  | $ | 25,031    |  |  | $ | 322,509   | 



---



|    |                                                                                                                                                                                                                                                                                                 
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Represents the closing price per share on the
    date the option was exercised less the option exercise price
    multiplied by the number of shares acquired upon exercise.                                                                                                                   
|   
|(2) | Represents the closing price per share of the
    underlying shares on the last day of the fiscal year less the
    option exercise price multiplied by the number of shares. The
    closing price per share was $23.91 on the last trading day of
    the fiscal year as reported on the AMEX.

Director Compensation

Directors who are employees of Allied receive no
additional compensation for serving as a director. Each
non-employee director (an Outside Director) is
compensated for service as a director, including as a member of
committees of the Board, at the rate of $1,000 per month; an
award of 1,000 shares of Common Stock on each July 1; and an
award as of each July 1 of an option to acquire 6,500 shares of
common stock (commencing in 2000). As Chairman Emeritus,
Mr. Sculley is entitled to an additional $500 per month. As
Chairman of the Board, General Peay is entitled to the same cash
and stock based compensation as paid to non-employee members of
the Board of Directors plus (i) an additional $1,000 per month
and (ii) reimbursement of annual premiums on a
$1 million life insurance policy, together with all
applicable income taxes.

In 1992, the Board of Directors of Allied adopted
the Outside Directors Retirement Plan (the Directors
Retirement Plan) to provide retirement benefits for
long-standing Outside Directors. Under the Directors Retirement
Plan, Outside Directors are eligible for a retirement benefit if
they retire from the Board and have

25



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##### Table of Contents



served as a member of the Board for a minimum of
five (5) years. An eligible Outside Director who retires
from the Board is entitled to receive, commencing on the last
day of the first month following the month in which the director
attains age seventy (70), monthly payments equal to the monthly
cash compensation received from Allied at the time the director
terminated service in such capacity. Such payments will cease
upon the earlier of the expiration of a period of time
equivalent to the period of time the director served as a member
of the Board or the death of the director. The Directors
Retirement Plan was suspended in 2001. Messrs. Christ,
Warner and Sculley are entitled to receive benefits under the
Plan upon their retirement from the Board for prior service. No
further benefits have accrued or will accrue under the Plan
since its suspension in 2001.


In 2003, Mr. Sculley was paid approximately
$80,000 in satisfaction of his post-employment severance
entitlement. Mr. Sculley is entitled to annual payments of
$80,000 through 2005.

Employment Contract and Change-In-Control
Arrangements

Mr. Meyers employment agreement
provides for an annual salary of $270,000 and the potential to
earn an annual bonus up to 50% of the annual salary upon
satisfaction of certain performance standards. Upon certain
terminations of Mr. Meyers employment, he will be
entitled to receive his annual salary for up to three (3) years
following such termination. Further, if the termination of
employment occurs within twelve (12) months of a change of
control, the payments may be accelerated into a lump sum payment
at the election of Mr. Meyer.

Mr. Pickens employment agreement
provides for an annual salary of $185,000 and the potential to
earn an annual bonus up to 35% of the annual salary upon
satisfaction of certain performance standards. Upon certain
terminations of Mr. Pickens employment, he will be
entitled to receive his annual salary for one year following
such termination. Further, if the termination of employment
occurs within twelve (12) months of a change of control,
the payments may be accelerated into a lump sum payment at the
election of Mr. Pickens.

Mr. Haspers employment agreement
provides for an annual salary of $180,000 and the potential to
earn an annual bonus up to 35% of the annual salary upon
satisfaction of certain performance standards. Upon certain
terminations of Mr. Haspers employment, he will be
entitled to receive his annual salary for one year following
such termination. Further, if the termination of employment
occurs within twelve (12) months of a change of control,
the payments may be accelerated into a lump sum payment at the
election of Mr. Hasper.

Mr. Waddells employment agreement
provides for an annual salary of $163,500 and the potential to
earn an annual bonus up to 35% of the annual salary upon
satisfaction of certain performance standards. For periods
commencing in 2004, the performance standards will relate to
Mr. Waddells responsibilities as President of
SeaSpace Corporation. Upon certain terminations of
Mr. Waddells employment, he will be entitled to
receive his annual salary for one year following such
termination. Further, if the termination of employment occurs
within twelve (12) months of a change of control, the
payments may be accelerated into a lump sum payment at the
election of Mr. Waddell.

Mr. Sculleys employment with Allied
terminated in September, 1999. He is entitled to post-employment
payments of $80,000 per year through 2005. Such amounts are
subject to acceleration upon a change of control of Allied.

In June, 2001, the Board of Directors of Allied
adopted a new shareholder rights plan (the Rights
Plan). The Rights Plan provides each stockholder of record
on a dividend distribution one right for each
outstanding share of Allieds common stock. Rights become
exercisable at the earlier of ten days following: (1) a
public announcement that an acquirer has purchased or has the
right to acquire 15% or more of Allieds common stock, or
(2) the commencement of a tender offer which would result
in an offeror beneficially owning 15% or more of the outstanding
common stock of Allied. All rights held by an acquirer or
offeror expire on the announced acquisition date, and all rights
expire at the close of business on May 31, 2011. Each right
entitles a stockholder to acquire at a stated purchase price,
1/100 of a share of Allieds preferred stock which carries
voting and dividend rights similar to one share of its common
stock. Alternatively, a right holder may elect to purchase for
the stated price an equivalent number of shares of Allieds
common stock (or in certain circumstances, cash, property or
other securities of Allied) at a price per share equal to
one-half of the average market price for a specified period. In
lieu of the purchase price, a right holder may elect to acquire
one-half of the common stock

26



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##### Table of Contents



available under the second option. The purchase
price of the preferred stock fractional amount is subject to
adjustment for certain events as described in the Rights Plan.
At the discretion of a majority of the Board and within a
specified time period, Allied may redeem all of the rights at a
price of $.01 per right. The Board may also amend any provisions
of the Rights Plan prior to exercise.


Compensation Committee Interlocks and Insider
Participation

The Compensation Committee of Allied consists of
Messrs. Harry H. Warner and Ronald H. Griffith.
J.R. Sculley, a former Chairman of the Board and President
of Allied, also served on the Compensation Committee in 2003.






|         |                                                                                                       
|-------- | ------------------------------------------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management and Related Stockholder
    Matters

The following information is furnished with
respect to any person who is known to Allied to be the
beneficial owner of more than five percent (5%) of its Common
Stock and is based upon the most recent filings made by the
undersigned with the Securities and Exchange Commission:

|               |  |                                                                                                        |  |                      |                        |            |  |  |      | 
|-------------- |  | ------------------------------------------------------------------------------------------------------ |  | -------------------- | ---------------------- | ---------- |  |  | ---- | 
|               |  |                                                                                                        |  | Amount and Nature of |                        | Percent of
|Title of Class |  | Name and Address of Beneficial Owner                                                                   |  | Beneficial Ownership |                        | Class(1)  
|               |  |                                                                                                        |  |                      |                        |           
|Common         |  | Bricoleur Capital Management, LLC(2)
    12230 El Camino Rd., Ste. 100
    San Diego, CA 92130         |  |                      | 460,200 Owned directly |            |  |  | 7.3% | 
|Common         |  | FMR Corp.(3)
    82 Devonshire Street
    Boston, MA 02109                                             |  |                      | 475,000 Owned directly |            |  |  | 7.5% | 
|Common         |  | Dimensional Fund
    Advisors, Inc.(4)
    1299 Ocean Ave., 11th Floor
    Santa Monica, CA 90401      |  |                      | 307,230 Owned directly |            |  |  | 4.9% | 
|Common         |  | Riverview Group, LLC(5)
    666 Fifth Avenue
    New York, New York 10103                              |  |                      | 315,000 Owned directly |            |  |  | 5.0% | 
|Common         |  | Heartland Advisors, Inc.(6)
    789 North Water Street
    Milwaulkee, Wisconsin 53202                 |  |                      | 300,000 Owned directly |            |  |  | 4.8% | 
|Common         |  | Berno, Gambal & Barbee, Inc.(7)
    1100 North Glebe Road
    Suite 1040
    Arlington, Virginia 22201 |  |                      | 291,400 Owned directly |            |  |  | 4.6% | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                   
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Based upon 5,551,373 shares of common stock
    outstanding plus 427,998 shares which may be acquired within
    sixty (60) days pursuant to outstanding stock options plus
    315,000 shares which may be issued within sixty (60) days
    pursuant to a convertible debenture and stock purchase warrant.                                                                                                     
|   
|(2) | Bricoleur Capital Management, LLC
    (Bricoleur) filed an amended Schedule 13G with
    the SEC on February 9, 2004. This Schedule 13G states
    that Bricoleur beneficially owned 460,200 shares of Common Stock
    as of December 31, 2003.                                                                                                                                                                
|   
|(3) | FMR Corp. and its wholly-owned subsidiary,
    Fidelity Management & Research Company
    (Fidelity), Edward C. Johnson, 3rd and Abigail P.
    Johnson, jointly filed an amended Schedule 13G with the SEC
    on February 17, 2004. This Schedule 13G states that
    Fidelity Low-Priced Stock Fund owned 475,000 shares of Common
    Stock as of December 31, 2003.                                        
|   
|(4) | Dimensional Fund Advisors, Inc.
    (Dimensional), a registered investment advisor,
    filed an amended Schedule 13G with the SEC on
    February 6, 2004. This Schedule 13G states that
    Dimensional is deemed to have beneficial ownership of 307,230
    shares, all of which shares are owned by advisory clients of
    Dimensional. Dimensional disclaims beneficial ownership of all
    such shares.
|   
|(5) | Riverview Group, LLC has the right to acquire up
    to 315,000 shares within sixty (60) days pursuant to its
    convertible debenture and stock purchase warrant.                                                                                                                                                                                                                                               
|   
|(6) | Heartland Advisors, Inc. and William J. Nasgovitz
    filed a Schedule 13G with the SEC on February 12,
    2004. This Schedule 13G states that The Heartland Value
    Fund owns 300,000 shares of common stock.                                                                                                                                                                                                 
|   
|(7) | Berno, Gambal & Barbee, Inc. filed an
    amendment to its Schedule 13G with the SEC on
    February 13, 2004. This amendment states that Berno, Gambal
    & Barbee owns 291,400 shares of the common stock.                                                                                                                                                                                                     

27



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##### Table of Contents



The following information is furnished as of
March 1, 2004, with respect to the beneficial ownership by
management of Allieds Common Stock:

|               |  |                                                         |  |                               |  |            |      | 
|-------------- |  | ------------------------------------------------------- |  | ----------------------------- |  | ---------- | ---- | 
|               |  |                                                         |  | Amount and Nature of          |  | Percent of
|Title of Class |  | Name and Address of Beneficial Owner                    |  | Beneficial Ownership          |  | Class(1)  
|               |  |                                                         |  |                               |  |           
|Common         |  | J. H. Binford Peay, III                                 |  | 191,097(2)
    Owned directly |  |            | 3.0% | 
|Common         |  | John G. Meyer, Jr.                                      |  | 84,055(3)
    Owned directly  |  |            | *    | 
|Common         |  | Harry H. Warner                                         |  | 46,000(4)
    Owned directly  |  |            | *    | 
|Common         |  | Clifford C. Christ                                      |  | 39,000(5)
    Owned directly  |  |            | *    | 
|Common         |  | J. R. Sculley                                           |  | 72,400(4)
    Owned directly  |  |            | 1.2% | 
|Common         |  | Ronald H. Griffith                                      |  | 30,000(4)
    Owned directly  |  |            | *    | 
|Common         |  | Gilbert F. Decker                                       |  | 15,000(5)
    Owned directly  |  |            | *    | 
|Common         |  | All executive officers and directors as a group
    (9) |  | 542,864(6)
    Owned directly |  |            | 8.6% | 

Allied is aware of no arrangement the operation
of which may at a subsequent date result in a change in control
of Allied.

Equity Compensation Plan Information.The following table provides
information about the Companys Common Stock that may be
issued upon the exercise of options and rights under all of the
Companys existing equity compensation plans as of
December 31, 2003, including the 2001 Equity Incentive
Plan, the 1997 Incentive Stock Plan and the 1992 Employee Stock
Purchase Plan (all of which have been approved by the
Companys stockholders), as well as rights to acquire
shares of the Companys Common Stock granted to an
unaffiliated institutional investor in connection with a
$7.5 million convertible debenture issued by the Company to
the investor.

|                                                                 |  |                               |         |                               |  |                                 |       |  |  |  |   | 
|---------------------------------------------------------------- |  | ----------------------------- | ------- | ----------------------------- |  | ------------------------------- | ----- |  |  |  | - | 
|                                                                 |  |                               |         |                               |  | Number of securities available 
|                                                                 |  | Number of securities to be    |         |                               |  | for future issuance under      
|                                                                 |  | issued upon exercise of       |         | Weighted average exercise     |  | equity compensation plans      
|                                                                 |  | outstanding options, warrants |         | price of outstanding options, |  | (excluding securities reflected
|                                                                 |  | and rights                    |         | warrants and rights           |  | in column)                     
|                                                                 |  |                               |         |                               |  |                                
|Equity compensation plans approved by security
    holders       |  |                               | 592,000 |                               |  | $                               | 14.75 |  |  |  |  | 
|Equity compensation plans not approved by
    securities holders |  |                               | 315,000 |                               |  | $                               | 25.18 |  |  |  |  | 
|                                                                 |  |                               |         |                               |  |                                 |       |  |  |  |   | 
|Total                                                            |  |                               | 907,000 |                               |  | $                               | 17.42 |  |  |  |  | 
|                                                                 |  |                               |         |                               |  |                                 |       |  |  |  |   | 



---



|    |                                                                                                                                                                                                                                                                                                              
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Based upon 5,551,373 shares of common stock
    outstanding plus 427,998 shares which may be acquired within
    sixty (60) days pursuant to outstanding stock options plus
    315,000 shares which may be issued within sixty (60) days
    pursuant to a convertible debenture and stock purchase warrant.
|   
|(2) | Includes stock options for 159,666 shares which
    may be exercised within sixty (60) days.                                                                                                                                                                                                                 
|   
|(3) | Includes stock options for 72,666 shares which
    may be exercised within sixty (60) days.                                                                                                                                                                                                                  
|   
|(4) | Includes stock options for 26,000 shares which
    may be exercised within sixty (60) days.                                                                                                                                                                                                                  
|   
|(5) | Includes stock options for 13,000 shares which
    may be exercised within sixty (60) days.                                                                                                                                                                                                                  
|   
|(6) | Includes stock options for 397,998 shares which
    may be exercised within sixty (60) days.                                                                                                                                                                                                                 
|   
|*   | Less than 1%                                                                                                                                                                                                                                                                                                 

28



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##### Table of Contents






Item
13.     Certain Relationships and
Related Transactions

Mr. Sculleys employment with the
Company terminated in September, 1999. During 2003, 2002 and
2001, the Company paid Mr. Sculley approximately $80,000,
$80,000 and $100,000, respectively, in satisfaction of his
post-employment entitlement. He is entitled to post-employment
payments of $80,000 per year through 2005. Such amounts are
subject to acceleration upon a change of control of the Company.




Item
14.     Principal Accounting Fees
and Service

The following table sets forth the fees incurred
by the Company to Grant Thornton LLP for audit and other
services provided for 2003 and 2002:

|                   |  |      |         |      |  |   |         | 
|------------------ |  | ---- | ------- | ---- |  | - | ------- | 
|                   |  | 2003 |         | 2002
|                   |  |      |         |     
|Audit fees         |  | $    | 280,300 |      |  | $ | 173,100 | 
|Audit-related fees |  | $    | 3,255   |      |  | $ | 11,500  | 
|Tax fees           |  | $    | 51,800  |      |  | $ | 39,000  | 
|All other fees     |  | $    | 3,474   |      |  | $ | 14,000  | 
|                   |  |      |         |      |  |   |         | 
|Total              |  | $    | 338,829 |      |  | $ | 237,600 | 
|                   |  |      |         |      |  |   |         | 

Audit fees include work in connection with
quarterly reviews.

Additional audit and other service fees of
approximately $120,000 and $110,000 were billed to the
Companys foreign subsidiaries by other auditors for audit
related services primarily involving statutory audits required
by the laws of Belgium for 2003 and 2002, respectively.

The Audit Committee considered whether the
provision of services referenced above is compatible with
maintaining Grant Thorntons independence.

The Audit Committees policy is to
pre-approve all audit and permissible non-audit services
provided by the independent auditors. These services may include
audit services, audit-related services, tax services and other
services. Pre-approval is generally provided for up to one year.
The Audit Committee may also pre-approve particular services on
a case-by-case basis.

29



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##### Table of Contents



PART IV



Item
15.     Exhibits, Financial
Statement Schedules, and Reports on Form 8-K

For the purposes of complying with the amendments
to the rules governing Form S-8 under the Securities Act of
1933, the undersigned registrant hereby undertakes, as follows,
which undertaking shall be incorporated by reference into
Allieds Registration Statements on Form S-8:

Insofar as indemnification for liabilities
arising under the Securities Act of 1933 may be permitted to
directors, officers and controlling persons of the registrant
pursuant to the foregoing provisions, or otherwise, the
registrant has been advised that in the opinion of the
Securities and Exchange Commission such indemnification is
unenforceable. In the event that a claim for indemnification
against such liabilities (other than the payment by Allied of
expenses incurred or paid by a director, officer or controlling
person of the registrant in the successful defense of any
action, suit or proceeding) is asserted by such director,
officer or controlling person in connection with the securities
being registered, Allied will, unless in the opinion of its
counsel the matter has been settled by controlling precedent,
submit to a court of appropriate jurisdiction the question
whether such indemnification by it is against public policy as
expressed in the Act and will be governed by the final
adjudication of such issue.

(a)(1)     Financial
Statements:

|                                                                                                                          |  |     
|------------------------------------------------------------------------------------------------------------------------- |  | ----
|Report of Independent Certified Public Accountants                                                                        |  | F-3 
|Consolidated Balance Sheets at December 31,
    2003 and 2002                                                             |  | F-4 
|Consolidated Statements of Operations for each of
    the three years in the period ended December 31, 2003               |  | F-6 
|Consolidated Statements of Stockholders
    Equity for each of the three years in the period ended
    December 31, 2003 |  | F-7 
|Consolidated Statements of Cash Flows for each of
    the three years in the period ended December 31, 2003               |  | F-8 
|Notes to Consolidated Financial Statements                                                                                |  | F-10

(a)(2)     Financial
Statement Schedules:

The following financial statement schedules are
included in Part IV of this report:

(a)(2)(a) As of December 31, 2003 and 2002
and for the three years ended December 31, 2003:

|                                                           |  |     
|---------------------------------------------------------- |  | ----
|Schedule I  Condensed Financial
    Information of Allied |  | F-34
|Schedule II  Valuation and
    Qualifying Accounts        |  | F-35

30



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##### Table of Contents



(a)(3)     Exhibits:

|            |       |                         |  |                                                                                                                                                                    
|----------- | ----- | ----------------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |       | Description of Exhibits
|            |       |                        
|            | 3.1   |                         |  | Certificate of Incorporation, as amended
    (Incorporated by reference from Form 10-Q filed in August
    2002).                                                  
|            | 3.2   |                         |  | By-Laws (Incorporated by reference from
    Form 10-Q filed in August 2002).                                                                                       
|            | 3.3   |                         |  | Rights Agreement between Allied and Mellon
    Investor Services, LLC (Incorporated by reference from
    Form 8-K filed in June 2001).                            
|            | 10.1  |                         |  | Employment Agreement between Allied and John G.
    Meyer, Jr. (Incorporated by reference from Form 8-K filed
    in March 2001 and Form 8-K filed in August 2001).
|            | 10.2  |                         |  | Employment Agreement between Allied and Charles
    A. Hasper (Incorporated by reference from Form 8-K filed in
    August 2001).                                  
|            | 10.3  |                         |  | Employment Agreement between Allied and Monte L.
    Pickens (Incorporated by reference from Form 8-K filed in
    April 2003).                                    
|            | 10.4  |                         |  | 2001 Equity Incentive Plan, as amended
    (Incorporated by reference from Proxy Statements filed in April
    2001 and April 2002).                               
|            | 10.5  |                         |  | 8% Convertible Debenture, Series A and
    related documents (Incorporated by reference from Form 8-K
    filed in July 2002).                                     
|            | 10.6  |                         |  | Credit Agreement for MECAR S.A. (Incorporated by
    reference from Form 10-Q filed in August 2002).                                                               
|            | 10.7  |                         |  | Award/ Contract dated as of March 1, 2002,
    by and between MECAR S.A. and U.S. Government (Incorporated by
    reference from Form 10-Q filed in August 2002).  
|            | 10.8  |                         |  | Employee Stock Purchase Plan, as amended
    (Incorporated by reference from Form 10-Q filed in November
    2002).                                                
|            | 10.9  |                         |  | Lease Agreement, as amended (Incorporated by
    reference from Form 10-Q filed in November 2002).                                                                 
|            | 10.10 |                         |  | Form of Indemnity Agreement for Directors and
    Executive Officers (Incorporated by reference from
    Form 10-Q filed in November 2002).                        
|            | 10.11 |                         |  | International Distribution Agreement
    (Incorporated by reference from Form 10-Q filed in November
    2002).                                                    
|            | 21    |                         |  | List of Subsidiaries                                                                                                                                               
|            | 23    |                         |  | Consent of Independent Certified Public
    Accountants                                                                                                            
|            | 31.1  |                         |  | Certification of Chief Executive Officer Pursuant
    to Section 302 of the Sarbanes-Oxley Act of 2002                                                             
|            | 31.2  |                         |  | Certification of Chief Financial Officer Pursuant
    to Section 302 of the Sarbanes-Oxley Act of 2002                                                             
|            | 32    |                         |  | Certification Pursuant to 18 U.S.C.
    Section 1350, as Adopted Pursuant to Section 906 of
    the Sarbanes-Oxley Act of 2002                                     

(b)     Reports on
Form 8-K:

On November 5, 2003, the Company filed a
Form 8-K reporting its 2003 third quarter financial results.

On November 13, 2003, the Company filed a
Form 8-K reporting a change in executive management of one
of its subsidiary corporations.

Supplemental Information to be Furnished with
Reports Filed Pursuant to Section 15(d) of the Act by
Registrants Which Have Not Registered Securities Pursuant to
Section 12 of the Act.

No annual report or proxy material has as yet
been sent to Allieds stockholders, although it is expected
that an annual report and proxy material will be furnished to
Allieds stockholders subsequent to the filing of this
Form 10-K.

31



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##### Table of Contents






SIGNATURES

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



| |                               
| | ------------------------------
| | THE ALLIED DEFENSE GROUP, INC.



| |     |                       
| | --- | ----------------------
| | By: | /s/ JOHN G. MEYER, JR.

| |                                          
| | -----------------------------------------
| |                                          
| | John G. Meyer, Jr.                       
| | Chief Executive Officer and
    President

Date: March 15, 2004

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

|                                                   |  |                                        |  |                                       |  |               
|-------------------------------------------------- |  | -------------------------------------- |  | ------------------------------------- |  | --------------
|                                                   |  |                                        |  |                                      
|Signature                                          |  | Title                                  |  | Date                                 
|                                                   |  |                                        |  |                                      
|By:                                                |  | /s/ CHARLES A. HASPERCharles A. Hasper |  | Chief Financial Officer and Treasurer |  | March 15, 2004
|                                                  
|By:                                                |  | /s/ GRESFORD B. GRAYGresford B. Gray   |  | Controller and Corporate Secretary    |  | March 15, 2004
|                                                  
|/s/ J. R. SCULLEYJ. R. Sculley                     |  | Director                               |  | March 15, 2004                       
|                                                  
|/s/ CLIFFORD C. CHRISTClifford C. Christ           |  | Director                               |  | March 15, 2004                       
|                                                  
|/s/ HARRY H. WARNERHarry H. Warner                 |  | Director                               |  | March 15, 2004                       
|                                                  
|/s/ RONALD H. GRIFFITHRonald H. Griffith           |  | Director                               |  | March 15, 2004                       
|                                                  
|/s/ GILBERT F. DECKERGilbert F. Decker             |  | Director                               |  | March 15, 2004                       
|                                                  
|/s/ JOHN G. MEYER, JR.John G. Meyer, Jr.           |  | Director                               |  | March 15, 2004                       
|                                                  
|/s/ J. H. BINFORD PEAY, IIIJ. H. Binford Peay, III |  | Director                               |  | March 15, 2004                       

32



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##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FINANCIAL STATEMENTS AND SCHEDULES

December 31, 2003


FORMING A PART OF

ANNUAL REPORT PURSUANT TO


THE SECURITIES EXCHANGE ACT OF 1934


FORM 10-K

OF


The Allied Defense Group Inc.


F-1



---



##### Table of Contents



THE ALLIED DEFENSE GROUP INC.

INDEX TO FINANCIAL STATEMENTS AND
SCHEDULES

|                                                                                                                          |                                                                |      |      |      | 
|------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------- | ---- | ---- | ---- | 
|                                                                                                                          |                                                                | Page
|                                                                                                                          |                                                                |     
|Report of Independent Certified
    Public Accountants                                                                    |                                                                |      | F-3  |     
|Consolidated Balance Sheets at December 31,
    2003 and 2002                                                             |                                                                |      | F-4  |     
|Consolidated Statements of Earnings for each of
    the three years in the period ended December 31, 2003                 |                                                                |      | F-6  |     
|Consolidated Statements of Stockholders
    Equity for each of the three years in the period ended
    December 31, 2003 |                                                                |      | F-7  |     
|Consolidated Statements of Cash Flows for each of
    the three years in the period ended December 31, 2003               |                                                                |      | F-8  |     
|Notes to Consolidated Financial Statements                                                                                |                                                                |      | F-10 |     
|Schedules as of and for the three years ended
    December 31, 2003                                                       |                                                                |      |      |     
|                                                                                                                          | Schedule I  Condensed Financial
    Information of Registrant |      |      | F-32 | 
|                                                                                                                          | Schedule II  Valuation and
    Qualifying Accounts            |      |      | F-35 | 

F-2



---



##### Table of Contents



REPORT OF INDEPENDENT CERTIFIED PUBLIC
ACCOUNTANTS

Board of Directors

The Allied Defense Group, Inc.


We have audited the accompanying consolidated
balance sheets of The Allied Defense Group, Inc. and
subsidiaries as of December 31, 2003 and 2002 and the
related consolidated statements of earnings, stockholders
equity and cash flows for each of the three years in the period
ended December 31, 2003. These financial statements are the
responsibility of the Companys management. Our
responsibility is to express an opinion on these financial
statements based on our 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 financial statements referred
to above present fairly, in all material respects, the
consolidated financial position of The Allied Defense Group,
Inc. and subsidiaries as of December 31, 2003 and 2002, and
the consolidated results of their earnings and their
consolidated cash flows for each of the three years in the
period ended December 31, 2003 in conformity with
accounting principles generally accepted in the United States of
America.

As discussed in Note A to the consolidated
financial statements, in 2002 the Company changed its method of
accounting for goodwill and other intangible assets.

We have also audited Schedules I and II for each
of the three years in the period ended December 31, 2003.
In our opinion, these schedules present fairly, in all material
respects, the information required to be set forth therein.



| |                       
| | ----------------------
| | /S/ GRANT THORNTON LLP

Baltimore, Maryland

February 20, 2004


F-3



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.

CONSOLIDATED BALANCE SHEETS

|                                            |                                                                                       |                        |         |        |         |   |         |        |         | 
|------------------------------------------- | ------------------------------------------------------------------------------------- | ---------------------- | ------- | ------ | ------- | - | ------- | ------ | ------- | 
|                                            |                                                                                       |                       
|                                            |                                                                                       | December 31,          
|                                            |                                                                                       |                       
|                                            |                                                                                       | 2003                   |         | 2002  
|                                            |                                                                                       |                        |         |       
|                                            |                                                                                       |                       
|                                            |                                                                                       | (Thousands of Dollars)
|ASSETS                                     
|Current Assets                              |                                                                                       |                        |         |        |         |   |         |       
|                                            | Cash and equivalents                                                                  |                        | $       | 43,377 |         |   | $       | 14,876 |        
|                                            | Restricted cash                                                                       |                        |         | 15,937 |         |   |         | 8,052  |        
|                                            | Accounts receivable                                                                   |                        |         | 29,321 |         |   |         | 28,551 |        
|                                            | Costs and accrued earnings on
    uncompleted contracts                               |                        |         | 68,414 |         |   |         | 56,728 |        
|                                            | Inventories (less reserve for obsolescence of
    $214 in 2003 and $148 in 2002)      |                        |         | 12,068 |         |   |         | 9,409  |        
|                                            | Deferred tax asset                                                                    |                        |         | 1,016  |         |   |         | 305    |        
|                                            | Fair value of foreign exchange contracts                                              |                        |         | 9,378  |         |   |         | 13,595 |        
|                                            | Prepaid and other current assets                                                      |                        |         | 4,880  |         |   |         | 2,898  |        
|                                            |                                                                                       |                        |         |        |         |   |         |       
|                                            |                                                                                       | Total current assets   |         |        | 184,391 |   |         |        | 134,414 | 
|Property, Plant and Equipment  At
    Cost |                                                                                       |                        |         |        |         |   |         |       
|                                            | Buildings and improvements                                                            |                        |         | 20,021 |         |   |         | 15,144 |        
|                                            | Machinery and equipment                                                               |                        |         | 50,309 |         |   |         | 38,919 |        
|                                            |                                                                                       |                        |         |        |         |   |         |       
|                                            |                                                                                       |                        | 70,330  |        |         |   | 54,063  |       
|                                            | Less accumulated depreciation                                                         |                        |         | 47,217 |         |   |         | 36,673 |        
|                                            |                                                                                       |                        |         |        |         |   |         |       
|                                            |                                                                                       |                        | 23,113  |        |         |   | 17,390  |       
|                                            | Land                                                                                  |                        |         | 1,502  |         |   |         | 1,254  |        
|                                            |                                                                                       |                        |         |        |         |   |         |       
|                                            |                                                                                       |                        | 24,615  |        |         |   | 18,644  |       
|Other Assets                                |                                                                                       |                        |         |        |         |   |         |       
|                                            | Intangible assets, less accumulated amortization
    of $785 in 2003 and $340 in 2002 |                        |         | 4,135  |         |   |         | 4,114  |        
|                                            | Goodwill                                                                              |                        |         | 13,718 |         |   |         | 10,604 |        
|                                            | Other assets                                                                          |                        |         | 378    |         |   |         | 392    |        
|                                            |                                                                                       |                        |         |        |         |   |         |       
|                                            |                                                                                       |                        | 18,231  |        |         |   | 15,110  |       
|                                            |                                                                                       |                        |         |        |         |   |         |       
|                                            |                                                                                       | $                      | 227,237 |        |         | $ | 168,168 |       
|                                            |                                                                                       |                        |         |        |         |   |         |       

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

F-4



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.

CONSOLIDATED BALANCE SHEETS 
Continued

|                                         |                                                                                                                                                |                           |         |        |         |   |         |        |        | 
|---------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------- | ------- | ------ | ------- | - | ------- | ------ | ------ | 
|                                         |                                                                                                                                                |                          
|                                         |                                                                                                                                                | December 31,             
|                                         |                                                                                                                                                |                          
|                                         |                                                                                                                                                | 2003                      |         | 2002  
|                                         |                                                                                                                                                |                           |         |       
|                                         |                                                                                                                                                |                          
|                                         |                                                                                                                                                | (Thousands of Dollars)   
|LIABILITIES AND STOCKHOLDERS
    EQUITY
|                                        
|Current Liabilities                      |                                                                                                                                                |                           |         |        |         |   |         |       
|                                         | Notes payable                                                                                                                                  |                           | $       | 14,200 |         |   | $       | 6,517  |       
|                                         | Current maturities of long-term debt                                                                                                           |                           |         | 2,709  |         |   |         | 1,915  |       
|                                         | Convertible subordinated debenture, current                                                                                                    |                           |         | 5,250  |         |   |         | 5,250  |       
|                                         | Accounts payable                                                                                                                               |                           |         | 53,284 |         |   |         | 30,966 |       
|                                         | Accrued liabilities                                                                                                                            |                           |         | 16,846 |         |   |         | 8,219  |       
|                                         | Customer deposits                                                                                                                              |                           |         | 4,938  |         |   |         | 5,092  |       
|                                         | Foreign exchange contracts                                                                                                                     |                           |         | 9,378  |         |   |         | 13,595 |       
|                                         | Income taxes                                                                                                                                   |                           |         | 906    |         |   |         | 2,678  |       
|                                         |                                                                                                                                                |                           |         |        |         |   |         |       
|                                         |                                                                                                                                                | Total current liabilities |         |        | 107,511 |   |         |        | 74,232 | 
|                                        
|Long-Term Obligations                    |                                                                                                                                                |                           |         |        |         |   |         |       
|                                         | Long-term debt, less current maturities                                                                                                        |                           |         | 4,902  |         |   |         | 4,738  |       
|                                         | Convertible subordinated debenture, less current
    maturities and unamortized discount                                                       |                           |         | 2,156  |         |   |         | 2,029  |       
|                                         | Deferred compensation                                                                                                                          |                           |         | 1,334  |         |   |         | 544    |       
|                                         | Deferred taxes                                                                                                                                 |                           |         | 1,339  |         |   |         | 111    |       
|                                         |                                                                                                                                                |                           |         |        |         |   |         |       
|                                         |                                                                                                                                                |                           | 9,731   |        |         |   | 7,422   |       
|Contingencies and Commitments            |                                                                                                                                                |                           |        |        |         |   |        |       
|                                        
|Stockholders Equity                     |                                                                                                                                                |                           |         |        |         |   |         |       
|                                         | Preferred stock, no par value; authorized,
    1,000,000 shares; none issued                                                                   |                           |         |       |         |   |         |       |       
|                                         | Common stock, par value, $.10 per share;
    authorized 30,000,000 shares; issued and outstanding, 5,551,373
    in 2003 and 5,474,813 in 2002 |                           |         | 555    |         |   |         | 547    |       
|                                         | Capital in excess of par value                                                                                                                 |                           |         | 25,891 |         |   |         | 24,871 |       
|                                         | Retained earnings                                                                                                                              |                           |         | 70,166 |         |   |         | 61,345 |       
|                                         | Accumulated other comprehensive income (loss)                                                                                                  |                           |         | 13,383 |         |   |         | (249   | )     
|                                         |                                                                                                                                                |                           |         |        |         |   |         |       
|                                         |                                                                                                                                                |                           | 109,995 |        |         |   | 86,514  |       
|                                         |                                                                                                                                                |                           |         |        |         |   |         |       
|                                         |                                                                                                                                                | $                         | 227,237 |        |         | $ | 168,168 |       
|                                         |                                                                                                                                                |                           |         |        |         |   |         |       

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

F-5



---



##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.

CONSOLIDATED STATEMENTS OF EARNINGS

|                                              |                            |                                               |                              |           |        |        |         |           |        |        |        |           |        |        | 
|--------------------------------------------- | -------------------------- | --------------------------------------------- | ---------------------------- | --------- | ------ | ------ | ------- | --------- | ------ | ------ | ------ | --------- | ------ | ------ | 
|                                              |                            |                                              
|                                              |                            | Years ended December 31,                     
|                                              |                            |                                              
|                                              |                            | 2003                                          |                              | 2002      |        | 2001  
|                                              |                            |                                               |                              |           |        |       
|                                              |                            |                                              
|                                              |                            | (Thousands of Dollars, except per share data)
|Revenue                                       |                            | $                                             | 171,407                      |           |        | $      | 130,866 |           |        | $      | 96,947 |          
|Cost and expenses                             |                            |                                               |                              |           |        |        |         |           |        |        |        |          
|                                              | Cost of sales              |                                               |                              | 124,558   |        |        |         | 91,509    |        |        |        | 63,253    |       
|                                              | Selling and administrative |                                               |                              | 24,987    |        |        |         | 17,497    |        |        |        | 12,109    |       
|                                              | Research and development   |                                               |                              | 3,543     |        |        |         | 1,629     |        |        |        | 1,504     |       
|                                              |                            |                                               |                              |           |        |        |         |           |        |        |        |          
|                                              |                            |                                               | 153,088                      |           |        |        | 110,635 |           |        |        | 76,866 |          
|                                              |                            |                                               |                              |           |        |        |         |           |        |        |        |          
|                                              |                            | Operating income                              |                              |           | 18,319 |        |         |           | 20,231 |        |        |           | 20,081 |       
|                                             
|Other income (expense)                        |                            |                                               |                              |           |        |        |         |           |        |        |        |          
|                                              | Interest income            |                                               |                              | 459       |        |        |         | 506       |        |        |        | 645       |       
|                                              | Interest expense           |                                               |                              | (2,490    | )      |        |         | (2,087    | )      |        |        | (1,666    | )     
|                                              | Other  net                |                                               |                              | 255       |        |        |         | 1,300     |        |        |        | (316      | )     
|                                              |                            |                                               |                              |           |        |        |         |           |        |        |        |          
|                                              |                            |                                               | (1,776                       | )         |        |        | (281    | )         |        |        | (1,337 | )        
|                                              |                            |                                               |                              |           |        |        |         |           |        |        |        |          
|                                              |                            |                                               | Earnings before income taxes |           |        | 16,543 |         |           |        | 19,950 |        |           |        | 18,744 | 
|Income tax expense                            |                            |                                               | 7,722                        |           |        |        | 9,278   |           |        |        | 8,377  |          
|                                              |                            |                                               |                              |           |        |        |         |           |        |        |        |          
|                                              |                            | NET EARNINGS                                  |                              | $         | 8,821  |        |         | $         | 10,672 |        |        | $         | 10,367 |       
|                                              |                            |                                               |                              |           |        |        |         |           |        |        |        |          
|                                             
|Earnings per share                            |                            |                                               |                              |           |        |        |         |           |        |        |        |          
|                                              | Basic                      |                                               | $                            | 1.60      |        |        | $       | 2.01      |        |        | $      | 2.11      |       
|                                              | Diluted                    |                                               | $                            | 1.54      |        |        | $       | 1.92      |        |        | $      | 2.10      |       
|                                             
|Weighted average number of common
    shares: |                            |                                               |                              |           |        |        |         |           |        |        |        |          
|                                              | Basic                      |                                               |                              | 5,496,786 |        |        |         | 5,304,998 |        |        |        | 4,905,114 |       
|                                              |                            |                                               |                              |           |        |        |         |           |        |        |        |          
|                                              | Diluted                    |                                               |                              | 5,970,119 |        |        |         | 5,658,274 |        |        |        | 4,947,260 |       
|                                              |                            |                                               |                              |           |        |        |         |           |        |        |        |          

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

F-6



---



##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY

|                                 |                                                      |                                               |                            |              |   |           |           |              |   |          |     |               |   |               |        |       |   |   |        |        |   |   |        |   |        |   |         |       |   |        | 
|-------------------------------- | ---------------------------------------------------- | --------------------------------------------- | -------------------------- | ------------ | - | --------- | --------- | ------------ | - | -------- | --- | ------------- | - | ------------- | ------ | ----- | - | - | ------ | ------ | - | - | ------ | - | ------ | - | ------- | ----- | - | ------ | 
|                                 |                                                      |                                              
|                                 |                                                      | Years ended December 31, 2003, 2002 and 2001 
|                                 |                                                      |                                              
|                                 |                                                      |                                               |                            |              |   |          
|                                 |                                                      |                                               |                            | Common Stock |   |           |           | Accumulated  |   |         
|                                 |                                                      | Preferred                                     |                            |              |   | Capital   |           |              |   | other    |     | Total        
|                                 |                                                      | Stock, no                                     |                            |              |   | $.10      |           | in excess    |   | Retained |     | comprehensive |   | stockholders
|                                 |                                                      | par value                                     |                            | Shares       |   | par value |           | of par value |   | earnings |     | (loss) income |   | Equity       
|                                 |                                                      |                                               |                            |              |   |           |           |              |   |          |     |               |   |              
|                                 |                                                      |                                              
|                                 |                                                      | (Thousands of Dollars, except per share data)
|Balance at January 1, 2001       |                                                      | $                                             |                           |              |   |           | 4,812,464 |              |   | $        | 481 |               |   | $             | 13,689 |       |   | $ | 40,306 |        |   | $ | (7,756 | ) |        | $ | 46,720  |      
|                                 | Common stock awards                                  |                                               |                            |             |   |           |           | 71,400       |   |          |     | 7             |   |               |        | 575   |   |   |        |       |   |   |        |  |        |   |         | 582   |  
|                                 | Common stock issued                                  |                                               |                            |             |   |           |           | 184,777      |   |          |     | 19            |   |               |        | 2,429 |   |   |        |       |   |   |        |  |        |   |         | 2,448 |  
|                                 | Employee stock purchase plan purchases               |                                               |                            |             |   |           |           | 38,538       |   |          |     | 4             |   |               |        | 282   |   |   |        |       |   |   |        |  |        |   |         | 286   |  
|                                 | Exercise stock options                               |                                               |                            |             |   |           |           | 22,000       |   |          |     | 2             |   |               |        | 298   |   |   |        |       |   |   |        |  |        |   |         | 300   |  
|                                 | Comprehensive income
      Net earnings for the year |                                               |                            |             |   |           |           |             |   |          |     |              |   |               |        |      |   |   |        | 10,367 |   |   |        |  |        |   |         |      |  
|                                 |                                                      | Currency translation adjustment               |                            |              |  |           |           |              |  |          |     |               |  |               |        |       |  |   |        |        |  |   |        |   | (2,054 | ) |         |       |  |       
|                                 |                                                      |                                               | Total comprehensive income |              |   |          |           |              |   |         |     |               |   |              |        |       |   |  |        |        |   |  |        |   |        |  |         |       |   | 8,313  | 
|                                 |                                                      |                                               |                            |              |   |           |           |              |   |          |     |               |   |               |        |       |   |   |        |        |   |   |        |   |        |   |         |      
|Balance at
    December 31, 2001 |                                                      | $                                             |                           |              |   |           | 5,129,179 |              |   | $        | 513 |               |   | $             | 17,273 |       |   | $ | 50,673 |        |   | $ | (9,810 | ) |        | $ | 58,649  |      
|                                 | Common stock awards                                  |                                               |                            |             |   |           |           | 35,964       |   |          |     | 3             |   |               |        | 785   |   |   |        |       |   |   |        |  |        |   |         | 789   |  
|                                 | Common stock issued                                  |                                               |                            |             |   |           |           | 293,070      |   |          |     | 29            |   |               |        | 6,444 |   |   |        |       |   |   |        |  |        |   |         | 6,473 |  
|                                 | Employee stock purchase plan purchases               |                                               |                            |             |   |           |           | 9,100        |   |          |     | 0.9           |   |               |        | 168   |   |   |        |       |   |   |        |  |        |   |         | 169   |  
|                                 | Exercise stock options                               |                                               |                            |             |   |           |           | 7,500        |   |          |     | 0.8           |   |               |        | 61    |   |   |        |       |   |   |        |  |        |   |         | 62    |  
|                                 | Warrants issued                                      |                                               |                            |             |   |           |           |             |   |          |     |              |   |               |        | 140   |   |   |        |       |   |   |        |  |        |   |         | 140   |  
|                                 | Comprehensive income
      Net earnings for the year |                                               |                            |             |   |           |           |             |   |          |     |              |   |               |        |      |   |   |        | 10,672 |   |   |        |  |        |   |         |      |  
|                                 |                                                      | Currency translation adjustment               |                            |              |  |           |           |              |  |          |     |               |  |               |        |       |  |   |        |        |  |   |        |   | 9,561  |   |         |       |  |       
|                                 |                                                      |                                               | Total comprehensive income |              |   |          |           |              |   |         |     |               |   |              |        |       |   |  |        |        |   |  |        |   |        |  |         |       |   | 20,233 | 
|                                 |                                                      |                                               |                            |              |   |           |           |              |   |          |     |               |   |               |        |       |   |   |        |        |   |   |        |   |        |   |         |      
|Balance at
    December 31, 2002 |                                                      | $                                             |                           |              |   |           | 5,474,813 |              |   | $        | 547 |               |   | $             | 24,871 |       |   | $ | 61,345 |        |   | $ | (249   | ) |        | $ | 86,514  |      
|                                 | Common stock awards                                  |                                               |                            |             |   |           |           | 6,000        |   |          |     | 1             |   |               |        | 110   |   |   |        |       |   |   |        |  |        |   |         | 111   |  
|                                 | Employee stock purchase plan purchases               |                                               |                            |             |   |           |           | 10,560       |   |          |     | 1             |   |               |        | 151   |   |   |        |       |   |   |        |  |        |   |         | 152   |  
|                                 | Exercise stock options                               |                                               |                            |             |   |           |           | 60,000       |   |          |     | 6             |   |               |        | 759   |   |   |        |       |   |   |        |  |        |   |         | 765   |  
|                                 | Comprehensive income
      Net earnings for the year |                                               |                            |             |   |           |           |             |   |          |     |              |   |               |        |      |   |   |        | 8,821  |   |   |        |  |        |   |         |      |  
|                                 |                                                      | Currency translation adjustment               |                            |              |  |           |           |              |  |          |     |               |  |               |        |       |  |   |        |        |  |   |        |   | 13,632 |   |         |       |  |       
|                                 |                                                      |                                               | Total comprehensive income |              |   |          |           |              |   |         |     |               |   |              |        |       |   |  |        |        |   |  |        |   |        |  |         |       |   | 22,453 | 
|                                 |                                                      |                                               |                            |              |   |           |           |              |   |          |     |               |   |               |        |       |   |   |        |        |   |   |        |   |        |   |         |      
|Balance at
    December 31, 2003 |                                                      | $                                             |                           |              |   |           | 5,551,373 |              |   | $        | 555 |               |   | $             | 25,891 |       |   | $ | 70,166 |        |   | $ | 13,383 |   |        | $ | 109,995 |      
|                                 |                                                      |                                               |                            |              |   |           |           |              |   |          |     |               |   |               |        |       |   |   |        |        |   |   |        |   |        |   |         |      

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

F-7



---



##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                            |                                                                                                      |                                                                  |                                                        |                                           |       |        |        |        |       |         |         |        |       |         |        |  
|------------------------------------------- | ---------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------- | ------------------------------------------------------ | ----------------------------------------- | ----- | ------ | ------ | ------ | ----- | ------- | ------- | ------ | ----- | ------- | ------ | -
|                                            |                                                                                                      |                                                                 
|                                            |                                                                                                      | Years ended December 31,                                        
|                                            |                                                                                                      |                                                                 
|                                            |                                                                                                      | 2003                                                             |                                                        | 2002                                      |       | 2001  
|                                            |                                                                                                      |                                                                  |                                                        |                                           |       |       
|                                            |                                                                                                      |                                                                 
|                                            |                                                                                                      | (Thousands of Dollars)                                          
|Cash flows from operating activities        |                                                                                                      |                                                                  |                                                        |                                           |       |        |        |        |       |         |         |       
|                                            | Net earnings for the year                                                                            |                                                                  | $                                                      | 8,821                                     |       |        | $      | 10,672 |       |         | $       | 10,367 |      
|                                            | Adjustments to reconcile net earnings to net cash
    from (used in) continuing operating activities |                                                                  |                                                        |                                           |       |        |        |        |       |         |         |        |      
|                                            |                                                                                                      | Depreciation and amortization                                    |                                                        |                                           | 4,037 |        |        |        | 3,322 |         |         |        | 2,225 |        
|                                            |                                                                                                      | Gain on sale of fixed assets                                     |                                                        |                                           | (18   | )      |        |        |      |         |         |        |      |        
|                                            |                                                                                                      | Deferred income taxes                                            |                                                        |                                           | (810  | )      |        |        | 793   |         |         |        | (702  | )      
|                                            |                                                                                                      | Provision for estimated losses on contracts                      |                                                        |                                           | 255   |        |        |        | 282   |         |         |        | (330  | )      
|                                            |                                                                                                      | Amortization of debenture issue costs and
    conversion feature |                                                        |                                           | 243   |        |        |        |      |         |         |        |      |        
|                                            |                                                                                                      | Deferred Compensation                                            |                                                        |                                           | 672   |        |        |        | 300   |         |         |        |      |        
|                                            |                                                                                                      | Common stock awards                                              |                                                        |                                           | 111   |        |        |        | 651   |         |         |        | 582   |        
|                                            |                                                                                                      | Changes in assets and liabilities                                |                                                        |                                           |       |        |        |        |       |         |         |        |       |        
|                                            |                                                                                                      |                                                                  | Accounts receivable                                    |                                           |       | 2,305  |        |        |       | (2,572  | )       |        |       | (494    | )     
|                                            |                                                                                                      |                                                                  | Cost and accrued earnings on
    Uncompleted contracts |                                           |       | (830   | )      |        |       | (29,570 | )       |        |       | 12,325  |       
|                                            |                                                                                                      |                                                                  | Inventories                                            |                                           |       | (1,392 | )      |        |       | (3,309  | )       |        |       | 1,002   |       
|                                            |                                                                                                      |                                                                  | Prepaid expenses and other assets                      |                                           |       | (1,609 | )      |        |       | 532     |         |        |       | 992     |       
|                                            |                                                                                                      |                                                                  | Accounts payable and accrued liabilities               |                                           |       | 21,488 |        |        |       | 18,801  |         |        |       | (10,634 | )     
|                                            |                                                                                                      |                                                                  | Customer deposits                                      |                                           |       | (928   | )      |        |       | 993     |         |        |       | (3,490  | )     
|                                            |                                                                                                      |                                                                  | Income taxes                                           |                                           |       | (2,188 | )      |        |       | 455     |         |        |       | 1,688   |       
|                                            |                                                                                                      |                                                                  |                                                        |                                           |       |        |        |        |       |         |         |       
|                                            |                                                                                                      |                                                                  | 21,336                                                 |                                           |       |        | (9,322 | )      |       |         | 3,164   |       
|                                            |                                                                                                      |                                                                  |                                                        |                                           |       |        |        |        |       |         |         |       
|                                            |                                                                                                      |                                                                  |                                                        | Net cash provided by operating activities |       |        | 30,157 |        |       |         | 1,350   |        |       |         | 13,531 |  
|                                           
|Cash flows used in investing
    activities |                                                                                                      |                                                                  |                                                        |                                           |       |        |        |        |       |         |         |       
|                                            | Capital expenditures                                                                                 |                                                                  |                                                        | (6,362                                    | )     |        |        | (6,290 | )     |         |         | (3,109 | )    
|                                            | Acquisitions, net of cash acquired                                                                   |                                                                  |                                                        |                                          |       |        |        | (3,810 | )     |         |         | (556   | )    
|                                            | Proceeds from sale of fixed assets                                                                   |                                                                  |                                                        | 20                                        |       |        |        |       |       |         |         | 130    |      
|                                            |                                                                                                      |                                                                  |                                                        |                                           |       |        |        |        |       |         |         |       
|                                            |                                                                                                      |                                                                  |                                                        | Net cash used in investing activities     |       |        | (6,342 | )      |       |         | (10,100 | )      |       |         | (3,535 | )

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

F-8



---



##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS  Continued

|                                                                 |                                                      |                                                                            |                                                         |        |       |        |        |        |       |        |        |        |       |        |  
|---------------------------------------------------------------- | ---------------------------------------------------- | -------------------------------------------------------------------------- | ------------------------------------------------------- | ------ | ----- | ------ | ------ | ------ | ----- | ------ | ------ | ------ | ----- | ------ | -
|                                                                 |                                                      |                                                                           
|                                                                 |                                                      | Years ended December 31,                                                  
|                                                                 |                                                      |                                                                           
|                                                                 |                                                      | 2003                                                                       |                                                         | 2002   |       | 2001  
|                                                                 |                                                      |                                                                            |                                                         |        |       |       
|                                                                 |                                                      |                                                                           
|                                                                 |                                                      | (Thousands of Dollars)                                                    
|Cash flows from (used in) financing
    activities               |                                                      |                                                                            |                                                         |        |       |        |        |        |       |        |        |       
|                                                                 | Net (decrease) increase in
    short-term borrowings |                                                                            |                                                         | 5,780  |       |        |        | 3,245  |       |        |        | (1,058 | )    
|                                                                 | Proceeds from convertible
    subordinated debenture |                                                                            |                                                         |       |       |        |        | 7,500  |       |        |        |       |      
|                                                                 | Debenture issue costs                                |                                                                            |                                                         |       |       |        |        | (158   | )     |        |        |       |      
|                                                                 | Principal payments on long-term debt                 |                                                                            |                                                         | (2,343 | )     |        |        | (1,486 | )     |        |        | (3,884 | )    
|                                                                 | Proceeds from issuance of long-term debt             |                                                                            |                                                         | 1,989  |       |        |        | 2,796  |       |        |        | 1,307  |      
|                                                                 | Proceeds from stock purchases                        |                                                                            |                                                         | 152    |       |        |        | 169    |       |        |        | 587    |      
|                                                                 | Option exercises                                     |                                                                            |                                                         | 765    |       |        |        | 62     |       |        |        |       |      
|                                                                 | Restricted cash and restricted deposits              |                                                                            |                                                         | (5,807 | )     |        |        | (775   | )     |        |        | (3,202 | )    
|                                                                 |                                                      |                                                                            |                                                         |        |       |        |        |        |       |        |        |       
|                                                                 |                                                      |                                                                            | Net cash provided by (used in)
    financing activities |        |       | 536    |        |        |       | 11,353 |        |        |       | (6,250 | )
|Effects of exchange rates
    on cash                            |                                                      |                                                                            | 4,150                                                   |        |       |        | 1,351  |        |       |        | (395   | )     
|                                                                 |                                                      |                                                                            |                                                         |        |       |        |        |        |       |        |        |       
|                                                                 |                                                      |                                                                            | Net increase in cash and equivalents                    |        |       | 28,501 |        |        |       | 3,954  |        |        |       | 3,351  |  
|Cash and equivalents at beginning
    of year                    |                                                      |                                                                            | 14,876                                                  |        |       |        | 10,922 |        |       |        | 7,571  |       
|                                                                 |                                                      |                                                                            |                                                         |        |       |        |        |        |       |        |        |       
|Cash and equivalents at end
    of year                          |                                                      | $                                                                          | 43,377                                                  |        |       | $      | 14,876 |        |       | $      | 10,922 |       
|                                                                 |                                                      |                                                                            |                                                         |        |       |        |        |        |       |        |        |       
|                                                                
|Supplemental Disclosures of Cash Flow
    Information:           |                                                      |                                                                            |                                                         |        |       |        |        |        |       |        |        |       
|                                                                 | Cash paid during the year for                        |                                                                            |                                                         |        |       |        |        |        |       |        |        |        |      
|                                                                 |                                                      | Interest                                                                   |                                                         | $      | 1,492 |        |        | $      | 535   |        |        | $      | 1,692 |       
|                                                                 |                                                      | Income taxes                                                               |                                                         |        | 9,455 |        |        |        | 9,510 |        |        |        | 6,939 |       
|                                                                
|Supplemental of Non-Cash Investing and
    Financing Activities: |                                                      |                                                                            |                                                         |        |       |        |        |        |       |        |        |       
|                                                                 |                                                      | Non-cash consideration in connection with
    business acquisition         |                                                         |        |      |        |        | $      | 6,473 |        |        | $      | 6,833 |       
|                                                                 |                                                      | Warrants issued in conjunction with convertible
    subordinated debenture |                                                         |        |      |        |        |        | 140   |        |        |        |      |       
|                                                                 |                                                      | Convertible debenture beneficial
    conversion feature                    |                                                         |        |      |        |        |        | 138   |        |        |        |      |       

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

F-9



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

(Thousands of Dollars)




|         |                                               
|-------- | ----------------------------------------------
|Note A  | Summary of Significant Accounting
    Policies

A summary of significant accounting policies
consistently applied in the preparation of the accompanying
consolidated financial statements follows.

Basis of Presentation The consolidated financial statements
of the Company include the accounts of The Allied Defense Group
Inc. (Allied), a Delaware corporation, and its wholly-owned
subsidiaries as follows:



| |   |                                                                                       
| | - | --------------------------------------------------------------------------------------
| |  | ARC Europe, S. A. (ARC Europe), a Belgian company,                                    
|
| |  | Allied Research Corporation Limited (Limited), an
    inactive United Kingdom company,
|
| |  | News/ Sports Microwave Rental, Inc. (NS
    Microwave), a California corporation,     
|
| |  | Titan Dynamics Systems, Inc., (Titan Dynamics), a
    Texas corporation, and          
|
| |  | SeaSpace Corporation (SeaSpace), a California
    corporation.                        

NS Microwave, Titan Dynamics Systems and SeaSpace
were acquired on December 31, 2001, June 6, 2002 and
July 31, 2002, respectively. The results of operations of
NS Microwave, Titan and SeaSpace are included in the
consolidated statements of operations subsequent to their
respective acquisition dates.

ARC Europe includes its wholly-owned subsidiaries
MECAR S.A. (MECAR), Sedachim, S.I. (Sedachim) and the VSK Group.
The VSK Group is comprised of VSK Electronics N.V. and its
wholly-owned subsidiaries, Tele Technique Generale, S.A.,
I.D.C.S., N.V., Belgian Automation Units, N.V. and Vigitec S.A.
(Vigitec).

The Company operates in four (4) principal
segments as follows.



| |   |                                                                                                                                                                                                         
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | MECAR engages principally in the development and
    production of medium caliber ammunition and mortars (Ordnance
    & Manufacturing Segment).                                                        
|
| |  | The VSK Group and NS Microwave engage in the
    design, manufacture, distribution and service of industrial and
    law enforcement security products and systems (Electronic
    Security Segment).   
|
| |  | Titan Dynamics engages in the design, manufacture
    and sale of battlefield effects simulators (Software, Training
    & Simulation Segment).                                                         
|
| |  | SeaSpace Corporation engages in the design,
    manufacture, distribution and service of weather and
    environmental satellite ground reception systems (Environmental
    Safety & Security Segment).
|
| |  | ARC Europe has no operating activities. Allied,
    the parent company, provides management services to its
    subsidiaries and has no operating activities.                                           

Significant intercompany transactions have been
eliminated in the consolidation.

Foreign Currency
Translation.The assets and
liabilities of ARC Europe, MECAR, the VSK Group and Limited are
translated into U.S. dollars at year-end exchange rates.
Resulting translation gains and losses are accumulated in a
separate component of stockholders equity. Income and
expense items are converted into U.S. dollars at average rates
of exchange prevailing during the year. Foreign currency
transaction gains and losses are credited or charged directly to
operations.

Revenue and Cost
Recognition.Revenues under fixed
price contracts are recognized on the percentage-of-completion
method measured by costs incurred to total estimated costs at
completion. Provision for estimated losses and penalties on
contracts are recorded when identified. Revenues under
cost-plus-fixed-fee and time and material contracts are
recognized on the basis of costs incurred during the period plus
the fee earned. As contracts extend over one or more years,
revisions in costs and earnings estimated during the course of
the work are reflected in the accounting period in which the
facts which require the revision become known.

F-10



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)


Costs and accrued profits on uncompleted direct
and indirect fixed price contracts with foreign governments,
direct and indirect U.S. Government foreign military sales
contracts, and custom designed domestic security and weather
systems, which are billable upon completion, are carried as
costs and accrued earnings on uncompleted contracts.

Revenues from the sale of traditional fire and
security systems are recognized when the installation is
completed, less a provision for anticipated service costs.
Security system maintenance contract revenues are recognized
over the term of the contract on a straight-line basis. Revenues
from service work rendered are recorded when performed.

In the normal course of the Companys
business, it does not bill shipping and handling costs to
customers. Shipping and handling costs are included in cost of
sales.

Use of Estimates.In
preparing financial statements in conformity with accounting
principles generally accepted in the United States of America,
management is required to make estimates and assumptions that
affect the reported amounts of assets and liabilities and the
disclosure of contingent assets and liabilities at the date of
the financial statements and revenue and expenses during the
reporting period. Actual results could differ from those
estimates.

Inventories.Inventories, which consist primarily of raw materials, are
stated principally at the lower of cost or market. Cost is
determined principally by the first-in, first-out method.

Property, Plant and
Equipment.Depreciation and
amortization, including amortization for assets under
capitalized leases, is provided for in amounts sufficient to
relate the cost of depreciable assets to operations over their
estimated service lives, primarily on a straight-line basis.
Accelerated depreciation methods are used for tax purposes on
certain assets. The estimated service lives used in determining
depreciation are as follows:

|                        |  |  |             | 
|----------------------- |  |  | ----------- | 
|Buildings               |  |  | 20-30 years | 
|Machinery and equipment |  |  | 3-10 years  | 

Maintenance and repairs are charged to expense as
incurred; additions and betterments are capitalized. Upon
retirement or sale, the cost and related accumulated
depreciation of the disposed assets are removed and any
resulting gain or loss is credited or charged to operations.

Intangibles.Intangibles represent intangibles and goodwill acquired in
connection with businesses acquired. The cost of intangibles
other than goodwill is amortized to operations on a
straight-line basis over their expected lives of three to twenty
years. Goodwill acquired prior to July 1, 2001 was
amortized through December 31, 2001. Subsequent to such
date, and for goodwill acquired subsequent to June 30,
2001, goodwill is not amortized, but is subject to an annual
impairment test along with other intangibles, pursuant to the
provision of Statement of Financial Accounting Standards
(SFAS) No. 142. SFAS No. 142 was adopted
effective January 1, 2002. The recoverability of carrying
values of intangible assets is evaluated on a recurring basis.
The primary indicators are current and forecasted profitability
and cash flow of the related business. There have been no
adjustments to the carrying values of intangible assets
resulting from these impairment tests. The Companys
segments for purposes of applying SFAS No. 142 are
Electronic Security, Environmental Safety and Security and
Software, Training and Simulation.

F-11



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)


The effects of adoption of SFAS No. 142 for
the years ended December 31, 2003, 2002 and 2001 are as
follows:

|                                                         |  |                                   |       |      |  |      |        |  |  |   |        | 
|-------------------------------------------------------- |  | --------------------------------- | ----- | ---- |  | ---- | ------ |  |  | - | ------ | 
|                                                         |  | 2003                              |       | 2002 |  | 2001
|                                                         |  |                                   |       |      |  |     
|                                                         |  |                                  
|                                                         |  | (Dollars in thousands, except per
|                                                         |  | share data)                      
|Earnings, as reported                                    |  | $                                 | 8,821 |      |  | $    | 10,672 |  |  | $ | 10,367 | 
|Add back goodwill amortization (net of
    income taxes) |  |                                   |      |      |  |      |       |  |  |   | 138    | 
|                                                         |  |                                   |       |      |  |      |        |  |  |   |        | 
|Adjusted earnings                                        |  | $                                 | 8,821 |      |  | $    | 10,672 |  |  | $ | 10,505 | 
|                                                         |  |                                   |       |      |  |      |        |  |  |   |        | 
|Earnings per share  basic                               |  | $                                 | 1.60  |      |  | $    | 2.01   |  |  | $ | 2.11   | 
|Add back goodwill amortization (net of
    income taxes) |  |                                   |      |      |  |      |       |  |  |   | .03    | 
|                                                         |  |                                   |       |      |  |      |        |  |  |   |        | 
|Adjusted earnings  basic                                |  | $                                 | 1.60  |      |  | $    | 2.01   |  |  | $ | 2.14   | 
|                                                         |  |                                   |       |      |  |      |        |  |  |   |        | 
|Earnings per share  diluted                             |  | $                                 | 1.54  |      |  | $    | 1.92   |  |  | $ | 2,10   | 
|Add back goodwill amortization (net of
    income taxes) |  |                                   |      |      |  |      |       |  |  |   | .03    | 
|                                                         |  |                                   |       |      |  |      |        |  |  |   |        | 
|Adjusted earnings  diluted                              |  | $                                 | 1.54  |      |  | $    | 1.92   |  |  | $ | 2.13   | 
|                                                         |  |                                   |       |      |  |      |        |  |  |   |        | 

Derivative Financial
Instruments.Derivative financial
instruments are utilized by the Company to hedge certain sales
contracts. The Company does not hold or issue derivative
financial instruments for trading or speculative purposes.

The Company recognizes the fair value of hedge
contracts to which it is a party on its balance sheet. Currency
gains and losses on contracts designated as hedges of foreign
currency commitments are deferred and recognized when the
measurement of the related foreign currency transactions are
recognized as a component of revenue or cost of sales in
accordance with criteria established by SFAS No. 133 and
SFAS No. 149. The adoption of SFAS No. 149 did
not have a material impact on the Companys results of
operations or financial position.

Stock-Based Compensation The Company currently accounts for
stock options using the intrinsic value method and is applying
APB Opinion No. 25, Accounting for Stock Issued to
Employees.Accordingly, compensation costs for stock
options is measured and recorded as the excess, if any, of the
quoted market price of the Companys stock at the date of
grant over the amount an employee must pay to acquire the stock.
Compensation cost for stock awards is recorded based on the
quoted market value of the Companys stock at the time of
grant. No compensation cost has been recognized for the granting
of stock options to employees in the years ended 2003, 2002 and
2001.

F-12



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)


The following table presents the pro forma
decrease in income that would have been recorded had the fair
values of options granted been recognized as compensation
expense on a straight-line basis over the vesting period of the
grant:

|                                                                                                                                                                                   |                                    |                                       |       |       |   |      |        |       |   |   |        |       |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------- | ------------------------------------- | ----- | ----- | - | ---- | ------ | ----- | - | - | ------ | ----- | -
|                                                                                                                                                                                   |                                    | 2003                                  |       | 2002  |   | 2001
|                                                                                                                                                                                   |                                    |                                       |       |       |   |     
|                                                                                                                                                                                   |                                    |                                      
|                                                                                                                                                                                   |                                    | (in thousands, except per share data)
|Reported net earnings                                                                                                                                                              |                                    | $                                     | 8,821 |       |   | $    | 10,672 |       |   | $ | 10,367 |      
|Stock-based compensation costs that would have
    been included in the determination of reported net earnings, if
    the fair value method was applied to all awards, net of tax |                                    |                                       | (471  | )     |   |      | (347   | )     |   |   | (142   | )    
|                                                                                                                                                                                   |                                    |                                       |       |       |   |      |        |       |   |   |        |      
|Pro forma net earnings                                                                                                                                                             |                                    | $                                     | 8,350 |       |   | $    | 10,325 |       |   | $ | 10,225 |      
|                                                                                                                                                                                   |                                    |                                       |       |       |   |      |        |       |   |   |        |      
|Basic earnings per share                                                                                                                                                           |                                    |                                       |       |       |   |      |        |       |   |   |        |      
|                                                                                                                                                                                   | Reported earnings per share        |                                       |       | 1.60  |   |      |        | 2.01  |   |   | $      | 2.11  |  
|                                                                                                                                                                                   | Compensation costs, net of tax     |                                       |       | (0.09 | ) |      |        | (0.07 | ) |   |        | (0.03 | )
|                                                                                                                                                                                   |                                    |                                       |       |       |   |      |        |       |   |   |        |      
|                                                                                                                                                                                   | Pro forma basic earnings per share |                                       | $     | 1.51  |   |      | $      | 1.94  |   |   | $      | 2.08  |  
|                                                                                                                                                                                   |                                    |                                       |       |       |   |      |        |       |   |   |        |      
|Diluted earnings per share                                                                                                                                                         |                                    |                                       |       |       |   |      |        |       |   |   |        |      
|                                                                                                                                                                                   | Reported earnings per share        |                                       |       | 1.54  |   |      |        | 1.92  |   |   | $      | 2.10  |  
|                                                                                                                                                                                   | Compensation costs, net of tax     |                                       |       | (0.08 | ) |      |        | (0.06 | ) |   |        | (0.03 | )
|                                                                                                                                                                                   |                                    |                                       |       |       |   |      |        |       |   |   |        |      
|                                                                                                                                                                                   | Pro forma basic earnings per share |                                       | $     | 1.46  |   |      | $      | 1.84  |   |   | $      | 2.07  |  
|                                                                                                                                                                                   |                                    |                                       |       |       |   |      |        |       |   |   |        |      

Options granted during the years ended
December 31, 2003, 2002 and 2001 were 149,000, 252,500, and
246,000, respectively. The fair value of each option grant is
estimated on the date of grant using the Black-Scholes options
pricing model. The weighted-average fair values of each option
at the date of grant for 2003, 2002 and 2001 were $6.72, $6.38
and $2.86, respectively. The weighted average assumptions used
in the model were as follows.

|                         |  |      |       |      |  |      |       |   |  |  |       |  
|------------------------ |  | ---- | ----- | ---- |  | ---- | ----- | - |  |  | ----- | -
|                         |  | 2003 |       | 2002 |  | 2001
|                         |  |      |       |      |  |     
|Risk free interest rate  |  |      | 2.86  | %    |  |      | 1.82  | % |  |  | 4.54  | %
|Expected volatility rate |  |      | 47.00 | %    |  |      | 44.00 | % |  |  | 40.00 | %
|Expected lives  years   |  |      | 3     |      |  |      | 3     |   |  |  | 3     |  
|Divided yield            |  |      |      |      |  |      |      |   |  |  |      |  

The pro forma amounts may not be representative
of future amounts since the estimated fair value of stock
options is amortized to expense over the vesting period, and
additional options may be granted in future periods.

Advertising Costs.Advertising costs are expensed as
incurred. These costs are not material to the Companys
operations.

Research and
Development.Costs incurred in
research and development activities are charged to operations as
incurred.

Warranties.The
Company grants warranties on certain products for periods
varying from one to five years. Provision is made for estimated
losses arising from warranty claims on ammunition products as
incurred. Provision is made for estimated warranty costs on the
sale of security, weather and environmental satellite systems at
the time of the sale.

Income Taxes.Income
taxes are provided based on the liability method for financial
reporting purposes. Deferred and prepaid taxes are provided for
on temporary differences in the basis of assets and liabilities
which are recognized in different periods for financial and tax
reporting purposes.

F-13



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)


Earnings Per Common
Share.Basic earnings per share
amounts have been computed based on the weighted average number
of common shares outstanding. Diluted earnings per share
reflects the increase in weighted average common shares
outstanding that would result from the assumed exercise of
outstanding options, warrants, and convertible debt calculated
using the treasury stock method, unless they are anti-dilutive.

Statement of Cash
Flows.For purposes of the Statement
of Cash Flows, the Company considers all highly liquid debt
instruments purchased with a maturity of three months or less to
be cash equivalents.

Reclassifications.Certain items in the 2003 and 2002 financial statements have
been reclassified to conform to the current presentation.

Newly Issued Accounting
Standards.In January 2003, the
FASB issued FIN 46, Consolidation of Variable Interest
Entities: an interpretation of ARB No. 51. As amended
in December 2003, FIN 46 clarifies the application of Accounting
Research Bulletin No. 51, Consolidated Financial
Statements, for certain entities (known as variable interest
entities) that do not have sufficient equity at risk for the
entity to finance its activities without additional subordinated
financial support from other parties or in which equity
investors do not have the characteristics of a controlling
financial interest. Variable interest entities are required to
be consolidated by their primary beneficiary. The primary
beneficiary is the party that absorbs a majority of the
entitys expected losses, receives a majority of its
expected returns, or both. FIN 46 applies immediately to
variable interest entities created after January 31, 2003,
and to variable interest entities in which an enterprise obtains
an interest after that date. A public enterprise applies FIN 46
to variable interest entities in which the enterprise holds a
variable interest that it acquired before February 1, 2003
in the first fiscal year or interim period beginning after
June 15, 2003. The Company does not have any interests in
variable interest entities.

In November 2002, the Emerging Issues Task
Force (EITF) issued a final consensus on Issue
No. 00-21, Accounting for Revenue Arrangements with
Multiple Deliverables(Issue 00-21). Issue 00-21
provides guidance on how and when to recognize revenues from
arrangements requiring delivery of more than one product or
service. It also addresses how arrangement consideration should
be measured and allocated to the separate units of accounting in
an arrangement. To the extent that a deliverable is part of an
arrangement that is within the scope of other existing
higher-level authoritative literature, Issue 00-21 does not
apply. Issue 00-21 is effective prospectively for arrangements
entered into in fiscal periods beginning after June 15,
2003. The adoption of EITF Issue 00-21 has not had a material
effect on the Companys results of operations and financial
position.

In July, 2001, the FASB issued SFAS No. 143,
Accounting for Asset Retirement Obligations. This
Statement addresses financial accounting and reporting for
obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs.
This Statement applies to all entities. It applies to legal
obligations associated with the retirement of long-lived assets
that result from the acquisition, construction, development and
(or) the normal operation of a long-lived asset, except for
certain obligations of lessees. This Statement is effective for
financial statements issued for fiscal years beginning after
June 15, 2002. This statement did not have an effect on any
of the Companys assets.

In June 2002, the FASB issued SFAS 146,
Accounting for Costs Associated with Exit on Disposal
Activities. SFAS 146 is effective for exits or disposal
activities initiated after December 31, 2002. SFAS 146
provides financial accounting and reporting guidance for costs
associated with exit or disposal activities, including one-time
termination benefits, contract termination costs other than for
a capital lease, and costs to consolidate facilities or relocate
employees. SFAS 146 has not impacted the Companys
operations.

In December 2002, the FASB issued SFAS 148,
Accounting for Stock-Based Compensation 
Transition and Disclosure: an amendment of FASB Statement
No. 123. SFAS 148 allows several methods for an
entity to report a voluntary change to the fair value based
method of accounting for stock-based employee compensation.
SFAS 148 is effective for fiscal years ending after
December 15, 2002. The Company did not adopt the transition
methods allowed under this standard.

F-14



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)


The FASB issued FASB Interpretation
(FIN) 45, Guarantors Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others: an interpretation of FASB Statements
No. 5, 57, and 107 and rescission of FASB Interpretation
No. 34. FIN 45 requires guarantors to recognize a
liability for the obligation undertaken in issuing certain
guarantees. FIN 45s initial recognition and
measurement provisions are effective for guarantees issued or
modified after December 31, 2002 and disclosure
requirements are effective for interim or annual periods ending
after December 15, 2002. The Company did not have any
impact from the adoption of FIN 45 based on current business
activity.



|         |             
|-------- | ------------
|Note B  | Acquisitions



| |                       
| | ----------------------
| | Titan Dynamics Systems

On June 6, 2002, the Company acquired all
the common stock of Titan Dynamics Systems in a transaction
accounted for as a purchase. This acquisition was undertaken to
provide Allied with a strong position in a high-growth segment
of the North American Software, Training & Simulation
market. The total cost of acquisition was $2,027 consisting of
cash and direct incremental expenses of $144, and shares of
Allied common stock valued at $1,883, based on the market price
of the shares. The results of Titan Dynamics Systems
operations have been consolidated since its acquisition on
June 6, 2002.

The following table summarizes the fair value of
the assets acquired and liabilities assumed in the acquisition
Titan Dynamics System:

|                       |                     |   |       |       | 
|---------------------- | ------------------- | - | ----- | ----- | 
|Current assets         |                     | $ | 92    |      
|Property and equipment |                     |   | 64    |      
|Goodwill               |                     |   | 1,656 |      
|Intangibles            |                     |   | 894   |      
|                       |                     |   |       |      
|Total assets acquired  |                     |   | 2,706 |      
|Deferred tax liability |                     |   | (311  | )    
|Other liabilities      |                     |   | (368  | )    
|                       |                     |   |       |      
|                       | Net assets acquired |   | $     | 2,027 | 
|                       |                     |   |       |      



| |                     
| | --------------------
| | SeaSpace Corporation

On July 31, 2002, the Company acquired all
the common stock of SeaSpace Corporation in a transaction
accounted for as a purchase. This acquisition was undertaken to
provide Allied with a strong position in a high-growth segment
of the North America Environmental Safety & Security market.

The cost of acquisition was $9,266 consisting of
cash of $4,500, direct incremental expenses of $51, and shares
of Allied common stock valued at $4,590, based on the market
price of the shares. The Company also issued a $250 promissory
note payable in equal installments on July 31, 2003 and
2004. Payment is subject to certain conditions being met as
defined in the Agreement and Plan of Merger (Agreement). The
Company has recorded the $125 installment paid in 2003 as
additional goodwill. The Company will record $125 in additional
goodwill in 2004 if the remaining conditions are met and payment
is required under the Agreement. The results of SeaSpaces
operations have been consolidated since its acquisition on
July 31, 2002.

F-15



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)


The following table summarizes the fair value of
the assets acquired and liabilities assumed in the acquisition
of SeaSpace Corporation:

|                       |                     |   |        |       | 
|---------------------- | ------------------- | - | ------ | ----- | 
|Current assets         |                     | $ | 4,245  |      
|Property and equipment |                     |   | 725    |      
|Goodwill               |                     |   | 4,322  |      
|Intangibles            |                     |   | 2,495  |      
|Other assets           |                     |   | 153    |      
|                       |                     |   |        |      
|Total assets acquired  |                     |   | 11,940 |      
|Deferred tax liability |                     |   | (874   | )    
|Other liabilities      |                     |   | (1,800 | )    
|                       |                     |   |        |      
|                       | Net assets acquired |   | $      | 9,266 | 
|                       |                     |   |        |      

The acquired identifiable intangibles assets in
these transactions were as follows:

|                     |  |            |       |                     |  |  |          | 
|-------------------- |  | ---------- | ----- | ------------------- |  |  | -------- | 
|                     |  | Estimated  |       | Weighted Average   
|                     |  | Fair Value |       | Amortization Period
|                     |  |            |       |                    
|Capitalized Software |  | $          | 523   |                     |  |  | 6 years  | 
|Customer lists       |  |            | 1,972 |                     |  |  | 15 years | 
|Patents              |  |            | 894   |                     |  |  | 13 years | 
|                     |  |            |       |                     |  |  |          | 
|Total                |  | $          | 3,389 |                     |  |  | 13 years | 
|                     |  |            |       |                     |  |  |          | 

Goodwill arising from these transactions of
$5,649 is related to the Software, Training & Simulation and
Environmental Safety & Security Segments and is not
deductible for tax purposes.

Note C  Restricted
Cash

MECAR is generally required under the terms of
its contracts for direct and indirect sales to foreign
governments to provide performance bonds, advance payment
guarantees and letters of credit. The credit facility agreements
used to provide these financial guarantees place restrictions on
certain cash deposits and other liens on MECARs assets.
VSK has also pledged certain term deposits to secure outstanding
bank guarantees.

Restricted cash of $15,813 and $8,052 included in
current assets at December 31, 2003 and 2002, respectively, was
restricted or pledged as collateral for these agreements and
other obligations.

Note D  Accounts
Receivable

Accounts receivable at December 31 are
comprised as follows:

|                                                                                                               |  |      |        |      |  |   |        | 
|-------------------------------------------------------------------------------------------------------------- |  | ---- | ------ | ---- |  | - | ------ | 
|                                                                                                               |  | 2003 |        | 2002
|                                                                                                               |  |      |        |     
|Direct and indirect receivables from
    foreign governments                                                   |  | $    | 15,613 |      |  | $ | 15,785 | 
|Commercial and other receivables, less allowance
    for doubtful receivables of $115 in 2003 and $232 in 2002 |  |      | 13,708 |      |  |   | 12,766 | 
|                                                                                                               |  |      |        |      |  |   |        | 
|                                                                                                               |  | $    | 29,321 |      |  | $ | 28,551 | 
|                                                                                                               |  |      |        |      |  |   |        | 

Receivables from foreign government and
government agencies are generally due within 30 days of
shipment, less a 10% hold back provision which is generally due
within 90 days. Since these receivables are supported by
letters of credit or other guarantees, no provision for doubtful
accounts is deemed necessary. The Company evaluates its
allowance for doubtful accounts on commercial receivables on an
ongoing basis and provides for losses as deemed necessary.

F-16



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)




|         |                                 
|-------- | --------------------------------
|Note E  | Prepaid and Other Current Assets

Advance payments on contracts in process in 2003
and 2002 of approximately $330 and $818, respectively, were
included in prepaid and other current assets. Prepaid and other
current assets also included tax receivables of $2,142 and
$1,587 at December 31, 2003 and 2002 that were due from
foreign jurisdictions.



|         |                               
|-------- | ------------------------------
|Note F  | Intangible Assets and Goodwill

Intangible assets and goodwill at
December 31 are comprised as follows:

|                        |                      |                   |        |                   |       |     |       |        |     |              |        |       |       |   |        |       |       |   |       |     |     |   |        |       |       | 
|----------------------- | -------------------- | ----------------- | ------ | ----------------- | ----- | --- | ----- | ------ | --- | ------------ | ------ | ----- | ----- | - | ------ | ----- | ----- | - | ----- | --- | --- | - | ------ | ----- | ----- | 
|                        |                      |                   |        |                  
|                        |                      | December 31, 2003 |        | December 31, 2002
|                        |                      |                   |        |                  
|Intangible assets       |                      | Gross             |        | Accumulated       |       |     |       | Gross  |     | Accumulated  |        |      
|subject to amortization |                      | Amount            |        | Amortization      |       | Net |       | Amount |     | Amortization |        | Net  
|                        |                      |                   |        |                   |       |     |       |        |     |              |        |      
|                        | Capitalized Software |                   | $      | 1,179             |       |     | $     | 282    |     |              | $      | 897   |       |   | $      | 713   |       |   | $     | 109 |     |   | $      | 604   |      
|                        | Customer Lists       |                   |        | 2,247             |       |     |       | 356    |     |              |        | 1,891 |       |   |        | 2,247 |       |   |       | 172 |     |   |        | 2,075 |      
|                        | Patents              |                   |        | 1,494             |       |     |       | 147    |     |              |        | 1,347 |       |   |        | 1,494 |       |   |       | 59  |     |   |        | 1,435 |      
|                        |                      |                   |        |                   |       |     |       |        |     |              |        |       |       |   |        |       |       |   |       |     |     |   |        |      
|                        |                      | Total             |        |                   | 4,920 |     |       |        | 785 |              |        |       | 4,135 |   |        |       | 4,454 |   |       |     | 340 |   |        |       | 4,114 | 
|                        |                      |                   |        |                   |       |     |       |        |     |              |        |       |       |   |        |       |       |   |       |     |     |   |        |      
|Goodwill                |                      | $                 | 17,035 |                   |       | $   | 3,317 |        |     | $            | 13,718 |       |       | $ | 13,373 |       |       | $ | 2,769 |     |     | $ | 10,604 |      
|                        |                      |                   |        |                   |       |     |       |        |     |              |        |       |       |   |        |       |       |   |       |     |     |   |        |      

Consolidated amortization expense related to
intangible assets, excluding goodwill, for 2003, 2002 and 2001
was $445, $340 and $0, respectively.

The goodwill, net of amortization, of $13,718 at
December 31, 2003 is comprised of $7,740 related to the
Electronic Security Segment, $4,322 related to the Environmental
Safety & Security Segment and $1,656 related to the
Software, Training & Simulation Segment. The change in net
goodwill during 2003 is due primarily to increases related to
adjustments to the original purchase price allocations in 2003
of approximately $1,611 and the impact of currency translation
fluctuations.

Estimated future aggregate annual amortization
for intangible assets is as follows:

|     |      |        |  |   |     | 
|---- | ---- | ------ |  | - | --- | 
|Year |      | Amount
|     |      |       
|     | 2004 |        |  | $ | 687 | 
|     | 2005 |        |  |   | 540 | 
|     | 2006 |        |  |   | 379 | 
|     | 2007 |        |  |   | 297 | 
|     | 2008 |        |  |   | 225 | 



|         |                                  
|-------- | ---------------------------------
|Note G  | Notes Payable and Credit Facility

Notes Payable  At December 31,
2003 the Company had borrowed $4,322 under its lines of credit
with its lenders. In addition, the Company also borrowed $9,878
under a short-term loan which was secured by a receivable of
$9,878. These loans bear interest at an average rate of
approximately 3%.

Credit Facility  The Company is
obligated under various credit agreements (the Agreements) with
MECARs foreign bank syndicate that provide credit
facilities primarily for letters of credit, bank guarantees,
performance bonds and similar instruments required for specific
sales contracts. The Agreements provide for certain bank charges
and fees as the line is used, plus fees of 2% of guarantees
issued and annual fees of 1.25% based on bonds and guarantees
outstanding. These fees are charged to interest expense. As of
December 31, 2003, guarantees and performance bonds of
approximately $17,233 remain outstanding.

Advances under the Agreements are secured by
restricted cash of approximately $15,813 at December 31,
2003. Amounts outstanding are also collateralized by the letters
of credit received under the contracts financed,

F-17



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)


and a pledge of approximately $43,250 on
MECARs assets. Certain Agreements provide for the
maintenance of certain net worth levels and other provisions.



|         |                            
|-------- | ---------------------------
|Note H  | Accrued Losses on Contracts

The Company provided for accrued losses of $283
at December 31, 2003 in connection with the completion of
certain contracts in progress. These contracts are scheduled to
be completed in 2004. Accrued contract losses at
December 2002 were $313. These amounts are included in
accrued liabilities.



|         |               
|-------- | --------------
|Note I  | Long-Term Debt

Long-term obligations as of December 31
consist of the following:

|                         |  |      |       |      |  |   |       | 
|------------------------ |  | ---- | ----- | ---- |  | - | ----- | 
|                         |  | 2003 |       | 2002
|                         |  |      |       |     
|Mortgage loan agreements |  | $    | 908   |      |  | $ | 1,295 | 
|Other                    |  |      | 6,703 |      |  |   | 5,358 | 
|                         |  |      |       |      |  |   |       | 
|                         |  | $    | 7,611 |      |  |   | 6,653 | 
|Less current maturities  |  |      | 2,709 |      |  |   | 1,915 | 
|                         |  |      |       |      |  |   |       | 
|                         |  | $    | 4,902 |      |  | $ | 4,738 | 
|                         |  |      |       |      |  |   |       | 

Mortgage Loan
Agreements.The Company entered into a
mortgage loan agreement in 1986, which was amended in 1994, to
partially finance the construction of MECARs manufacturing
and administration facilities in Belgium, which had a balance
due of $591 at December 31, 2003. The loan was fully repaid
in January, 2004. The Company is also obligated on several
mortgages on the VSK Groups buildings which have a total
balance due of $317 at December 31, 2003. The mortgages
mature at various dates through 2005 in annual installments of
approximately $53, plus interest at rates ranging from 3.9% to
4.5% per year.

Other.The Company
is also obligated on various vehicle, equipment, capital lease
obligations and other loans. The notes and leases are generally
secured by the assets acquired, bear interest at rates ranging
from 3.50% to 8.00% and mature at various dates through 2010.

Scheduled annual maturities of long-term
obligations as of December 31, 2003 are as follows:

|           |  |        |       | 
|---------- |  | ------ | ----- | 
|Year       |  | Amount
|           |  |       
|2004       |  | $      | 2,709 | 
|2005       |  |        | 2,037 | 
|2006       |  |        | 1,494 | 
|2007       |  |        | 1,099 | 
|2008       |  |        | 252   | 
|Thereafter |  |        | 20    | 



|         |                                   
|-------- | ----------------------------------
|Note J  | Convertible Subordinated Debenture

On June 28, 2002 the Company sold to an
accredited investor for $7,500 (i) an 8% subordinated
debenture that is convertible into shares of the Companys
common stock at $25.00 per share and (ii) warrants to
purchase 15,000 shares of the Companys common stock at an
exercise price of $28.75 per share in cash. The debenture bears
interest at the rate of 8% per year, payable semi-annually. The
Company may elect to pay the principal and/or the interest in
cash or in registered shares of its common stock at a 10%
discount to the then current market price. The warrants to
purchase 15,000 shares of the Companys common stock
were valued at $140.

The initial terms called for monthly principal
payments, in the amount of $750, to begin on June 28, 2003
and continue for a period of ten (10) months or until
March 28, 2004.

F-18



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)


On June 27, 2003, the lender notified the
Company that it was exercising its right to extend the terms of
the debenture by twelve (12) months. The holder of the
debenture may choose to convert all or a portion of the
principal amount outstanding into shares of the Companys
common stock at any time before maturity. The right of the
Company to sell and the holders right to purchase
additional debentures expired in August 2003. The Company
has registered the shares of common stock that could be issued
in the event the holder elects to convert the debenture and
exercise the warrants.



|         |              
|-------- | -------------
|Note K  | Benefit Plans

The Company instituted a simplified employee
pension plan in 2000 for its domestic staff. In 2003, the
Company adopted a 401(k) plan. Employer contributions to the
plan in 2003, 2002 and 2001 were approximately $108, $105, and
$104, respectively. Employee contributions to the plan in 2003
were $72. Employees did not contribute to the simplified
employee pension plan in 2002 and 2001.

Under the terms of labor agreements at its
Belgian subsidiaries, the Company contributes to certain
governmental and labor organization employee benefit and
retirement programs.



|         |                              
|-------- | -----------------------------
|Note L  | Contingencies and Commitments

A suit has been filed against one of the VSK
subsidiaries in the Belgian courts alleging a breach of a
non-compete clause within a teaming agreement executed with a
claimant in prior years. The suit demands damages of
approximately $770. Management intends to vigorously defend this
suit and believes that it has meritorious defense to the claim,
and therefore no loss provision has been established.

A suit has been filed against SeaSpace in the
Japanese courts. This proceeding relates to SeaSpaces
termination of its distributor in Japan and its designation of a
new distributor. The terminated distributor has asked the court
to enjoin SeaSpace from selling its products in Japan to or
through the new distributor; and to require SeaSpace to continue
to fulfill purchase orders submitted by the terminated
distributor. The suit does not demand any monetary damages as it
is in the form of a preliminary injunction proceeding. There
have been a number of hearings to date but no rulings have yet
been issued by the court. Management intends to continue to
vigorously defend this suit and believes that it has meritorious
defense to the claim, and therefore no loss provision has been
established.

U.S. Government contracts and subcontracts are by
their terms subject to termination by the Government or the
prime contractor either for convenience or for default. U.S.
Government sponsored foreign military sales contracts are
subject to U.S. Government review. It is not anticipated that
adjustments, if any, with respect to determination of costs
under these direct contracts or subcontracts will have a
material effect on the Companys consolidated results of
operations or financial position.

MECAR, NS Microwave and SeaSpace recognize
revenues under fixed price contracts using the percentage of
completion method. Estimates of total costs at completion are
used to determine the amount of revenue earned. The actual costs
on these contracts may differ from the Companys estimate
at completion.

The Company enters into foreign exchange
contracts in the normal course of business to hedge certain
sales contracts. These contracts typically mature within twelve
months, and forward exchange gains and losses are recognized
upon final maturity or at the time the related foreign currency
transaction is recognized. Contracts with a notional amount of
$50,000 were outstanding as of December 31, 2003 ($93,000
at December 31, 2002).

In connection with its commitment to provide
management services to its subsidiaries, the Company has entered
into consulting and employment agreements with certain
management personnel for these subsidiaries. The Company has
also entered into employment agreements and consulting
agreements with certain domestic

F-19



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)


management personnel. Certain of these agreements
provide for severance payments in the event of termination under
certain conditions.

The Company leases domestic office space and
equipment under operating leases which expire at various dates
through 2008. Certain leases also include escalation provisions
for taxes and operating costs. The following is a schedule by
year of base rentals due on operating leases that have initial
or remaining lease terms in excess of one year as of
December 31, 2003:

|     |        |        |  |   |          | 
|---- | ------ | ------ |  | - | -------- | 
|Year |        | Amount
|     |        |       
|     | 2004   |        |  | $ | 360      | 
|     | 2005   |        |  |   | 368      | 
|     | 2006   |        |  |   | 378      | 
|     | 2007   |        |  |   | 390      | 
|     | 2008   |        |  |   | 401      | 
|     | Therea |        |  |   | fter 373 | 

Total rental expense charged to operations
approximated $356, $214 and $136, for the years ended
December 31, 2003, 2002 and 2001, respectively.

The Companys domestic operations do not
provide post employment benefits to its employees. Under Belgian
labor provisions, the Company may be obligated for future
severance costs for its employees. The Company has provided for
known severance costs related to its workforce reductions. After
giving effect to prior workforce reductions, current workloads,
expected levels of future operations, severance policies and
future severance costs, post employment benefits are not
expected to be material to the Companys financial position.



|         |                                    
|-------- | -----------------------------------
|Note M  | Fair Value of Financial Instruments

At December 31, 2003 and 2002, the
Companys financial instruments include cash, cash
equivalents, receivables, accounts payable, borrowings, forward
exchange contracts, guarantees and performance bonds. The face
value of cash, cash equivalents, receivables and payables
approximate their carrying values because of the short-term
nature of the instruments. The estimated fair value of the other
financial instruments and off-balance-sheet credit obligations
are as follows:

|                                                                          |                           |          |        |            |  |          |        |            |  |   |        |   |  |   |        |       | 
|------------------------------------------------------------------------- | ------------------------- | -------- | ------ | ---------- |  | -------- | ------ | ---------- |  | - | ------ | - |  | - | ------ | ----- | 
|                                                                          |                           |          |        |           
|                                                                          |                           | 2003     |        | 2002      
|                                                                          |                           |          |        |           
|                                                                          |                           | Carrying |        | Estimated  |  | Carrying |        | Estimated 
|                                                                          |                           | Amount   |        | Fair Value |  | Amount   |        | Fair Value
|                                                                          |                           |          |        |            |  |          |        |           
|Notes payable and long-term obligations,
    including current maturities |                           | $        | 30,550 |            |  | $        | 30,550 |            |  | $ | 20,993 |   |  | $ | 20,844 |      
|Foreign exchange contracts                                                |                           |          | 21,966 |            |  |          | 21,966 |            |  |   | 18,833 |   |  |   | 18,833 |      
|Off-balance-sheet instruments                                             |                           |          |        |            |  |          |        |            |  |   |        |   |  |   |        |      
|Guarantees and performance bonds                                          |                           |          |       |            |  |          | 18,097 |            |  |   |       |   |  |   | 18,876 |      
|                                                                          | Standby letters of credit |          |        |           |  |          |        |           |  |   |        |  |  |   |        | 1,500 | 

The following methods and assumptions were used
to estimate the fair value of each class of financial
instruments for which it is practicable to estimate that value.



| |   |                                                                                                                                                                                                                                                                                                                           
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The fair value of notes payable and long-term
    obligations is estimated based on approximate market prices for
    the same or similar issues or the current rates offered to the
    Company for debt of the same remaining maturities. The Company
    believes the aggregate carrying value approximates fair value.
|
| |  | The fair value of foreign exchange contracts is
    based on quoted market prices for the same or similar
    instruments. At December 31, 2003, the total fair value was
    included in costs and accrued earnings on                                                                                                   

F-20



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)




| |   |                                                                                                                                                                                                                                                                                                          
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | uncompleted contracts and fair value of foreign
    exchange contracts. At December 31, 2002, the total fair
    value was included in accounts receivable, costs and accrued
    earnings on uncompleted contracts, and fair value of foreign
    exchange contracts.                                   
|
| |  | Estimated fair values for off-balance-sheet
    instruments, which include performance bonds and advance payment
    guarantees are reflected at the face value of these obligations,
    since management does not expect to have any claims against
    these obligations based on its past experience.



|         |                                 
|-------- | --------------------------------
|Note N  | Derivative Financial Instruments

The Company designates its derivatives based upon
the criteria established by Statement of Financial Accounting
Standards No. 133, Accounting for Derivative
Instruments and Hedging Activities (SFAS 133),
which establishes accounting and reporting standards for
derivative instruments, including certain derivative instruments
embedded in other contracts, and for hedging activities.
SFAS 133, as amended by SFAS 138 and SFAS 149,
requires that an entity recognize all derivatives as either
assets or liabilities in the statement of financial position and
measure those instruments at fair value. The accounting for the
changes in the fair value of the derivative depends on the
intended use of the derivative and the resulting designation.
For a derivative designated as a fair value hedge, the gain or
loss is recognized in earnings in the period of change together
with the offsetting loss or gain on the risk being hedged. For a
derivative designated as a cash flow hedge, the effective
portion of the derivatives gain or loss is initially
reported as a component of accumulated other comprehensive
income (loss) and is subsequently reclassified to earnings
when the hedge exposure effects earnings. The ineffective
portion of the hedge is reported in earnings immediately.

The Company uses foreign currency future
contracts to minimize the foreign currency exposures that arise
from sales contracts with certain foreign customers. Under the
terms of these sales contracts, the selling price and certain
costs are payable in U.S. dollars rather than the Euro, which is
MECARs functional currency. These futures contracts are
designated as fair value hedges since they are designed to lock
in the net Euros that will be realized when the amounts due
under the sales agreement are received. As a matter of policy,
the Company does not enter into speculative hedge contracts or
use other derivative financial instruments. The Company
estimates the fair value of outstanding hedge contracts based on
quotes obtained for the derivative contracts. The Company
recognizes the fair value of hedge contracts that expire in less
than one year as current assets or liabilities. Those that
expire in more than one year are recognized as long-term assets
or liabilities.

As of December 31, 2003 and 2002, futures
contracts designated as fair value hedges with notional amounts
of $50,000 and $93,000 were outstanding and the fair value of
these contracts were $21,966 and $18,833, respectively. At
December 31, 2003, the total fair value was included in
costs and accrued earnings on uncompleted contracts ($12,588),
and fair value of foreign exchange contracts ($9,378). At
December 31, 2002, the total fair value was included in
accounts receivable ($1,869), costs and accrued earnings on
uncompleted contracts ($3,369), and fair value of foreign
exchange contracts ($13,595).

Gains and losses from settlements of derivative
contracts are reported as a component of other income. There
were no net gains or losses realized during the years ended
December 31, 2003 and 2002 from hedge ineffectiveness, from
firm commitments that no longer qualifies as fair value hedges,
nor were any amounts excluded from the assessment of hedge
effectiveness.

The Companys foreign exchange forward and
option contracts expose the Company to credit risks to the
extent that the counter parties may be unable to meet the terms
of the agreement. The company minimizes such risk by using major
financial institutions as its counterparties. Management does
not expect any material loss as result of default by
counterparties.

F-21



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)




|         |                     
|-------- | --------------------
|Note O  | Stockholders Equity

During 1998, the Board of Directors authorized
the repurchase of up to 200,000 shares of the Companys
common stock. No shares were reacquired in 2002 or 2003.

The Company may grant stock options, appreciation
rights, incentive options, performance shares and other awards
to key executives, management, directors and employees under
various plans at prices equal to or in excess of the market
price at the date of the grant. The options for common shares
generally are exercisable over a five to ten year period and
expire up to ten years from the date of grant. At
December 31, 2003, options to acquire 620,000 shares
of the Companys common stock were outstanding under the
following plans:

2001 Equity Incentive
Plan.During 2001, the Board of
Directors and shareholders approved and reserved 240,000 shares
of common stock for awards to key employees of the Company and
its subsidiaries. In each of 2002 and 2003, the Board of
Directors and the shareholders authorized the plan to be
increased by 250,000 shares. The plan authorizes the
Compensation Committee of the Board of Directors to grant stock
options, stock appreciation rights, restricted stock,
performance shares and cash awards. Each type of grant places
certain requirements and restrictions upon the Company and
grantee.

1997 Incentive Stock
Plan.During 1997, the Board of
Directors and shareholders approved and reserved 225,000 shares
of common stock for awards to key employees of the Company and
its subsidiaries in the form of stock options and stock awards.
The Plan is administered by the Compensation Committee of the
Board of Directors, and employees of the Company and its
subsidiaries who are deemed to be key employees by the Committee
are eligible for awards under the Plan.

1992 Employee Stock Purchase
Plan.During 1992, the Board of
Directors and shareholders approved and reserved 525,000 shares
for the plan. The plan is voluntary and substantially all
full-time employees are eligible to participate through payroll
deductions. The purchase price of each share is equal to 85% of
the closing price of the common stock at the end of each
calendar quarter. The Plan is subject to certain restrictions
and the Board may amend or terminate it at any time.

1993 Outside Directors Compensation
Plan.During 1993, the Board of
Directors and shareholders approved a plan whereby each director
is entitled to receive a cash payment of $1,000 per month, and
an annual grant of 1,000 shares of the Companys common
stock while serving as a board member. The Company reserved
52,400 shares of common stock for the plan which is subject to
certain restrictions. The plan terminated on December 31,
2003.

1991 Outside Directors Stock Option
Plan.During 1991, the Board of
Directors and shareholders approved and reserved 208,000 shares
of common stock for the plan. During 2001, the Company granted
options to purchase a total of 26,000 shares at $7.88 per share.
This plan expired in 2001; therefore, no further grants can be
made.

Preferred Share Purchase Rights
Agreement.The Board of Directors
adopted a Preferred Stock Purchase Rights Agreement in 2001. The
Agreement provides each stockholder of record a dividend
distribution of one right for each outstanding share
of common stock. Rights become exercisable the earlier of ten
days following: (1) a public announcement that an acquiring
person has purchased or has the right to acquire 15% or more of
the Companys common stock, or (2) the commencement of
a tender offer which would result in an offeror beneficially
owning 15% or more of the outstanding common stock. All rights
held by an acquiring person or offeror expire on the announced
acquisition date and all rights expire at the close of business
on May 31, 2011.

Each right under the Preferred Stock Purchase
Rights Agreement entitles a stockholder to acquire at a purchase
price of $50, one-hundredth of a share of preferred stock which
carries voting and dividend rights similar to one share of
common stock. Alternatively, a right holder may elect to
purchase for $50 an equivalent number of common shares (or in
certain circumstances, cash, property or other securities of the
Company) at a

F-22



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)


price per share equal to one-half of the average
market price for a specified period. In lieu of the purchase
price, a right holder may elect to acquire one-half of the
common shares available under the second option. The purchase
price and the preferred share fractional amount are subject to
adjustment for certain events as described in the Agreement.

Rights also entitle the holder to receive a
specified number of shares of an acquiring companys common
stock in the event that the Company is not the surviving
corporation in a merger or if 50% or more of the Companys
assets are sold or transferred.

At the discretion of a majority of the Board and
within a specified time period, the Company may redeem all of
the rights at a price of $.01 per right. The Board may also
amend any provision of the Agreement prior to exercise of the
rights.

The following table summarizes option activity:

|                                                                    |  |        |         |          |  |        |       |          |  |        |         |          |  |   |       |  |  |   |         |   |  |   |      | 
|------------------------------------------------------------------- |  | ------ | ------- | -------- |  | ------ | ----- | -------- |  | ------ | ------- | -------- |  | - | ----- |  |  | - | ------- | - |  | - | ---- | 
|                                                                    |  |        |         | 2003     |  |        |       | 2002     |  |        |         | 2001    
|                                                                    |  |        |         |          |  |        |       |          |  |        |         |         
|                                                                    |  |        |         | Weighted |  |        |       | Weighted |  |        |         | Weighted
|                                                                    |  |        |         | Average  |  |        |       | Average  |  |        |         | Average 
|                                                                    |  |        |         | Exercise |  |        |       | Exercise |  |        |         | Exercise
|                                                                    |  | Shares |         | Price    |  | Shares |       | Price    |  | Shares |         | Price   
|                                                                    |  |        |         |          |  |        |       |          |  |        |         |         
|Options outstanding at beginning of year                            |  |        | 531,000 |          |  | $      | 12.81 |          |  |        | 286,000 |          |  | $ | 8.54  |  |  |   | 62,000  |   |  | $ | 7.83 | 
|Options granted                                                     |  |        | 149,000 |          |  |        | 16.92 |          |  |        | 252,500 |          |  |   | 17.51 |  |  |   | 246,000 |   |  |   | 8.63 | 
|Options exercised                                                   |  |        | (60,000 | )        |  |        | 9.87  |          |  |        | (7,500  | )        |  |   | 8.25  |  |  |   | (22,000 | ) |  |   | 7.45 | 
|Options forfeited                                                   |  |        |        |          |  |        |      |          |  |        |        |          |  |   |      |  |  |   |        |   |  |   |     | 
|Options expired                                                     |  |        |        |          |  |        |      |          |  |        |        |          |  |   |      |  |  |   |        |   |  |   |     | 
|                                                                    |  |        |         |          |  |        |       |          |  |        |         |          |  |   |       |  |  |   |         |   |  |   |      | 
|Options outstanding at end of year                                  |  |        | 620,000 |          |  | $      | 14.08 |          |  |        | 531,000 |          |  | $ | 12.81 |  |  |   | 286,000 |   |  | $ | 8.54 | 
|                                                                    |  |        |         |          |  |        |       |          |  |        |         |          |  |   |       |  |  |   |         |   |  |   |      | 
|Options exercisable at end of year                                  |  |        | 305,333 |          |  |        |       |          |  |        | 179,000 |          |  |   |       |  |  |   | 102,000 |   |  |   |      | 
|Weighted-average fair value of options, granted
    during the year |  | $      | 7.73    |          |  |        |       |          |  | $      | 7.10    |          |  |   |       |  |  | $ | 3.03    |   |  |   |      | 

The following table summarizes options
outstanding at December 31, 2003:

|            |         |                 |  |                  |                 |                  |  |             |       |                  |  |  |            |  |  |  |         |  |  |   |       | 
|----------- | ------- | --------------- |  | ---------------- | --------------- | ---------------- |  | ----------- | ----- | ---------------- |  |  | ---------- |  |  |  | ------- |  |  | - | ----- | 
|            |         |                 |  |                  |                 |                  |  |            
|            |         |                 |  |                  |                 | Weighted         |  | Exercisable
|            |         |                 |  |                  |                 | Average          |  |            
|Number      |         | Range of        |  | Weighted Average |                 | Remaining        |  | Number of   |       | Weighted average
|Outstanding |         | Exercise Prices |  | Exercise Prices  |                 | Contractual Life |  | Options     |       | Exercise Prices 
|            |         |                 |  |                  |                 |                  |  |             |       |                 
|            | 193,500 |                 |  | $                | 7.88 to $ 8.63  |                  |  | $           | 8.47  |                  |  |  | 4.56 Years |  |  |  | 129,500 |  |  | $ | 8.39  | 
|            | 75,000  |                 |  | $                | 9.01 to $14.90  |                  |  | $           | 12.15 |                  |  |  | 3.52 Years |  |  |  | 27,000  |  |  | $ | 10.76 | 
|            | 351,500 |                 |  | $                | 16.40 to $25.00 |                  |  | $           | 17.59 |                  |  |  | 5.64 Years |  |  |  | 148,833 |  |  | $ | 18.90 | 



|         |                
|-------- | ---------------
|Note P  | Major Customers

The Company derives the majority of its revenues
directly or indirectly from foreign governments (some of which
are through the U.S. government via the Foreign Military Sales
program), primarily on fixed price contracts. Direct and
indirect sales to agencies of The Kingdom of Saudi Arabia and
Belgium accounted for approximately 56% and 4% of revenue in
2003, 65% and 1% of revenue in 2002, and 77% and 1% of revenue
in 2001.

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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)




|         |                              
|-------- | -----------------------------
|Note Q  | Concentrations of Credit Risk

Financial instruments and related items which
potentially subject the Company to concentrations of credit risk
consist principally of temporary cash investments, trade
receivables and costs and accrued earnings on uncompleted
contracts. The Company places its temporary cash investments
with high credit quality financial institutions. Credit risk
with respect to trade receivables and costs and accrued earnings
on uncompleted contracts are concentrated due to the nature of
the Companys customer base. The Company generally receives
guarantees and letters of credit from its foreign customers and
performs ongoing credit evaluations of its other customers
financial condition. The Companys provision for doubtful
accounts for 2003 and 2002 was not significant.

The majority of ammunition sales are to or for
the benefit of agencies of The Kingdom of Saudi Arabia and other
foreign governments. MECARs ammunition sales in any given
period and its backlog at any particular time may be
significantly influenced by one or a few large orders. In
addition, the production period required to fill most orders
ranges from several months to a year. Accordingly, MECARs
business is dependent upon its ability to obtain such large
orders and the required financing for these orders. As of
December 31, 2003 and 2002, backlog orders, believed to be firm,
from operations, approximated $115,400 and $156,800,
respectively. The December 31, 2003 backlog included an
unfunded portion of $12,000 from a federal contract.

Amounts in foreign banks at December 31,
2003 and 2002 were approximately $42,954 and $14,940,
respectively. Changes in the value of the U.S. dollar and other
currencies affect the Companys financial position and
results of operations since the Company has assets and
operations in Belgium and sells its products on a worldwide
basis.



|         |            
|-------- | -----------
|Note R  | Other  Net

Other income (expense) included in the
Companys consolidated statements of operations is
comprised of the following:

|                                        |  |      |      |      |  |      |       |  |  |   |      |  
|--------------------------------------- |  | ---- | ---- | ---- |  | ---- | ----- |  |  | - | ---- | -
|                                        |  | 2003 |      | 2002 |  | 2001
|                                        |  |      |      |      |  |     
|Net currency transaction gains (losses) |  | $    | (545 | )    |  | $    | 872   |  |  | $ | (437 | )
|Miscellaneous  net                     |  |      | 800  |      |  |      | 428   |  |  |   | 121  |  
|                                        |  |      |      |      |  |      |       |  |  |   |      |  
|                                        |  | $    | 255  |      |  | $    | 1,300 |  |  | $ | (316 | )
|                                        |  |      |      |      |  |      |       |  |  |   |      |  

Miscellaneous  net includes bank
charges related to MECARs performance bonds and advance
payment guarantees, which are generally required under the terms
of MECARs contracts with foreign governments and its
distributor.



|         |             
|-------- | ------------
|Note S  | Income Taxes

The Company recognizes deferred tax liabilities
and assets for the expected future tax consequences of events
that have been included in the financial statements or tax
returns. Under this method, deferred tax liabilities and assets
are determined based on the difference between the financial
statement and tax basis of assets and liabilities using enacted
tax rates in effect for the year in which the differences are
expected to reverse.

Earnings (loss) from operations before
income taxes is comprised as follows:

|         |  |      |        |      |  |      |        |   |  |   |        |  
|-------- |  | ---- | ------ | ---- |  | ---- | ------ | - |  | - | ------ | -
|         |  | 2003 |        | 2002 |  | 2001
|         |  |      |        |      |  |     
|Domestic |  | $    | (5,295 | )    |  | $    | (93    | ) |  | $ | (1,975 | )
|Foreign  |  |      | 21,838 |      |  |      | 20,043 |   |  |   | 20,719 |  
|         |  |      |        |      |  |      |        |   |  |   |        |  
|         |  | $    | 16,543 |      |  | $    | 19,950 |   |  | $ | 18,744 |  
|         |  |      |        |      |  |      |        |   |  |   |        |  

F-24



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)


The Companys provision for income taxes is
comprised as follows:

|                               |          |                     |       |       |       |      |        |       |       |  |       |       |       | 
|------------------------------ | -------- | ------------------- | ----- | ----- | ----- | ---- | ------ | ----- | ----- |  | ----- | ----- | ----- | 
|                               |          | 2003                |       | 2002  |       | 2001
|                               |          |                     |       |       |       |     
|Currently (refundable) payable |          |                     |       |       |       |      |        |       |       |  |       |      
|                               | Domestic |                     | $     | 309   |       |      | $      | 1,781 |       |  | $     | 159   |      
|                               | Foreign  |                     |       | 8,301 |       |      |        | 8,290 |       |  |       | 8,921 |      
|                               |          |                     |       |       |       |      |        |       |       |  |       |      
|                               |          |                     | 8,610 |       |       |      | 10,071 |       |       |  | 9,080 |      
|Deferred  net                 |          |                     | (888  | )     |       |      | (793   | )     |       |  | (703  | )    
|                               |          |                     |       |       |       |      |        |       |       |  |       |      
|                               |          | Total tax provision |       | $     | 7,722 |      |        | $     | 9,278 |  |       | $     | 8,377 | 
|                               |          |                     |       |       |       |      |        |       |       |  |       |      

The Companys provision for income taxes
differs from the anticipated United States federal statutory
rate. Differences between the statutory rate and the
Companys provision are as follows:

|                                    |              |      |      |      |   |      |      |      |   |  |      |      |  
|----------------------------------- | ------------ | ---- | ---- | ---- | - | ---- | ---- | ---- | - |  | ---- | ---- | -
|                                    |              | 2003 |      | 2002 |   | 2001
|                                    |              |      |      |      |   |     
|Taxes at statutory rate             |              |      | 34.0 | %    |   |      | 34.0 | %    |   |  | 34.0 | %   
|Foreign tax rate differential       |              |      | 10.0 |      |   |      | 6.9  |      |   |  | 6.8  |     
|State taxes, net of federal benefit |              |      | (1.2 | )    |   |      |     |      |   |  |     |     
|Permanent differences               |              |      | 4.3  |      |   |      |     |      |   |  | 2.8  |     
|Amortization of intangibles         |              |      |     |      |   |      | 1.2  |      |   |  | 0.3  |     
|Other                               |              |      | (0.4 | )    |   |      | 4.4  |      |   |  | 0.8  |     
|                                    |              |      |      |      |   |      |      |      |   |  |      |     
|                                    | Income taxes |      |      | 46.7 | % |      |      | 46.5 | % |  |      | 44.7 | %
|                                    |              |      |      |      |   |      |      |      |   |  |      |     

At December 31, 2003, the Company had a tax
effected US net operating loss of approximately $375 which will
begin to expire in 2010. A portion of the US net operating loss
carryforwards are subject to limitations on the amount that can
be utilized each year. As of December 31, 2003, the Company
also had foreign tax credits and alternative minimum tax credits
of approximately $3,857 and $204, respectively. The foreign tax
credits will begin to expire in 2004 and the alternative minimum
tax credits do not expire. The Company has recorded a valuation
allowance on the foreign tax credits and a portion of the net
operating losses for which the realizeability is uncertain.

We have not recorded US income tax expense for
foreign earnings that are indefinitely reinvested offshore. The
amount of earnings designated as indefinitely reinvested
offshore is based upon the actual deployment of such earnings in
our offshore assets and our expectations of the future cash
needs of our US and foreign entities. In the event that actual
cash needs of our US entities exceed our current expectations,
we may need to repatriate foreign earnings which have been
designated as indefinitely reinvested offshore. This could
result in additional income tax expense being recorded.

F-25



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)


The components of the deferred taxes at
December 31, 2003 and 2002 are comprised as follows:

|                                           |                                  |                                        |        |        |        |   |        |       |       |  
|------------------------------------------ | -------------------------------- | -------------------------------------- | ------ | ------ | ------ | - | ------ | ----- | ----- | -
|                                           |                                  | 2003                                   |        | 2002  
|                                           |                                  |                                        |        |       
|Current deferred tax asset                 |                                  |                                        |        |        |        |   |        |      
|                                           | Inventory                        |                                        | $      | 249    |        |   | $      | 16    |      
|                                           | Compensation Accruals            |                                        |        | 114    |        |   |        | 171   |      
|                                           | Valuation adjustments            |                                        |        | 152    |        |   |        | 166   |      
|                                           | Accrued expenses                 |                                        |        | 162    |        |   |        |      |      
|                                           | Business tax credits             |                                        |        | 204    |        |   |        |      |      
|                                           | Net operating loss carryforwards |                                        |        | 135    |        |   |        |      |      
|                                           | Other                            |                                        |        |       |        |   |        | (48   | )    
|                                           |                                  |                                        |        |        |        |   |        |      
|                                           |                                  | Current deferred tax asset             |        |        | 1,016  |   |        |       | 305   |  
|Non-current deferred tax asset (liability) |                                  |                                        |        |        |        |   |        |      
|                                           | Foreign tax credit carryforwards |                                        |        | 3,857  |        |   |        | 1,243 |      
|                                           | Net operating loss carryforwards |                                        |        | 260    |        |   |        |      |      
|                                           | Depreciation and amortization    |                                        |        | (1,356 | )      |   |        | (2    | )    
|                                           | Deferred Compensation            |                                        |        | 185    |        |   |        | 89    |      
|                                           | Deferred income                  |                                        |        | (168   | )      |   |        | (239  | )    
|                                           | Valuation adjustments            |                                        |        |       |        |   |        | 42    |      
|                                           |                                  |                                        |        |        |        |   |        |      
|                                           |                                  | Non-current deferred tax asset         |        |        | 2,778  |   |        |       | 1,133 |  
|Valuation allowance                        |                                  |                                        | (4,117 | )      |        |   | (1,244 | )    
|                                           |                                  |                                        |        |        |        |   |        |      
|                                           |                                  | Net non-current deferred tax liability |        |        | (1,339 | ) |        |       | (111  | )
|                                           |                                  |                                        |        |        |        |   |        |      
|                                           |                                  | Net deferred tax asset (liability)     |        | $      | (323   | ) |        | $     | 194   |  
|                                           |                                  |                                        |        |        |        |   |        |      

The deferred tax components are included in the
following balance sheet accounts:

|                                   |  |      |        |      |  |   |      |  
|---------------------------------- |  | ---- | ------ | ---- |  | - | ---- | -
|                                   |  | 2002 |        | 2002
|                                   |  |      |        |     
|Current deferred tax asset         |  | $    | 1,016  |      |  | $ | 305  |  
|Non-current deferred tax liability |  |      | (1,339 | )    |  |   | (111 | )
|                                   |  |      |        |      |  |   |      |  
|                                   |  | $    | (323   | )    |  | $ | 194  |  
|                                   |  |      |        |      |  |   |      |  



|         |                          
|-------- | -------------------------
|Note T  | Earnings Per Common Share

Basic earnings per share exclude dilution and are
computed by dividing net earnings by the weighted average number
of common shares outstanding for the period. The computation of
diluted earnings per share includes the effects of convertible
debenture, stock options and warrants, if such effect is
dilutive. The table

F-26



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)


below shows the calculation of basic and diluted
earnings per share for the years ended December 31, 2003,
2002 and 2001, respectively:

|                                                         |  |      |           |      |  |      |           |  |  |   |           | 
|-------------------------------------------------------- |  | ---- | --------- | ---- |  | ---- | --------- |  |  | - | --------- | 
|                                                         |  | 2003 |           | 2002 |  | 2001
|                                                         |  |      |           |      |  |     
|Net earnings                                             |  | $    | 8,821     |      |  | $    | 10,672    |  |  | $ | 10,367    | 
|Interest on convertible debenture, net
    of taxes      |  |      | 360       |      |  |      | 185       |  |  |   |          | 
|                                                         |  |      |           |      |  |      |           |  |  |   |           | 
|Net earnings after interest on
    convertible debenture |  | $    | 9,181     |      |  | $    | 10,857    |  |  | $ | 10,367    | 
|                                                         |  |      |           |      |  |      |           |  |  |   |           | 
|Weighted average number of basic shares                  |  |      | 5,496,786 |      |  |      | 5,304,998 |  |  |   | 4,905,114 | 
|Common stock equivalents                                 |  |      | 473,333   |      |  |      | 353,276   |  |  |   | 42,146    | 
|                                                         |  |      |           |      |  |      |           |  |  |   |           | 
|Weighted average number of basic shares                  |  |      | 5,970,119 |      |  |      | 5,658,274 |  |  |   | 4,947,260 | 
|                                                         |  |      |           |      |  |      |           |  |  |   |           | 
|Basic earnings per share                                 |  | $    | 1.60      |      |  | $    | 2.01      |  |  | $ | 2.11      | 
|                                                         |  |      |           |      |  |      |           |  |  |   |           | 
|Diluted earnings per share                               |  | $    | 1.54      |      |  | $    | 1.92      |  |  | $ | 2.10      | 
|                                                         |  |      |           |      |  |      |           |  |  |   |           | 



|         |                                           
|-------- | ------------------------------------------
|Note U  | Geographic Areas and Industry
    Segments

The Company operates in four (4) principal
segments. MECAR engages principally in the development and
production of medium caliber ammunition and mortars (Ordnance
& Manufacturing Segment). The VSK Group and NS Microwave
engage in the design, manufacture, distribution and service of
industrial and law enforcement security products and systems
(Electronic Security Segment). Titan Dynamics engages in the
design, manufacture and sale of battlefield effects simulators
(Software, Training & Simulation Segment). SeaSpace
Corporation engages in the design, manufacture, distribution and
service of weather and environmental satellite ground reception
systems (Environmental Safety & Security Segment).

The Companys foreign operations are
conducted by MECAR and the VSK Group.

F-27



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)


|                                 |                                 |      |         |         |   |      |         |        |   |   |        |        |  
|-------------------------------- | ------------------------------- | ---- | ------- | ------- | - | ---- | ------- | ------ | - | - | ------ | ------ | -
|                                 |                                 | 2003 |         | 2002    |   | 2001
|                                 |                                 |      |         |         |   |     
|Revenues from external customers |                                 |      |         |         |   |      |         |        |   |   |        |       
|                                 | Ordnance & Manufacturing        |      | $       | 129,710 |   |      | $       | 95,279 |   |   | $      | 77,071 |  
|                                 | Electronic Security             |      |         | 33,303  |   |      |         | 31,302 |   |   |        | 19,876 |  
|                                 | Environmental Safety & Security |      |         | 7,065   |   |      |         | 4,032  |   |   |        |       |  
|                                 | Software Training & Simulation  |      |         | 1,329   |   |      |         | 253    |   |   |        |       |  
|                                 |                                 |      |         |         |   |      |         |        |   |   |        |       
|                                 |                                 | $    | 171,407 |         |   | $    | 130,866 |        |   | $ | 96,947 |       
|                                 |                                 |      |         |         |   |      |         |        |   |   |        |       
|Interest expense                 |                                 |      |         |         |   |      |         |        |   |   |        |       
|                                 | Ordnance & Manufacturing        |      | $       | 1,603   |   |      | $       | 1,350  |   |   | $      | 1,574  |  
|                                 | Electronic Security             |      |         | 49      |   |      |         | 52     |   |   |        | 92     |  
|                                 | Environmental Safety & Security |      |         | 1       |   |      |         | 1      |   |   |        |       |  
|                                 | Software Training & Simulation  |      |         |        |   |      |         |       |   |   |        |       |  
|                                 | Corporate and Other             |      |         | 837     |   |      |         | 684    |   |   |        |       |  
|                                 |                                 |      |         |         |   |      |         |        |   |   |        |       
|                                 |                                 | $    | 2,490   |         |   | $    | 2,087   |        |   | $ | 1,666  |       
|                                 |                                 |      |         |         |   |      |         |        |   |   |        |       
|Interest income                  |                                 |      |         |         |   |      |         |        |   |   |        |       
|                                 | Ordnance & Manufacturing        |      | $       | 221     |   |      | $       | 232    |   |   | $      | 322    |  
|                                 | Electronic Security             |      |         | 167     |   |      |         | 193    |   |   |        | 185    |  
|                                 | Environmental Safety & Security |      |         | 35      |   |      |         | 11     |   |   |        |       |  
|                                 | Software Training & Simulation  |      |         |        |   |      |         |       |   |   |        |       |  
|                                 | Corporate and Other             |      |         | 36      |   |      |         | 70     |   |   |        | 137    |  
|                                 |                                 |      |         |         |   |      |         |        |   |   |        |       
|                                 |                                 | $    | 459     |         |   | $    | 506     |        |   | $ | 644    |       
|                                 |                                 |      |         |         |   |      |         |        |   |   |        |       
|Income tax expense (benefit)     |                                 |      |         |         |   |      |         |        |   |   |        |       
|                                 | Ordnance & Manufacturing        |      | $       | 6,254   |   |      | $       | 6,648  |   |   | $      | 7,347  |  
|                                 | Electronic Security             |      |         | 654     |   |      |         | 1,638  |   |   |        | 1,432  |  
|                                 | Environmental Safety & Security |      |         | (199    | ) |      |         | 212    |   |   |        |       |  
|                                 | Software Training & Simulation  |      |         | (68     | ) |      |         | (48    | ) |   |        |       |  
|                                 | Corporate and Other             |      |         | 1,081   |   |      |         | 828    |   |   |        | (402   | )
|                                 |                                 |      |         |         |   |      |         |        |   |   |        |       
|                                 |                                 | $    | 7,722   |         |   | $    | 9,278   |        |   | $ | 8,377  |       
|                                 |                                 |      |         |         |   |      |         |        |   |   |        |       
|Depreciation and amortization    |                                 |      |         |         |   |      |         |        |   |   |        |       
|                                 | Ordnance & Manufacturing        |      | $       | 2,336   |   |      | $       | 1,767  |   |   | $      | 1,297  |  
|                                 | Electronic Security             |      |         | 1,093   |   |      |         | 1,010  |   |   |        | 913    |  
|                                 | Environmental Safety & Security |      |         | 488     |   |      |         | 206    |   |   |        |       |  
|                                 | Software Training & Simulation  |      |         | 74      |   |      |         | 43     |   |   |        |       |  
|                                 | Corporate and Other             |      |         | 46      |   |      |         | 296    |   |   |        | 15     |  
|                                 |                                 |      |         |         |   |      |         |        |   |   |        |       
|                                 |                                 | $    | 4,037   |         |   | $    | 3,322   |        |   | $ | 2,225  |       
|                                 |                                 |      |         |         |   |      |         |        |   |   |        |       

F-28



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)


|                                            |                                 |      |         |         |   |      |         |         |   |   |        |        |  
|------------------------------------------- | ------------------------------- | ---- | ------- | ------- | - | ---- | ------- | ------- | - | - | ------ | ------ | -
|                                            |                                 | 2003 |         | 2002    |   | 2001
|                                            |                                 |      |         |         |   |     
|Segment profit (loss) from before
    taxes |                                 |      |         |         |   |      |         |         |   |   |        |       
|                                            | Ordnance & Manufacturing        |      | $       | 16,487  |   |      | $       | 16,439  |   |   | $      | 17,379 |  
|                                            | Electronic Security             |      |         | 2,618   |   |      |         | 3,903   |   |   |        | 3,498  |  
|                                            | Environmental Safety & Security |      |         | (528    | ) |      |         | 550     |   |   |        |       |  
|                                            | Software Training & Simulation  |      |         | (207    | ) |      |         | (181    | ) |   |        |       |  
|                                            | Corporate and Other             |      |         | (1,827  | ) |      |         | (761    | ) |   |        | (2,133 | )
|                                            |                                 |      |         |         |   |      |         |         |   |   |        |       
|                                            |                                 | $    | 16,543  |         |   | $    | 19,950  |         |   | $ | 18,744 |       
|                                            |                                 |      |         |         |   |      |         |         |   |   |        |       
|Segment assets                              |                                 |      |         |         |   |      |         |         |   |   |        |       
|                                            | Ordnance & Manufacturing        |      | $       | 159,447 |   |      | $       | 118,065 |   |   | $      | 59,265 |  
|                                            | Electronic Security             |      |         | 35,048  |   |      |         | 28,641  |   |   |        | 25,798 |  
|                                            | Environmental Safety & Security |      |         | 12,207  |   |      |         | 10,833  |   |   |        |       |  
|                                            | Software Training & Simulation  |      |         | 3,077   |   |      |         | 2,883   |   |   |        |       |  
|                                            | Corporate and Other(1)          |      |         | 17,458  |   |      |         | 7,747   |   |   |        | 1,721  |  
|                                            |                                 |      |         |         |   |      |         |         |   |   |        |       
|                                            |                                 | $    | 227,237 |         |   | $    | 168,169 |         |   | $ | 86,784 |       
|                                            |                                 |      |         |         |   |      |         |         |   |   |        |       
|Capital Expenditure for Segment
    assets  |                                 |      |         |         |   |      |         |         |   |   |        |       
|                                            | Ordnance & Manufacturing        |      | $       | 4,918   |   |      | $       | 4,250   |   |   | $      | 2,171  |  
|                                            | Electronic Security             |      |         | 747     |   |      |         | 1,504   |   |   |        | 938    |  
|                                            | Environmental Safety & Security |      |         | 682     |   |      |         | 159     |   |   |        |       |  
|                                            | Software Training & Simulation  |      |         | 12      |   |      |         | 49      |   |   |        |       |  
|                                            | Corporate and Other             |      |         | 3       |   |      |         | 328     |   |   |        |       |  
|                                            |                                 |      |         |         |   |      |         |         |   |   |        |       
|                                            |                                 | $    | 6,362   |         |   | $    | 6,290   |         |   | $ | 3,109  |       
|                                            |                                 |      |         |         |   |      |         |         |   |   |        |       



---



|    |                                 
|--- | --------------------------------
|(1) | Net of intersegment receivables.

The following geographic area data includes trade
revenues based on customer location and assets based on physical
location.

|                                 |                         |                         |         |        |  |      |         |        |  |   |        |        | 
|-------------------------------- | ----------------------- | ----------------------- | ------- | ------ |  | ---- | ------- | ------ |  | - | ------ | ------ | 
|                                 |                         |                        
|                                 |                         | Geographic Segment Data
|                                 |                         |                        
|                                 |                         | 2003                    |         | 2002   |  | 2001
|                                 |                         |                         |         |        |  |     
|Revenues from external customers |                         |                         |         |        |  |      |         |        |  |   |        |       
|                                 | United States(1)        |                         | $       | 96,021 |  |      | $       | 55,455 |  |   | $      | 1,548  | 
|                                 | Belgium                 |                         |         | 24,320 |  |      |         | 16,373 |  |   |        | 15,117 | 
|                                 | Venezuela               |                         |         | 18,042 |  |      |         | 4,138  |  |   |        |       | 
|                                 | Saudi Arabia            |                         |         | 13,051 |  |      |         | 44,730 |  |   |        | 57,111 | 
|                                 | France                  |                         |         | 6,385  |  |      |         | 3,987  |  |   |        | 3,468  | 
|                                 | Kuwait                  |                         |         | 3,545  |  |      |         |       |  |   |        |       | 
|                                 | Germany                 |                         |         | 1,233  |  |      |         | 618    |  |   |        | 97     | 
|                                 | Canada(1)               |                         |         | 1      |  |      |         | 365    |  |   |        | 15,523 | 
|                                 | Other foreign countries |                         |         | 8,809  |  |      |         | 5,200  |  |   |        | 4,083  | 
|                                 |                         |                         |         |        |  |      |         |        |  |   |        |       
|                                 |                         | $                       | 171,407 |        |  | $    | 130,866 |        |  | $ | 96,947 |       
|                                 |                         |                         |         |        |  |      |         |        |  |   |        |       



---



|    |                                                                     
|--- | --------------------------------------------------------------------
|(1) | Includes foreign military sales for the benefit
    of Saudi Arabia.

F-29



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##### Table of Contents



THE ALLIED DEFENSE GROUP, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Thousands of Dollars)


|               |                  |                         |         |         |  |      |         |         |  |   |        |        | 
|-------------- | ---------------- | ----------------------- | ------- | ------- |  | ---- | ------- | ------- |  | - | ------ | ------ | 
|               |                  |                        
|               |                  | Geographic Segment Data
|               |                  |                        
|               |                  | 2003                    |         | 2002    |  | 2001
|               |                  |                         |         |         |  |     
|Segment assets |                  |                         |         |         |  |      |         |         |  |   |        |       
|               | Belgium          |                         | $       | 184,397 |  |      | $       | 136,735 |  |   | $      | 74,528 | 
|               | United Kingdom   |                         |         | 179     |  |      |         | 225     |  |   |        | 4      | 
|               | United States(1) |                         |         | 42,661  |  |      |         | 31,209  |  |   |        | 12,252 | 
|               |                  |                         |         |         |  |      |         |         |  |   |        |       
|               |                  | $                       | 227,237 |         |  | $    | 168,169 |         |  | $ | 86,784 |       
|               |                  |                         |         |         |  |      |         |         |  |   |        |       



---



|    |                                                 
|--- | ------------------------------------------------
|(1) | Net of intersegment receivables and investments.

|                       |               |      |        |        |  |      |        |        |  |   |        |        | 
|---------------------- | ------------- | ---- | ------ | ------ |  | ---- | ------ | ------ |  | - | ------ | ------ | 
|                       |               | 2003 |        | 2002   |  | 2001
|                       |               |      |        |        |  |     
|Property and equipment |               |      |        |        |  |      |        |        |  |   |        |       
|                       | Belgium       |      | $      | 23,308 |  |      | $      | 17,202 |  |   | $      | 12,067 | 
|                       | United States |      |        | 1,307  |  |      |        | 1,442  |  |   |        | 232    | 
|                       |               |      |        |        |  |      |        |        |  |   |        |       
|                       |               | $    | 24,615 |        |  | $    | 18,644 |        |  | $ | 12,299 |       
|                       |               |      |        |        |  |      |        |        |  |   |        |       



|         |                                     
|-------- | ------------------------------------
|Note V  | Quarterly Financial Data (Unaudited)

|                |         |                                               |        |         |  |         |        |         |  |          |        |      |  |   |        |      |  |   |         |      | 
|--------------- | ------- | --------------------------------------------- | ------ | ------- |  | ------- | ------ | ------- |  | -------- | ------ | ---- |  | - | ------ | ---- |  | - | ------- | ---- | 
|                |         |                                              
|                |         | (Amounts in thousands, except per share data)
|                |         |                                              
|                |         | First                                         |        | Second  |  | Third   |        | Fourth  |  | Total   
|                |         | Quarter                                       |        | Quarter |  | Quarter |        | Quarter |  | For Year
|2003            |         |                                               |        |         |  |         |        |         |  |         
|Revenue         |         | $                                             | 42,657 |         |  | $       | 42,723 |         |  | $        | 34,871 |      |  | $ | 51,156 |      |  | $ | 171,407 |     
|Gross profit    |         |                                               | 13,389 |         |  |         | 12,385 |         |  |          | 7,899  |      |  |   | 13,176 |      |  |   | 46,849  |     
|Net earnings    |         |                                               | 3,934  |         |  |         | 2,302  |         |  |          | 863    |      |  |   | 1,722  |      |  |   | 8,821   |     
|Per share data: |         |                                               |        |         |  |         |        |         |  |          |        |      |  |   |        |      |  |   |         |     
|                | Basic   |                                               | $      | 0.72    |  |         | $      | 0.42    |  |          | $      | 0.16 |  |   | $      | 0.31 |  |   | $       | 1.60 | 
|                |         |                                               |        |         |  |         |        |         |  |          |        |      |  |   |        |      |  |   |         |     
|                | Diluted |                                               | $      | 0.68    |  |         | $      | 0.40    |  |          | $      | 0.16 |  |   | $      | 0.30 |  |   | $       | 1.54 | 
|                |         |                                               |        |         |  |         |        |         |  |          |        |      |  |   |        |      |  |   |         |     

|                |         |                                               |        |         |  |         |        |         |  |          |        |     |  |   |        |      |  |   |         |      | 
|--------------- | ------- | --------------------------------------------- | ------ | ------- |  | ------- | ------ | ------- |  | -------- | ------ | --- |  | - | ------ | ---- |  | - | ------- | ---- | 
|                |         |                                              
|                |         | (Amounts in thousands, except per share data)
|                |         |                                              
|                |         | First                                         |        | Second  |  | Third   |        | Fourth  |  | Total   
|                |         | Quarter                                       |        | Quarter |  | Quarter |        | Quarter |  | For Year
|2002            |         |                                               |        |         |  |         |        |         |  |         
|Revenue         |         | $                                             | 16,928 |         |  | $       | 27,396 |         |  | $        | 30,806 |     |  | $ | 55,736 |      |  | $ | 130,866 |     
|Gross profit    |         |                                               | 5,230  |         |  |         | 8,278  |         |  |          | 7,699  |     |  |   | 18,150 |      |  |   | 39,357  |     
|Net earnings    |         |                                               | 1,173  |         |  |         | 2,151  |         |  |          | 673    |     |  |   | 6,675  |      |  |   | 10,672  |     
|Per share data: |         |                                               |        |         |  |         |        |         |  |          |        |     |  |   |        |      |  |   |         |     
|                | Basic   |                                               | $      | .23     |  |         | $      | .41     |  |          | $      | .13 |  |   | $      | 1.22 |  |   | $       | 2.01 | 
|                |         |                                               |        |         |  |         |        |         |  |          |        |     |  |   |        |      |  |   |         |     
|                | Diluted |                                               | $      | .23     |  |         | $      | .41     |  |          | $      | .12 |  |   | $      | 1.14 |  |   | $       | 1.92 | 
|                |         |                                               |        |         |  |         |        |         |  |          |        |     |  |   |        |      |  |   |         |     

F-30



---



##### Table of Contents



SCHEDULES

F-31



---



##### Table of Contents



SCHEDULE I  CONDENSED FINANCIAL
INFORMATION OF REGISTRANT

THE ALLIED DEFENSE GROUP, INC.

(Parent Company)


BALANCE SHEETS

|                                         |                                          |                        |         |        |         |   |        |        |        | 
|---------------------------------------- | ---------------------------------------- | ---------------------- | ------- | ------ | ------- | - | ------ | ------ | ------ | 
|                                         |                                          |                       
|                                         |                                          | December 31,          
|                                         |                                          |                       
|                                         |                                          | 2003                   |         | 2002  
|                                         |                                          |                        |         |       
|                                         |                                          |                       
|                                         |                                          | (Thousands of Dollars)
|ASSETS                                  
|Cash and equivalents                     |                                          | $                      | 15,039  |        |         | $ | 6,157  |       
|Restricted cash                          |                                          |                        | 125     |        |         |   | 250    |       
|Investment in subsidiaries               |                                          |                        | 103,073 |        |         |   | 81,760 |       
|Due from subsidiaries                    |                                          |                        |        |        |         |   | 5,378  |       
|Income tax recoverable                   |                                          |                        | 350     |        |         |   | 118    |       
|Deferred taxes                           |                                          |                        | 417     |        |         |   | 189    |       
|Other                                    |                                          |                        | 336     |        |         |   | 1,054  |       
|                                         |                                          |                        |         |        |         |   |        |       
|                                         |                                          | Total assets           |         | $      | 119,340 |   |        | $      | 94,906 | 
|                                         |                                          |                        |         |        |         |   |        |       
|LIABILITIES AND STOCKHOLDERS
    EQUITY
|Liabilities                              |                                          |                        |         |        |         |   |        |       
|                                         | Accounts payable and accrued liabilities |                        | $       | 725    |         |   | $      | 755    |       
|                                         | Due to subsidiaries                      |                        |         | 402    |         |   |        |       |       
|                                         | Deferred tax liability                   |                        |         |       |         |   |        | 146    |       
|                                         | Deferred Compensation                    |                        |         | 404    |         |   |        | 212    |       
|                                         | Convertible Debenture                    |                        |         | 7,405  |         |   |        | 7,279  |       
|                                         |                                          |                        |         |        |         |   |        |       
|                                         |                                          | Total liabilities      |         |        | 8,936   |   |        |        | 8,392  | 
|Stockholders Equity                     |                                          |                        |         |        |         |   |        |       
|                                         | Common stock                             |                        |         | 555    |         |   |        | 547    |       
|                                         | Capital in excess of par value           |                        |         | 25,891 |         |   |        | 24,871 |       
|                                         | Retained earnings                        |                        |         | 70,166 |         |   |        | 61,345 |       
|                                         | Accumulated other comprehensive loss     |                        |         | 13,792 |         |   |        | (249   | )     
|                                         |                                          |                        |         |        |         |   |        |       
|                                         |                                          |                        | 110,404 |        |         |   | 86,514 |       
|                                         |                                          |                        |         |        |         |   |        |       
|                                         |                                          | $                      | 119,340 |        |         | $ | 94,906 |       
|                                         |                                          |                        |         |        |         |   |        |       

F-32



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##### Table of Contents



SCHEDULE I  CONDENSED FINANCIAL
INFORMATION OF REGISTRANT  (Continued)


THE ALLIED DEFENSE GROUP, INC.

(Parent Company)


STATEMENTS OF EARNINGS

|                                                                  |                              |                                                                 |         |        |        |      |       |       |        |      |        |       |        |      | 
|----------------------------------------------------------------- | ---------------------------- | --------------------------------------------------------------- | ------- | ------ | ------ | ---- | ----- | ----- | ------ | ---- | ------ | ----- | ------ | ---- | 
|                                                                  |                              |                                                                
|                                                                  |                              | Year ended December 31,                                        
|                                                                  |                              |                                                                
|                                                                  |                              | 2003                                                            |         | 2002   |        | 2001
|                                                                  |                              |                                                                 |         |        |        |     
|                                                                  |                              |                                                                
|                                                                  |                              | (Thousands of Dollars)                                         
|Income                                                            |                              |                                                                 |         |        |        |      |       |       |        |      |        |      
|                                                                  | Intercompany management fees |                                                                 | $       | 4,146  |        |      | $     | 3,859 |        |      | $      | 2,871 |       
|                                                                  | Dividend from subsidiaries   |                                                                 |         | 14,186 |        |      |       | 4,883 |        |      |        |      |       
|                                                                  | Other  net                  |                                                                 |         | 99     |        |      |       | 60    |        |      |        | 491   |       
|                                                                  |                              |                                                                 |         |        |        |      |       |       |        |      |        |      
|                                                                  |                              |                                                                 | 18,431  |        |        |      | 8,802 |       |        |      | 3,362  |      
|Costs and expenses                                                |                              |                                                                 |         |        |        |      |       |       |        |      |        |      
|                                                                  | Administrative and other     |                                                                 |         | 5,905  |        |      |       | 4,688 |        |      |        | 5,337 |       
|                                                                  |                              |                                                                 |         |        |        |      |       |       |        |      |        |      
|                                                                  |                              | Earnings (loss) before equity in operations
    of subsidiaries |         |        | 12,526 |      |       |       | 4,114  |      |        |       | (1,975 | )   
|Equity in operations of subsidiaries, less
    dividends received |                              |                                                                 | (2,874  | )      |        |      | 7,350 |       |        |      | 11,779 |      
|                                                                  |                              |                                                                 |         |        |        |      |       |       |        |      |        |      
|                                                                  |                              | Earnings before income taxes                                    |         |        | 9,652  |      |       |       | 11,464 |      |        |       | 9,804  |     
|Income taxes (benefit)                                            |                              |                                                                 | 831     |        |        |      | 792   |       |        |      | (563   | )    
|                                                                  |                              |                                                                 |         |        |        |      |       |       |        |      |        |      
|                                                                  |                              | NET EARNINGS                                                    |         | $      | 8,821  |      |       | $     | 10,672 |      |        | $     | 10,367 |     
|                                                                  |                              |                                                                 |         |        |        |      |       |       |        |      |        |      
|                                                                  |                              | Earnings per common share                                       |         |        |        |      |       |       |        |      |        |       |        |     
|                                                                  |                              |                                                                 | Basic   |        | $      | 1.60 |       |       | $      | 2.01 |        |       | $      | 2.11 | 
|                                                                  |                              |                                                                 |         |        |        |      |       |       |        |      |        |      
|                                                                  |                              |                                                                 | Diluted |        | $      | 1.54 |       |       | $      | 1.92 |        |       | $      | 2.10 | 
|                                                                  |                              |                                                                 |         |        |        |      |       |       |        |      |        |      

F-33



---



##### Table of Contents



SCHEDULE I  CONDENSED FINANCIAL
INFORMATION OF REGISTRANT  (Continued)


THE ALLIED DEFENSE GROUP, INC.

(Parent Company)


STATEMENTS OF CASH FLOWS


|                                                                 |                                                                                           |                         |                                                                  |                                           |     |         |        |        |     |         |        |        |    |         |       |  
|---------------------------------------------------------------- | ----------------------------------------------------------------------------------------- | ----------------------- | ---------------------------------------------------------------- | ----------------------------------------- | --- | ------- | ------ | ------ | --- | ------- | ------ | ------ | -- | ------- | ----- | -
|                                                                 |                                                                                           |                        
|                                                                 |                                                                                           | Year ended December 31,
|                                                                 |                                                                                           |                        
|                                                                 |                                                                                           | 2003                    |                                                                  | 2002                                      |     | 2001   
|                                                                 |                                                                                           |                         |                                                                  |                                           |     |        
|                                                                 |                                                                                           |                        
|                                                                 |                                                                                           | (Thousands of Dollars) 
|Cash flows from operating activities                             |                                                                                           |                         |                                                                  |                                           |     |         |        |        |     |         |        |       
|                                                                 | Net earnings for the year                                                                 |                         | $                                                                | 8,821                                     |     |         | $      | 10,672 |     |         | $      | 10,367 |   
|                                                                 | Adjustments to reconcile net earnings to net cash
    from (used in) operating activities |                         |                                                                  |                                           |     |         |        |        |     |         |        |        |   
|                                                                 |                                                                                           |                         | Equity in operations of subsidiaries                             |                                           |     | (11,312 | )      |        |     | (12,233 | )      |        |    | (11,779 | )    
|                                                                 |                                                                                           |                         | Dividend from subsidiary                                         |                                           |     | 14,186  |        |        |     | 4,883   |        |        |    |        |      
|                                                                 |                                                                                           |                         | Depreciation and amortization                                    |                                           |     | 46      |        |        |     | 297     |        |        |    | 15      |      
|                                                                 |                                                                                           |                         | Deferred taxes                                                   |                                           |     | (375    | )      |        |     | 953     |        |        |    | (721    | )    
|                                                                 |                                                                                           |                         | Amortization of debenture issue costs and
    conversion feature |                                           |     | 243     |        |        |     |        |        |        |    |        |      
|                                                                 |                                                                                           |                         | Deferred compensation                                            |                                           |     | 191     |        |        |     |        |        |        |    |        |      
|                                                                 |                                                                                           |                         | Common stock awards and grants                                   |                                           |     | 111     |        |        |     | 651     |        |        |    | 582     |      
|                                                                 |                                                                                           |                         | Changes in assets and liabilities                                |                                           |     |         |        |        |     |         |        |        |    |         |      
|                                                                 |                                                                                           |                         |                                                                  | Other assets                              |     |         | (546   | )      |     |         | 342    |        |    |         | 845   |  
|                                                                 |                                                                                           |                         |                                                                  | Due to subsidiaries                       |     |         | (3,492 | )      |     |         | (2,504 | )      |    |         | 1,552 |  
|                                                                 |                                                                                           |                         |                                                                  | Accounts payable and accrued liabilities  |     |         | (30    | )      |     |         | (1,489 | )      |    |         | 185   |  
|                                                                 |                                                                                           |                         |                                                                  | Income taxes                              |     |         |       |        |     |         | (238   | )      |    |         | 120   |  
|                                                                 |                                                                                           |                         |                                                                  |                                           |     |         |        |        |     |         |        |       
|                                                                 |                                                                                           |                         | (978                                                             | )                                         |     |         | (9,338 | )      |     |         | (9,201 | )     
|                                                                 |                                                                                           |                         |                                                                  |                                           |     |         |        |        |     |         |        |       
|                                                                 |                                                                                           |                         |                                                                  | Net cash provided by operating activities |     |         | 7,843  |        |     |         | 1,334  |        |    |         | 1,166 |  
|Cash flows used in investing activities                          |                                                                                           |                         |                                                                  |                                           |     |         |        |        |     |         |        |       
|                                                                 | Capital expenditures                                                                      |                         |                                                                  | (3                                        | )   |         |        | (328   | )   |         |        |       |   
|                                                                 | Acquisitions                                                                              |                         |                                                                  |                                          |     |         |        | (4,895 | )   |         |        | (556   | ) 
|                                                                 |                                                                                           |                         |                                                                  |                                           |     |         |        |        |     |         |        |       
|                                                                 |                                                                                           |                         |                                                                  | Net cash used in investing activities     |     |         | (3     | )      |     |         | (5,223 | )      |    |         | (556  | )
|Cash flows from financing activities                             |                                                                                           |                         |                                                                  |                                           |     |         |        |        |     |         |        |       
|                                                                 | Proceeds from convertible
    subordinated debenture                                      |                         |                                                                  |                                          |     |         |        | 7,500  |     |         |        |       |   
|                                                                 | Debenture issue costs                                                                     |                         |                                                                  |                                          |     |         |        | (158   | )   |         |        |       |   
|                                                                 | Proceeds from employee stock purchase
    plan shares                                     |                         |                                                                  | 152                                       |     |         |        | 169    |     |         |        | 586    |   
|                                                                 | Option exercises                                                                          |                         |                                                                  | 765                                       |     |         |        | 62     |     |         |        |       |   
|                                                                 | Restricted cash                                                                           |                         |                                                                  | 125                                       |     |         |        | (250   | )   |         |        |       |   
|                                                                 |                                                                                           |                         |                                                                  |                                           |     |         |        |        |     |         |        |       
|                                                                 |                                                                                           |                         |                                                                  | Net cash provided by financing activities |     |         | 1,042  |        |     |         | 7,323  |        |    |         | 586   |  
|                                                                 |                                                                                           |                         |                                                                  |                                           |     |         |        |        |     |         |        |       
|                                                                 |                                                                                           |                         |                                                                  | Net increase in cash and equivalents      |     |         | 8,882  |        |     |         | 3,434  |        |    |         | 1,196 |  
|Cash and equivalents at beginning of year                        |                                                                                           |                         | 6,157                                                            |                                           |     |         | 2,723  |        |     |         | 1,527  |       
|                                                                 |                                                                                           |                         |                                                                  |                                           |     |         |        |        |     |         |        |       
|Cash and equivalents at end of year                              |                                                                                           | $                       | 15,039                                                           |                                           |     | $       | 6,157  |        |     | $       | 2,723  |       
|                                                                 |                                                                                           |                         |                                                                  |                                           |     |         |        |        |     |         |        |       
|Supplemental Disclosures of Cash Flow
    Information:           |                                                                                           |                         |                                                                  |                                           |     |         |        |        |     |         |        |       
|                                                                 | Cash paid during the year for:                                                            |                         |                                                                  |                                           |     |         |        |        |     |         |        |        |   
|                                                                 |                                                                                           | Income taxes            |                                                                  | $                                         |    |         |        | $      | 360 |         |        | $      | 44 |        
|                                                                 |                                                                                           | Interest                |                                                                  |                                           | 590 |         |        |        | 36  |         |        |        | 1  |        
|Supplemental of Non-Cash Investing and
    Financing Activities: |                                                                                           |                         |                                                                  |                                           |     |         |        |        |     |         |        |       
|                                                                 | Non-cash consideration in connection with
    business acquisition                        |                         |                                                                  |                                          |     |         | $      | 6,473  |     |         | $      | 6,833  |   
|                                                                 | Warrants issued in conjunction with
    convertible debenture                             |                         |                                                                  |                                          |     |         |        | 140    |     |         |        |       |   
|                                                                 | Convertible debenture beneficial
    conversion feature                                   |                         |                                                                  |                                          |     |         |        | 138    |     |         |        |       |   

F-34



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##### Table of Contents



SCHEDULE II  VALUATION AND
QUALIFYING ACCOUNTS

THE ALLIED DEFENSE GROUP, INC.

Valuation and Qualifying Accounts

Years ended December 31, 2003, 2002 and
2001

|                                 |                                             |                        |   |            |  |          |   |            |  |           |   |   |  |  |   |     |     |  |   |       | 
|-------------------------------- | ------------------------------------------- | ---------------------- | - | ---------- |  | -------- | - | ---------- |  | --------- | - | - |  |  | - | --- | --- |  | - | ----- | 
|                                 |                                             |                        |   |            |  |          |   |           
|                                 |                                             |                        |   | Additions  |  |          |   |           
|                                 |                                             |                        |   |            |  |          |   |           
|                                 |                                             | Balance at             |   | Charged to |  | Charged  |   |            |  | Balance  
|                                 |                                             | beginning              |   | costs and  |  | to other |   |            |  | at end of
|Description                      |                                             | of period              |   | expenses   |  | accounts |   | Deductions |  | period   
|                                 |                                             |                        |   |            |  |          |   |            |  |          
|                                 |                                             |                       
|                                 |                                             | (Thousands of Dollars)
|Year ended December 31,
    2003 |                                             |                        |   |            |  |          |   |            |  |           |   |   |  |  |   |     |     |  |   |      
|                                 | Estimated losses on contracts               |                        | $ | 313        |  |          | $ | 283        |  |           | $ |  |  |  | $ | 313 | (1) |  | $ | 283   | 
|                                 |                                             |                        |   |            |  |          |   |            |  |           |   |   |  |  |   |     |     |  |   |      
|                                 | Allowance for doubtful receivables          |                        | $ | 233        |  |          | $ | 115        |  |           | $ |  |  |  | $ | 233 | (2) |  | $ | 115   | 
|                                 |                                             |                        |   |            |  |          |   |            |  |           |   |   |  |  |   |     |     |  |   |      
|                                 | Valuation allowance on inventory            |                        | $ | 200        |  |          | $ | 14         |  |           | $ |  |  |  | $ |    |     |  | $ | 214   | 
|                                 |                                             |                        |   |            |  |          |   |            |  |           |   |   |  |  |   |     |     |  |   |      
|                                 | Valuation allowances on deferred tax assets |                        | $ | 1,244      |  |          | $ | 2,985      |  |           | $ |  |  |  | $ |    |     |  | $ | 4,229 | 
|                                 |                                             |                        |   |            |  |          |   |            |  |           |   |   |  |  |   |     |     |  |   |      
|Year ended December 31,
    2002 |                                             |                        |   |            |  |          |   |            |  |           |   |   |  |  |   |     |     |  |   |      
|                                 | Estimated losses on contracts               |                        | $ | 382        |  |          | $ | 313        |  |           | $ |  |  |  | $ | 382 | (1) |  | $ | 313   | 
|                                 |                                             |                        |   |            |  |          |   |            |  |           |   |   |  |  |   |     |     |  |   |      
|                                 | Allowance for doubtful receivables          |                        | $ | 107        |  |          | $ | 126        |  |           | $ |  |  |  | $ |    |     |  | $ | 233   | 
|                                 |                                             |                        |   |            |  |          |   |            |  |           |   |   |  |  |   |     |     |  |   |      
|                                 | Valuation allowance on inventory            |                        | $ | 150        |  |          | $ | 50         |  |           | $ |  |  |  | $ |    |     |  | $ | 200   | 
|                                 |                                             |                        |   |            |  |          |   |            |  |           |   |   |  |  |   |     |     |  |   |      
|                                 | Valuation allowances on deferred tax assets |                        | $ | 271        |  |          | $ | 973        |  |           | $ |  |  |  | $ |    |     |  | $ | 1,244 | 
|                                 |                                             |                        |   |            |  |          |   |            |  |           |   |   |  |  |   |     |     |  |   |      
|Year ended December 31,
    2001 |                                             |                        |   |            |  |          |   |            |  |           |   |   |  |  |   |     |     |  |   |      
|                                 | Estimated losses on contracts               |                        | $ | 712        |  |          | $ | 382        |  |           | $ |  |  |  | $ | 712 | (1) |  | $ | 382   | 
|                                 |                                             |                        |   |            |  |          |   |            |  |           |   |   |  |  |   |     |     |  |   |      
|                                 | Allowance for doubtful receivables          |                        | $ | 154        |  |          | $ |           |  |           | $ |  |  |  | $ | 47  | (2) |  | $ | 107   | 
|                                 |                                             |                        |   |            |  |          |   |            |  |           |   |   |  |  |   |     |     |  |   |      
|                                 | Valuation allowances on deferred tax assets |                        | $ | 288        |  |          | $ |           |  |           | $ |  |  |  | $ | 17  |     |  | $ | 271   | 
|                                 |                                             |                        |   |            |  |          |   |            |  |           |   |   |  |  |   |     |     |  |   |      



---



|    |                                                                           
|--- | --------------------------------------------------------------------------
|(1) | Represents amount of reserve relieved through
    completion of contracts.
|   
|(2) | Represents write-off of receivables.                                      

F-35



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##### Table of Contents



EXHIBIT INDEX

|       |      |                        |  |                                                                                                                                                          |  | 
|------ | ---- | ---------------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------- |  | 
|Number |      | Description of Exhibit |  |                                                                                                                                                         
|       |      |                        |  |                                                                                                                                                         
|       | 21   |                        |  | List of Subsidiaries                                                                                                                                     |  | 
|       | 23   |                        |  | Consent of Independent Certified
    Public Accountants                                                                                                  |  | 
|       | 31.1 |                        |  | Certification of Chief Executive Officer pursuant
    to Section 302 of Sarbanes-Oxley Act of 2002, dated March
    15, 2004                             |  | 
|       | 31.2 |                        |  | Certification of Chief Financial Officer pursuant
    to Section 302 of Sarbanes-Oxley Act of 2002, dated March
    15, 2004                             |  | 
|       | 32   |                        |  | Certification of Chief Executive Officer and
    Chief Financial Officer pursuant to Section 906 of
    Sarbanes-Oxley Act of 2002, dated March 15, 2004 |  |