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United States Securities and Exchange Commission
 Washington, D.C. 20549
 FORM 10-K
  þ
    
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the fiscal year ended December 31, 2006
 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from  to
 Commission file number: 0-21352
 Applied Innovation Inc.
  Delaware
    
    31-1177192(State or other jurisdiction of incorporation or organization)
    
    (I.R.S. Employer Identification No.)
 5800 Innovation Drive, Dublin, Ohio 43016
 614-798-2000
  Title of each class:
    
    Name of exchange on which registered:Common Stock, $0.01 par value per share
    
    Nasdaq
 None
 o þ
 o þ
 þ o
 o
  o o þ
 o þ




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TABLE OF CONTENTS  PART IITEM ONE | BusinessITEM ONE A | Risk FactorsITEM ONE B | Unresolved Staff CommentsITEM TWO | PropertiesITEM THREE | Legal ProceedingsITEM FOUR | Submission of Matters to a Vote of Security HoldersPART IIITEM FIVE | Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesITEM SIX | Selected Financial DataITEM SEVEN | Managements Discussion and Analysis of Financial Condition and Results of OperationITEM SEVEN A | Quantitative and Qualitative Disclosures About Market RiskITEM EIGHT | Financial Statements and Supplementary DataITEM NINE Changes in and Disagreements with Accountants on Accounting and Financial DisclosureITEM NINE A Controls and ProceduresITEM NINE B Other InformationPART IIIITEM TEN Directors, Executive Officers and Corporate GovernanceITEM ELEVEN Executive CompensationITEM TWELVE Security Ownership of Certain Beneficial Owners and Management and Related Stockholder MattersITEM THIRTEEN Certain Relationships and Related Transactions, and Director IndependenceITEM FOURTEEN Principal Accountant Fees and ServicesPART IVITEM FIFTEEN Exhibits Financial Statement SchedulesSIGNATURESEX-23EX-24EX-31.1EX-31.2EX-32.1EX-32.2    Table of Contents  This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section
21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of
1933, as amended. The words anticipate, believe, expect, estimate, project and similar
words and expressions identify forward-looking statements which speak only as of the date hereof.
Investors are cautioned that such statements involve risks and uncertainties that could cause
actual results to differ materially from historical or anticipated results due to many factors,
including, but not limited to, the factors discussed in Item One A  Risk Factors. The Company
undertakes no obligation to publicly update or revise any forward-looking statements.
 
 PART I
 
  All references to we, us, our, Applied Innovation, AI, or the Company in this
Annual Report on Form 10-K mean Applied Innovation Inc.
    THE COMPANYS MARKETS
      1




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PRODUCTS
 Hardware Solutions
 AI AI
 AI AI AI
 AI AI AI AI
 AI AI AI AI AI
 AI AI AI
 AI AI
 AI AI AI AI .
 AI AI AI AI
 Financial Disclosures
 Network Management Software Solutions
  2




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AI AI AI
 ®
 Financial Disclosures
 Services Solutions
    Financial Disclosures
  MANUFACTURING AND OPERATIONS
  3




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MARKETING, BUSINESS DEVELOPMENT AND SALES
     SIGNIFICANT CUSTOMERS
  RESEARCH AND DEVELOPMENT
 AI AI AI
 4




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AI
 AI
 AI
  SERVICES, CUSTOMER SERVICE AND WARRANTY
      COMPETITION
   INTELLECTUAL PROPERTY
  5




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SUPPLIERS AND RAW MATERIALS
  SEASONALITY
  PERSONNEL
  
  We desire to take advantage of the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. In addition to the other information in this report, readers should
carefully consider that the following important factors, among others, in some cases have affected,
and in the future could affect, our actual results and could cause our actual consolidated results
of operations for the year ended December 31, 2007 and beyond, to differ materially from those
expressed in any forward-looking statements made by us, or on our behalf.
 The Pending Merger with KEG Holdings may not occur at all.
  Because a small number of customers account for a high percentage of our sales and there are only a
small number of potential customers in our industry, the loss of a key customer could have a
negative impact on our business, operating results and financial condition.
  6




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A large portion of our revenues is derived from the sale, service and support of our AIswitch
family of products and a decline in the demand for such product family could have a material
adverse affect on our business, financial condition and results of operation.
 AI
 Our ability to succeed in the future may depend upon our ability to adapt to rapidly changing
technologies and customer requirements by our ability to enhance existing products and develop and
introduce new products.
   The market for supplying equipment and services to telecommunications service providers is highly
 7




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competitive, and, if we cannot compete effectively, our ability to grow our business or even to
maintain revenues and earnings at current levels, will be impaired.
  Our products are dependent in part upon our proprietary technology.
   We rely on the availability of raw materials and licensed technology on commercially reasonable
terms for our products.
  If we are unable to meet our additional capital needs in the future, we may miss expansion
opportunities or find ourselves unable to respond to actions by our competitors, which could impair
our competitive position and hurt sales and earnings.
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Our historical operating results may not necessarily be indicative of our future growth.
  Product problems may seriously harm our credibility and have a significant impact on our revenues,
earnings and growth prospects.
  We may fail to meet market expectations because of fluctuations in our quarterly operating results,
which could cause our stock price to decline. In addition, a small number of customers account for
a high percentage of our net sales. There are only a small number of potential major customers in
our primary markets, and the loss of a key customer could have a negative impact on our operating
results and cause our stock price to decline.
  9




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We rely on the expertise of certain key personnel.
  There is a limited market for trading in our common stock and our stock price has been volatile.
  We have certain anti-takeover provisions in our Certificate of Incorporation and Bylaws that may
make it difficult for a third party to acquire us.
  Ownership of our common stock is concentrated among a few shareholders, who may be able to exert
substantial influence over our company.
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We are subject to various regulations and may be a party to litigation from time to time.
  
   
   
   
   11




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PART II
 
   2006
    
    2005High
    
    Low
    
    High
    
    LowQ1
    
    $
    4.40
    
    
    $
    3.21
    
    
    $
    4.02
    
    
    $
    3.28Q2
    
    $
    4.50
    
    
    $
    3.53
    
    
    $
    4.96
    
    
    $
    3.43Q3
    
    $
    3.90
    
    
    $
    3.01
    
    
    $
    5.37
    
    
    $
    3.84Q4
    
    $
    3.46
    
    
    $
    3.05
    
    
    $
    3.91
    
    
    $
    3.20
   12




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Selected Consolidated Financial Data
 Years ended December 31,2006
    
    
    2005
    
    
    2004
    
    
    2003
    
    
    2002Operating Data:Sales
    
    $
    30,589,528
    
    
    $
    31,689,787
    
    
    $
    31,396,937
    
    
    $
    33,968,086
    
    
    $
    42,961,011Cost of sales
    
    
    15,131,527
    
    
    
    13,956,778
    
    
    
    14,524,397
    
    
    
    16,353,637
    
    
    
    23,556,671Gross profit
    
    
    15,458,001
    
    
    
    17,733,009
    
    
    
    16,872,540
    
    
    
    17,614,449
    
    
    
    19,404,340Selling, general and administrative expenses
    
    
    9,384,521
    
    
    
    10,184,754
    
    
    
    13,178,399
    
    
    
    13,689,576
    
    
    
    18,413,456Research and development expenses
    
    
    3,982,226
    
    
    
    4,416,058
    
    
    
    5,119,677
    
    
    
    5,575,652
    
    
    
    7,084,646Restructuring charges
    
    
    
    
    
    
    873,083
    
    
    
    605,804
    
    
    
    (32,237
    )
    
    
    2,890,155Gain on sale of land
    
    
    (1,035,937
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total operating expenses
    
    
    12,330,810
    
    
    
    15,473,895
    
    
    
    18,903,880
    
    
    
    19,232,991
    
    
    
    28,388,257Income (loss) from operations
    
    
    3,127,191
    
    
    
    2,259,114
    
    
    
    (2,031,340
    )
    
    
    (1,618,542
    )
    
    
    (8,983,917
    )Interest and other income, net
    
    
    1,659,989
    
    
    
    821,866
    
    
    
    451,756
    
    
    
    393,057
    
    
    
    597,137Income (loss) before income taxes
    
    
    4,787,180
    
    
    
    3,080,980
    
    
    
    (1,579,584
    )
    
    
    (1,225,485
    )
    
    
    (8,386,780
    )Income tax expense (benefit)
    
    
    1,533,000
    
    
    
    978,000
    
    
    
    (787,000
    )
    
    
    (690,000
    )
    
    
    (3,532,000
    )Net income (loss)
    
    $
    3,254,180
    
    
    $
    2,102,980
    
    
    $
    (792,584
    )
    
    $
    (535,485
    )
    
    $
    (4,854,780
    )Basic income (loss) per share
    
    $
    0.21
    
    
    $
    0.14
    
    
    $
    (0.05
    )
    
    $
    (0.04
    )
    
    $
    (0.32
    )Diluted income (loss) per share
    
    $
    0.21
    
    
    $
    0.14
    
    
    $
    (0.05
    )
    
    $
    (0.04
    )
    
    $
    (0.32
    )Shares used in computing basic income (loss) per share
    
    
    15,256,622
    
    
    
    15,189,895
    
    
    
    15,077,118
    
    
    
    14,994,924
    
    
    
    15,092,328Shares used in computing diluted income (loss) per share
    
    
    15,264,770
    
    
    
    15,238,730
    
    
    
    15,077,118
    
    
    
    14,994,924
    
    
    
    15,092,328Balance Sheet Data:Cash and short-term and non-current investments
    
    $
    35,266,473
    
    
    $
    30,092,267
    
    
    $
    25,697,634
    
    
    $
    27,973,038
    
    
    $
    23,964,017Net working capital
    
    
    27,486,240
    
    
    
    24,037,792
    
    
    
    20,777,822
    
    
    
    20,957,201
    
    
    
    25,127,859Total assets
    
    
    52,904,858
    
    
    
    50,507,466
    
    
    
    47,397,922
    
    
    
    49,882,879
    
    
    
    50,384,908Stockholders equity
    
    
    48,898,362
    
    
    
    45,389,807
    
    
    
    42,939,795
    
    
    
    43,476,636
    
    
    
    43,299,366
 13




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SAFE HARBOR STATEMENT
  OVERVIEW
     14




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AI AI AI AI AI
 AI AI AIr AI AI AI AI
   15




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COMPARISON OF 2006 TO 2005
 Total Sales and Gross Profit
    16




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GrossSales
    
    Gross Profit
    Profit %For the
Year ended
December
31, 2006:Products
    
    $
    25,929,000
    
    
    $
    13,093,000
    
    
    50
    %Services
    
    
    4,661,000
    
    
    
    2,365,000
    
    
    51
    %Total
    
    $
    30,590,000
    
    
    $
    15,458,000
    
    
    51
    %For the Year
ended December
31, 2005:Products
    
    $
    25,835,000
    
    
    $
    13,804,000
    
    
    53
    %Services
    
    
    5,855,000
    
    
    
    3,929,000
    
    
    67
    %Total
    
    $
    31,690,000
    
    
    $
    17,733,000
    
    
    56
    %
 Products Sales and Gross Profit
    Services Sales and Gross Profit
    Selling, General and Administrative Expenses
  Research and Development Expenses
  Restructuring Charges
  17




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Gain on Sale of Land
  Interest and Other Income, Net
  Income Taxes
  Net Income and Income Per Share
  Assets
  Liabilities and Stockholders Equity
   18




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COMPARISON OF 2005 TO 2004
 Total Sales and Gross Profit
     GrossSales
    
    
    Gross Profit
    
    
    Profit %For the
Year ended
December
31, 2005:Products
    
    $
    25,835,000
    
    
    $
    13,804,000
    
    
    
    53
    %Services
    
    
    5,855,000
    
    
    
    3,929,000
    
    
    
    67
    %Total
    
    $
    31,690,000
    
    
    $
    17,733,000
    
    
    
    56
    %For the Year
ended December
31, 2004:Products
    
    $
    25,876,000
    
    
    $
    13,785,000
    
    
    
    53
    %Services
    
    
    5,521,000
    
    
    
    3,088,000
    
    
    
    56
    %Total
    
    $
    31,397,000
    
    
    $
    16,873,000
    
    
    
    54
    %
 Products Sales and Gross Profit
    Services Sales and Gross Profit
    19




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Selling, General and Administrative Expenses
  Research and Development Expenses
  Restructuring Charges
    Interest and Other Income, Net
  Income Taxes
  Net Income (Loss) and Income (Loss) Per Share
  Assets
  20




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Liabilities and Stockholders Equity
   LIQUIDITY AND CAPITAL RESOURCES
   Operating Activities
  Investing Activities
  Financing Activities
   APPLICATION OF CRITICAL ACCOUNTING POLICIES
    21




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
    
    Revenue on internally developed software and hardware is recognized in accordance
with the following four elements of revenue recognition: (1) persuasive evidence of an
arrangement exists, (2) delivery has occurred, (3) the related fee is fixed or
determinable and (4) collectibility is reasonably assured. Software license fees are
generally recognized when the software product has been delivered, which is generally the
point at which all four criteria have been met.
    
    Third-party software and equipment revenue are recognized when delivery has
occurred and ownership and risk of loss have transferred. Revenue from resale of
third-party maintenance contracts is generally recorded upon delivery of the maintenance
agreement, provided the Company has no significant continuing obligation related to the
maintenance contract.
    
    Revenue from installation, training and consulting services is generally recognized
upon project completion.
    
    Revenue from maintenance and support agreements is recognized straight-line over
the term of the related agreement.
       22




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23




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CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
    Payments due by periodTotal
    
    Less than 1 year
    
    1-3 yearsOperating lease
    
    $
    19,350
    
    
    $
    12,900
    
    
    $
    6,450Purchase obligations
    
    
    808,964
    
    
    
    808,964
    
    
    
    Total
    
    $
    828,314
    
    
    $
    821,864
    
    
    $
    6,450
 IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
      24




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Report of Independent Registered Public Accounting Firm
 
    Share-Based Payment
  
 25




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APPLIED INNOVATION INC.
  December 31,2006
    
    
    2005AssetsCurrent assets:Cash and cash equivalents
    
    $
    16,977,282
    
    
    $
    9,874,406Short-term investments
    
    
    6,741,338
    
    
    
    10,477,682Accounts receivable, net of allowance of $72,000 in 2006
and $150,000 in 2005
    
    
    2,173,976
    
    
    
    4,273,406Inventory, net
    
    
    3,972,632
    
    
    
    2,997,403Other current assets
    
    
    509,508
    
    
    
    523,554Deferred income taxes
    
    
    907,000
    
    
    
    1,009,000Total current assets
    
    
    31,281,736
    
    
    
    29,155,451Property, plant and equipment, net
    
    
    5,112,106
    
    
    
    5,898,916Investments
    
    
    11,547,853
    
    
    
    9,740,179Goodwill
    
    
    3,525,801
    
    
    
    3,525,801Deferred income taxes
    
    
    
    
    
    
    808,000Other assets
    
    
    1,437,362
    
    
    
    1,379,119$
    52,904,858
    
    
    $
    50,507,466Liabilities and Stockholders EquityCurrent liabilities:Accounts payable
    
    $
    908,159
    
    
    $
    1,029,777Accrued expenses:Warranty
    
    
    215,000
    
    
    
    336,000Payroll and related expenses
    
    
    573,199
    
    
    
    1,275,036Restructuring
    
    
    
    
    
    
    27,695Income taxes payable
    
    
    241,111
    
    
    
    321,965Taxes, other than income taxes
    
    
    312,707
    
    
    
    396,484Other accrued expenses
    
    
    452,372
    
    
    
    628,658Deferred revenue
    
    
    1,092,948
    
    
    
    1,102,044Total current liabilities
    
    
    3,795,496
    
    
    
    5,117,659Deferred income taxes
    
    
    161,000
    
    
    
    Deferred revenue
    
    
    50,000
    
    
    
    Total liabilities
    
    
    4,006,496
    
    
    
    5,117,659Stockholders equity:Preferred stock; $.01 par value; authorized 5,000,000 shares;
none issued and outstanding
    
    
    
    
    
    
    Common stock; $.01 par value; authorized 55,000,000 shares; issued and
outstanding 15,266,658 shares in 2006 and 15,230,408 shares in 2005
    
    
    152,667
    
    
    
    152,304Additional paid-in capital
    
    
    7,083,945
    
    
    
    6,839,219Retained earnings
    
    
    41,710,028
    
    
    
    38,455,848Accumulated other comprehensive loss, net
    
    
    (48,278
    )
    
    
    (57,564
    )Total stockholders equity
    
    
    48,898,362
    
    
    
    45,389,807$
    52,904,858
    
    
    $
    50,507,466
  26




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APPLIED INNOVATION INC.
  Years ended December 31,2006
    
    
    2005
    
    
    2004Sales:Products
    
    $
    25,928,351
    
    
    $
    25,834,456
    
    
    $
    25,876,037Services
    
    
    4,661,177
    
    
    
    5,855,331
    
    
    
    5,520,900Total sales
    
    
    30,589,528
    
    
    
    31,689,787
    
    
    
    31,396,937Cost of sales:Products
    
    
    12,835,266
    
    
    
    12,030,064
    
    
    
    12,091,272Services
    
    
    2,296,261
    
    
    
    1,926,714
    
    
    
    2,433,125Total cost of sales
    
    
    15,131,527
    
    
    
    13,956,778
    
    
    
    14,524,397Gross profit
    
    
    15,458,001
    
    
    
    17,733,009
    
    
    
    16,872,540Operating expenses:Selling, general and administrative
    
    
    9,384,521
    
    
    
    10,184,754
    
    
    
    13,178,399Research and development
    
    
    3,982,226
    
    
    
    4,416,058
    
    
    
    5,119,677Restructuring charges
    
    
    
    
    
    
    873,083
    
    
    
    605,804Gain on sale of land
    
    
    (1,035,937
    )
    
    
    
    
    
    
    Total operating expenses
    
    
    12,330,810
    
    
    
    15,473,895
    
    
    
    18,903,880Income (loss) from operations
    
    
    3,127,191
    
    
    
    2,259,114
    
    
    
    (2,031,340
    )Interest and other income, net
    
    
    1,659,989
    
    
    
    821,866
    
    
    
    451,756Income (loss) before income taxes
    
    
    4,787,180
    
    
    
    3,080,980
    
    
    
    (1,579,584
    )Income tax expense (benefit)
    
    
    1,533,000
    
    
    
    978,000
    
    
    
    (787,000
    )Net income (loss)
    
    $
    3,254,180
    
    
    $
    2,102,980
    
    
    $
    (792,584
    )Income (loss) per share:Basic income (loss) per share
    
    $
    0.21
    
    
    $
    0.14
    
    
    $
    (0.05
    )Diluted income (loss) per share
    
    $
    0.21
    
    
    $
    0.14
    
    
    $
    (0.05
    )Weighted-average shares outstanding
for basic income (loss) per share
    
    
    15,256,622
    
    
    
    15,189,895
    
    
    
    15,077,118Weighted-average shares outstanding
for diluted income (loss) per share
    
    
    15,264,770
    
    
    
    15,238,730
    
    
    
    15,077,118
  27




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APPLIED INNOVATION INC.
  Common stockNumber
    
    
    
    
    
    
    Additional
    
    
    
    
    
    
    Accumulatedof shares
    
    
    
    
    
    
    paid-in
    
    
    Retained
    
    
    other comprehen-outstanding
    
    
    Amount
    
    
    capital
    
    
    earnings
    
    
    sive gain (loss), net
    
    
    TotalsBalance  December 31, 2003
    
    
    15,033,409
    
    
    $
    150,334
    
    
    $
    6,140,540
    
    
    $
    37,145,452
    
    
    $
    40,310
    
    
    $
    43,476,636Comprehensive loss:Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (792,584
    )
    
    
    
    
    
    
    (792,584
    )Unrealized loss on
investments, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (29,112
    )
    
    
    (29,112
    )Total comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (821,696
    )Stock options exercised
    
    
    40,600
    
    
    
    406
    
    
    
    155,330
    
    
    
    
    
    
    
    
    
    
    
    155,736Stock issued for employee
stock purchase plan
    
    
    28,714
    
    
    
    287
    
    
    
    94,702
    
    
    
    
    
    
    
    
    
    
    
    94,989Stock issued to non-employees
    
    
    4,644
    
    
    
    47
    
    
    
    15,953
    
    
    
    
    
    
    
    
    
    
    
    16,000Tax benefit associated with
exercise of stock options
    
    
    
    
    
    
    
    
    
    
    18,130
    
    
    
    
    
    
    
    
    
    
    
    18,130Balance  December 31, 2004
    
    
    15,107,367
    
    
    $
    151,074
    
    
    $
    6,424,655
    
    
    $
    36,352,868
    
    
    $
    11,198
    
    
    $
    42,939,795Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,102,980
    
    
    
    
    
    
    
    2,102,980Unrealized loss on
investments, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (68,762
    )
    
    
    (68,762
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,034,218Stock options exercised
    
    
    95,200
    
    
    
    952
    
    
    
    299,803
    
    
    
    
    
    
    
    
    
    
    
    300,755Stock issued to non-employees
    
    
    2,286
    
    
    
    23
    
    
    
    7,977
    
    
    
    
    
    
    
    
    
    
    
    8,000Stock issued for employee
stock purchase plan
    
    
    25,555
    
    
    
    255
    
    
    
    79,081
    
    
    
    
    
    
    
    
    
    
    
    79,336Tax benefit associated with
exercise of stock options
    
    
    
    
    
    
    
    
    
    
    27,703
    
    
    
    
    
    
    
    
    
    
    
    27,703Balance  December 31, 2005
    
    
    15,230,408
    
    
    $
    152,304
    
    
    $
    6,839,219
    
    
    $
    38,455,848
    
    
    $
    (57,564
    )
    
    $
    45,389,807Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,254,180
    
    
    
    
    
    
    
    3,254,180Unrealized gain on
investments, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9,286
    
    
    
    9,286Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,263,466Stock options exercised
    
    
    23,900
    
    
    
    239
    
    
    
    77,211
    
    
    
    
    
    
    
    
    
    
    
    77,450Stock issued for employee
stock purchase plan
    
    
    12,350
    
    
    
    124
    
    
    
    36,665
    
    
    
    
    
    
    
    
    
    
    
    36,789Employee stock compensation
and stock option plans
    
    
    
    
    
    
    
    
    
    
    126,864
    
    
    
    
    
    
    
    
    
    
    
    126,864Tax benefit associated with
exercise of stock options
    
    
    
    
    
    
    
    
    
    
    3,986
    
    
    
    
    
    
    
    
    
    
    
    3,986Balance  December 31, 2006
    
    
    15,266,658
    
    
    $
    152,667
    
    
    $
    7,083,945
    
    
    $
    41,710,028
    
    
    $
    (48,278
    )
    
    $
    48,898,362
  28




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##### Table of Contents



APPLIED INNOVATION INC.
  Years Ended December 31,2006
    
    
    2005
    
    
    2004Cash flows from operating activities:Net income (loss)
    
    $
    3,254,180
    
    
    $
    2,102,980
    
    
    $
    (792,584
    )Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:Depreciation
    
    
    476,500
    
    
    
    697,824
    
    
    
    1,078,128Amortization of intangible assets
    
    
    
    
    
    
    
    
    
    
    131,250Loss (gain) on disposal of assets
    
    
    (1,245,301
    )
    
    
    19,179
    
    
    
    38,661Deferred income taxes
    
    
    1,063,000
    
    
    
    860,000
    
    
    
    (569,000
    )Non-cash stock compensation
    
    
    126,864
    
    
    
    
    
    
    
    Tax benefit of options exercised
    
    
    
    
    
    
    27,703
    
    
    
    18,130Stock issued to non-employees
    
    
    
    
    
    
    8,000
    
    
    
    16,000Effects of change in operating assets and liabilities:Accounts receivable
    
    
    2,099,430
    
    
    
    384,508
    
    
    
    (1,208,862
    )Inventory
    
    
    (975,229
    )
    
    
    (605,024
    )
    
    
    422,063Other current assets
    
    
    14,046
    
    
    
    47,872
    
    
    
    684,274Other assets
    
    
    (58,243
    )
    
    
    (44,201
    )
    
    
    (19,643
    )Accounts payable
    
    
    (121,618
    )
    
    
    176,337
    
    
    
    63,403Income taxes
    
    
    (80,854
    )
    
    
    (38,952
    )
    
    
    629,204Accrued expenses
    
    
    (1,107,519
    )
    
    
    321,354
    
    
    
    (254,688
    )Deferred revenue
    
    
    40,904
    
    
    
    200,793
    
    
    
    (1,367,748
    )Net cash provided by (used in) operating activities
    
    
    3,486,160
    
    
    
    4,158,373
    
    
    
    (1,131,412
    )Cash flows from investing activities:Purchases of property, plant and equipment
    
    
    (61,824
    )
    
    
    (96,687
    )
    
    
    (646,764
    )Proceeds from sales of property, plant and equipment
    
    
    1,395,918
    
    
    
    21,618
    
    
    
    26,180Purchases of investments
    
    
    (10,157,083
    )
    
    
    (13,507,167
    )
    
    
    (7,809,025
    )Proceeds from maturities of investments
    
    
    11,096,052
    
    
    
    8,335,279
    
    
    
    6,971,705Proceeds from sales of investments
    
    
    1,225,428
    
    
    
    809,313
    
    
    
    831,539Net cash provided by (used in) investing activities
    
    
    3,498,491
    
    
    
    (4,437,644
    )
    
    
    (626,365
    )Cash flows from financing activities:Payment of note payable related to acquisition
    
    
    
    
    
    
    
    
    
    
    (750,000
    )Tax benefit of options exercised
    
    
    3,986
    
    
    
    
    
    
    
    Proceeds from issuance of common stock
    
    
    114,239
    
    
    
    380,091
    
    
    
    250,725Net cash provided by (used in) financing activities
    
    
    118,225
    
    
    
    380,091
    
    
    
    (499,275
    )Increase (decrease) in cash and cash equivalents
    
    
    7,102,876
    
    
    
    100,820
    
    
    
    (2,257,052
    )Cash and cash equivalents  beginning of year
    
    
    9,874,406
    
    
    
    9,773,586
    
    
    
    12,030,638Cash and cash equivalents  end of year
    
    $
    16,977,282
    
    
    $
    9,874,406
    
    
    $
    9,773,586Supplemental cash flow disclosure:Income taxes received (paid), net
    
    $
    (546,868
    )
    
    $
    (86,249
    )
    
    $
    865,335Interest paid
    
    $
    
    
    
    $
    
    
    
    $
    197,163
  29




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##### Table of Contents



(1) Summary of Significant Accounting Policies
  Description of Business Activity
    Principles of Consolidation
  Cash Equivalents
  Investments
   30




---



##### Table of Contents



Allowance for Doubtful Accounts
  Revenue Recognition
      31




---



##### Table of Contents



Inventory
  Property, Plant and Equipment
  Lives (in years)Building
    
    40Equipment
    
    3-5Furniture
    
    7
 Intangible Assets and Goodwill
   Other Assets
  Warranty
  Income Taxes
  32




---



##### Table of Contents



Stock-Based Compensation Plans
     33




---



##### Table of Contents



Research and Development
  General Credit Risk
  Use of Estimates
  Impairment of Long-Lived Assets
   (2) Inventory
  34




---



##### Table of Contents



2006
    
    
    2005Raw materials
    
    $
    3,416,576
    
    
    $
    2,237,102Work-in-process
    
    
    23,719
    
    
    
    136,882Finished goods
    
    
    828,837
    
    
    
    910,4194,269,132
    
    
    
    3,284,403Reserve for obsolescence
    
    
    (296,500
    )
    
    
    (287,000
    )$
    3,972,632
    
    
    $
    2,997,403
  (3) Investments and Financial Instruments
   Amortized
    
    
    Gross unrealized
    
    
    Gross unrealized
    
    
    FairDecember 31, 2006
    
    cost
    
    
    gains
    
    
    losses
    
    
    valueCertificates of deposit
    
    $
    370,020
    
    
    $
    
    
    
    $
    (2,043
    )
    
    $
    367,977Corporate obligations
    
    
    7,577,797
    
    
    
    2,911
    
    
    
    (29,026
    )
    
    
    7,551,682U.S. government agency obligations
    
    
    10,417,652
    
    
    
    4,478
    
    
    
    (52,598
    )
    
    
    10,369,532Total
    
    $
    18,365,469
    
    
    $
    7,389
    
    
    $
    (83,667
    )
    
    $
    18,289,191Reported as:Short-term investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    6,741,338Investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,547,853Total
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    18,289,191
 Amortized
    
    
    Gross unrealized
    
    
    Gross unrealized
    
    
    FairDecember 31, 2005
    
    cost
    
    
    gains
    
    
    losses
    
    
    valueCertificates of deposit
    
    $
    850,568
    
    
    $
    
    
    
    $
    (11,787
    )
    
    $
    838,781Corporate obligations
    
    
    6,438,807
    
    
    
    19
    
    
    
    (22,611
    )
    
    
    6,416,215Marketable equity securities
    
    
    795,398
    
    
    
    121,176
    
    
    
    (37,698
    )
    
    
    878,875U.S. government agency obligations
    
    
    12,226,651
    
    
    
    3,181
    
    
    
    (145,843
    )
    
    
    12,083,990Total
    
    $
    20,311,424
    
    
    $
    124,376
    
    
    $
    (217,939
    )
    
    $
    20,217,861Reported as:Short-term investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    10,477,682Investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9,740,179Total
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    20,217,861
 35




---



##### Table of Contents



Less than 12 months
    
    
    12 months or more
    
    
    TotalUnrealized
    
    
    
    
    
    
    Unrealized
    
    
    
    
    
    
    UnrealizedFair value
    
    
    losses
    
    
    Fair value
    
    
    losses
    
    
    Fair value
    
    
    lossesCertificates of deposit
    
    $
    318,996
    
    
    $
    1,024
    
    
    $
    48,981
    
    
    $
    1,019
    
    
    $
    367,977
    
    
    $
    2,043Corporate obligations
    
    
    1,975,076
    
    
    
    12,776
    
    
    
    2,894,835
    
    
    
    16,250
    
    
    
    4,869,911
    
    
    
    29,026U.S. government agency
obligations
    
    
    2,807,779
    
    
    
    14,587
    
    
    
    6,040,147
    
    
    
    38,011
    
    
    
    8,847,926
    
    
    
    52,598Total
    
    $
    5,101,851
    
    
    $
    28,387
    
    
    $
    8,983,963
    
    
    $
    55,280
    
    
    $
    14,085,814
    
    
    $
    83,667
    (4) Property, Plant and Equipment
  2006
    
    
    2005Land
    
    $
    1,279,044
    
    
    $
    1,639,303Building
    
    
    5,122,365
    
    
    
    5,086,561Equipment
    
    
    6,593,446
    
    
    
    7,593,254Furniture
    
    
    1,970,346
    
    
    
    1,985,76614,965,201
    
    
    
    16,304,884Accumulated depreciation
    
    
    (9,853,095
    )
    
    
    (10,405,968
    )$
    5,112,106
    
    
    $
    5,898,916
 36




---



##### Table of Contents



(5) Warranty
    Years ended December 31,2006
    
    
    2005Beginning balance
    
    $
    336,000
    
    
    $
    425,000Warranty provision
    
    
    190,473
    
    
    
    248,740Warranty costs incurred
    
    
    (311,473
    )
    
    
    (337,740
    )Ending balance
    
    $
    215,000
    
    
    $
    336,000
 (6) Major Customers and Geographic Data
   Years ended December 31,2006
    
    
    2005
    
    
    2004United States
    
    $
    27,619,143
    
    
    $
    26,228,400
    
    
    $
    29,322,593International
    
    
    2,970,385
    
    
    
    5,461,387
    
    
    
    2,074,344$
    30,589,528
    
    
    $
    31,689,787
    
    
    $
    31,396,937
 (7) Net Income (Loss) Per Share
  Years ended December 31,2006
    
    
    2005
    
    
    2004Net income (loss) available to common stockholders
    
    $
    3,254,180
    
    
    $
    2,102,980
    
    
    $
    (792,584
    )Weighted average shares outstanding  basic
    
    
    15,256,622
    
    
    
    15,189,895
    
    
    
    15,077,118Weighted average shares outstanding  diluted
    
    
    15,264,770
    
    
    
    15,238,730
    
    
    
    15,077,118Basic income (loss) per share
    
    $
    0.21
    
    
    $
    0.14
    
    
    $
    (0.05
    )Diluted income (loss) per share
    
    $
    0.21
    
    
    $
    0.14
    
    
    $
    (0.05
    )
 37




---



##### Table of Contents



(8) Stock Option Plans
    38




---



##### Table of Contents



2006
    
    2005
    
    2004Weighted-average fair value of options granted during the
period using a Black-Scholes option valuation model
    
    $
    1.99
    
    
    $
    3.71
    
    
    $
    4.07Weighted-average assumptions used for grants:Expected volatility
    
    
    59
    %
    
    
    83
    %
    
    
    87
    %Expected term (years)
    
    
    4.9
    
    
    
    5.6
    
    
    
    5.4Risk free interest rate
    
    
    4.74
    %
    
    
    4.10
    %
    
    
    3.10
    %Expected dividend yield
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %
   Income from operations:Before stock-based compensation
    
    $
    3,254,055Less: Stock-based compensation recorded under
SFAS 123(R)
    
    
    (126,864
    )As reported
    
    $
    3,127,191Income before income taxes:Before stock-based compensation
    
    $
    4,914,044Less: Stock-based compensation recorded under
SFAS 123(R)
    
    
    (126,864
    )As reported
    
    $
    4,787,180Net income:Before stock-based compensation
    
    $
    3,339,179Less: Stock-based compensation recorded under
SFAS 123(R)
    
    
    (84,999
    )As reported
    
    $
    3,254,180Net income per share, basic and dilutedBefore stock-based compensation
    
    $
    0.22Less: Stock-based compensation recorded under
SFAS 123(R)
    
    $
    (0.01
    )As reported
    
    $
    0.21
 39




---



##### Table of Contents



2005
    
    
    2004Net income (loss), as reported
    
    $
    2,102,980
    
    
    $
    (792,584
    )Deduct: Total stock-based employee compensation
expense determined under fair value based
method for all awards, net of related tax effects
    
    
    (1,229,995
    )
    
    
    (1,470,146
    )Pro forma net income (loss)
    
    $
    872,985
    
    
    $
    (2,262,730
    )Income (loss) per share:Basic and diluted  as reported
    
    $
    0.14
    
    
    $
    (0.05
    )Basic and diluted  pro forma
    
    $
    0.06
    
    
    $
    (0.15
    )
   Weighted averageNumber of
    
    Weighted average
    
    remaining contractual
    
    Aggregateoptions
    
    exercise price
    
    life (in years)
    
    intrinsic valueBalance at December 31, 2005
    
    
    1,192,400
    
    
    $
    6.33Granted
    
    
    571,250
    
    
    $
    3.86Exercised
    
    
    (23,900
    )
    
    $
    3.07Forfeited
    
    
    (411,700
    )
    
    $
    3.79Expired
    
    
    (118,700
    )
    
    $
    6.00Balance at December 31, 2006
    
    
    1,209,350
    
    
    $
    6.13
    
    
    
    6.27
    
    
    $
    27,379
   Weighted averageNumber of
    
    
    grant dateoptions
    
    
    fair valueNonvested at December 31, 2005
    
    
    247,650
    
    
    $
    3.22Granted
    
    
    571,250
    
    
    $
    1.99Vested
    
    
    (66,450
    )
    
    $
    4.26Forfeited
    
    
    (411,700
    )
    
    $
    2.26Nonvested at December 31, 2006
    
    
    340,750
    
    
    $
    4.84
  40




---



##### Table of Contents



OPTIONS OUTSTANDING
    
    OPTIONS EXERCISABLEWeightedaverage
    
    Weighted
    
    
    
    
    
    WeightedRange of
    
    Number
    
    remaining
    
    average
    
    Number
    
    averageexercise prices
    
    outstanding
    
    contractual life
    
    exercise price
    
    exercisable
    
    exercise Price$
    2.96
    
    
    
    
    
    
    $
    3.00
    
    
    
    16,500
    
    
    
    7.55
    
    
    $
    2.96
    
    
    
    6,900
    
    
    $
    2.97$
    3.03
    
    
    
    
    
    
    $
    3.03
    
    
    
    126,050
    
    
    
    6.00
    
    
    $
    3.03
    
    
    
    90,550
    
    
    $
    3.03$
    3.06
    
    
    
    
    
    
    $
    3.62
    
    
    
    128,700
    
    
    
    7.67
    
    
    $
    3.38
    
    
    
    91,200
    
    
    $
    3.38$
    3.64
    
    
    
    
    
    
    $
    4.11
    
    
    
    56,000
    
    
    
    8.82
    
    
    $
    3.76
    
    
    
    10,600
    
    
    $
    3.76$
    4.14
    
    
    
    
    
    
    $
    4.14
    
    
    
    186,250
    
    
    
    9.28
    
    
    $
    4.14
    
    
    
    0
    
    
    $
    0.00$
    4.25
    
    
    
    
    
    
    $
    5.00
    
    
    
    24,500
    
    
    
    7.04
    
    
    $
    4.67
    
    
    
    10,000
    
    
    $
    4.66$
    5.15
    
    
    
    
    
    
    $
    5.15
    
    
    
    161,750
    
    
    
    5.06
    
    
    $
    5.15
    
    
    
    158,750
    
    
    $
    5.15$
    5.20
    
    
    
    
    
    
    $
    6.03
    
    
    
    11,250
    
    
    
    6.10
    
    
    $
    5.68
    
    
    
    11,250
    
    
    $
    5.68$
    6.73
    
    
    
    
    
    
    $
    6.73
    
    
    
    163,000
    
    
    
    7.00
    
    
    $
    6.73
    
    
    
    154,000
    
    
    $
    6.73$
    6.88
    
    
    
    
    
    
    $
    17.38
    
    
    
    335,350
    
    
    
    3.86
    
    
    $
    10.30
    
    
    
    335,350
    
    
    $
    10.301,209,350
    
    
    
    6.27
    
    
    $
    6.13
    
    
    
    868,600
    
    
    $
    6.98
   (9) Employee Stock Purchase Plan
   (10) Defined Contribution Plan
  41




---



##### Table of Contents



in 2006, 2005 or 2004. For
2006, 2005 and 2004, the total expense related to the plan was $189,909, $176,735 and
$214,359, respectively.
 (11) Income Taxes
  Current
    
    
    Deferred
    
    
    TotalYear ended December 31, 2006:Federal
    
    $
    332,000
    
    
    $
    881,000
    
    
    $
    1,213,000State and local
    
    
    138,000
    
    
    
    182,000
    
    
    
    320,000$
    470,000
    
    
    $
    1,063,000
    
    
    $
    1,533,000Year ended December 31, 2005:Federal
    
    $
    (21,000
    )
    
    $
    817,000
    
    
    $
    796,000State and local
    
    
    101,000
    
    
    
    81,000
    
    
    
    182,000$
    80,000
    
    
    $
    898,000
    
    
    $
    978,000Year ended December 31, 2004:Federal
    
    $
    (310,000
    )
    
    $
    (575,000
    )
    
    $
    (885,000
    )State and local
    
    
    74,000
    
    
    
    24,000
    
    
    
    98,000$
    (236,000
    )
    
    $
    (551,000
    )
    
    $
    (787,000
    )
  2006
    
    
    2005
    
    
    2004Computed tax at the expected federal statutory rate
    
    $
    1,628,000
    
    
    $
    1,048,000
    
    
    $
    (537,000
    )State and local income taxes, net of federal income tax effect
    
    
    288,000
    
    
    
    408,000
    
    
    
    (39,000
    )Change in valuation allowance
    
    
    (169,000
    )
    
    
    (260,000
    )
    
    
    112,000Meals and entertainment expenses
    
    
    30,000
    
    
    
    33,000
    
    
    
    40,000Research and experimentation credit
    
    
    (228,000
    )
    
    
    (172,000
    )
    
    
    37,000Tax contingency reserve adjustment
    
    
    (100,000
    )
    
    
    (89,000
    )
    
    
    (379,000
    )Extraterritorial income exclusion
    
    
    (13,000
    )
    
    
    (50,000
    )
    
    
    Tax-exempt interest income
    
    
    (7,000
    )
    
    
    (12,000
    )
    
    
    (20,000
    )Other
    
    
    104,000
    
    
    
    72,000
    
    
    
    (1,000
    )$
    1,533,000
    
    
    $
    978,000
    
    
    $
    (787,000
    )
   2006
    
    
    
    
    
    
    2005Deferred tax assets:Accounts receivable allowance
    
    $
    26,000
    
    
    
    
    
    
    $
    56,000Inventory, principally due to obsolescence reserve
and additional costs inventoried for tax purposes
    
    
    233,000
    
    
    
    
    
    
    
    215,000Warranty reserve
    
    
    79,000
    
    
    
    
    
    
    
    126,000
 42




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##### Table of Contents



2006
    
    
    
    
    
    
    2005Other accrued expenses
    
    
    88,000
    
    
    
    
    
    
    
    99,000Deferred revenue
    
    
    418,000
    
    
    
    
    
    
    
    414,000Federal tax net operating loss carryforwards
    
    
    
    
    
    
    
    
    
    
    335,000State tax net operating loss carryforwards
    
    
    139,000
    
    
    
    
    
    
    
    453,000Research and experimentation credit carryforwards
    
    
    
    
    
    
    
    
    
    
    434,000Alternative minimum tax credits
    
    
    96,000
    
    
    
    
    
    
    
    56,000SFAS 123(R) stock-based compensation
    
    
    46,000
    
    
    
    
    
    
    
    Other
    
    
    16,000
    
    
    
    
    
    
    
    99,0001,141,000
    
    
    
    
    
    
    
    2,287,000Valuation allowance
    
    
    (75,000
    )
    
    
    
    
    
    
    (244,000
    )Net deferred tax assets
    
    $
    1,066,000
    
    
    
    
    
    
    $
    2,043,000Deferred tax liabilities:Depreciation and amortization
    
    $
    253,000
    
    
    
    
    
    
    $
    180,000Deferred interest
    
    
    67,000
    
    
    
    
    
    
    
    46,000$
    320,000
    
    
    
    
    
    
    $
    226,000
  (12) Equity
   43




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##### Table of Contents



(13) Restructuring Charges
     Lease
    
    
    Employee
    
    
    Employeecommitments,
    
    
    separations,
    
    
    separations,Jannet of sublease
    
    
    October 2004
    
    
    & Feb 2005
    
    
    TotalAccrual balance  December 31, 2004
    
    $
    25,469
    
    
    $
    113,551
    
    
    $
    
    
    
    $
    139,020Restructuring event
    
    
    
    
    
    
    
    
    
    
    965,481
    
    
    
    965,481Cash deductions
    
    
    (13,378
    )
    
    
    (82,473
    )
    
    
    (888,558
    )
    
    
    (984,409
    )Non-cash adjustments
    
    
    (12,091
    )
    
    
    (31,078
    )
    
    
    (49,228
    )
    
    
    (92,397
    )Accrual balance  December 31, 2005
    
    
    
    
    
    
    
    
    
    
    27,695
    
    
    
    27,695Cash deductions
    
    
    
    
    
    
    
    
    
    
    (27,695
    )
    
    
    (27,695
    )Accrual balance  December 31, 2006
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
 (14) Contingencies
  (15) Quarterly Financial Information (Unaudited)
  2006
    
    Q1
    
    Q2
    
    Q3
    
    Q4Net sales
    
    $
    8,406
    
    
    $
    9,374
    
    
    $
    7,746
    
    
    $
    5,064Gross profit
    
    
    4,395
    
    
    
    4,500
    
    
    
    4,001
    
    
    
    2,562Income before income taxes
    
    
    1,804
    
    
    
    1,211
    
    
    
    948
    
    
    
    824Net income
    
    
    1,190
    
    
    
    778
    
    
    
    548
    
    
    
    738Basic net income per share
    
    
    0.08
    
    
    
    0.05
    
    
    
    0.04
    
    
    
    0.05Diluted net income per share
    
    
    0.08
    
    
    
    0.05
    
    
    
    0.04
    
    
    
    0.05
 44




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##### Table of Contents



2005
    
    Q1
    
    Q2
    
    Q3
    
    Q4Net sales
    
    $
    6,933
    
    
    $
    8,021
    
    
    $
    8,424
    
    
    $
    8,312Gross profit
    
    
    4,056
    
    
    
    4,482
    
    
    
    4,662
    
    
    
    4,533Income (loss) before income taxes
    
    
    (447
    )
    
    
    1,175
    
    
    
    1,145
    
    
    
    1,208Net income (loss)
    
    
    (282
    )
    
    
    741
    
    
    
    826
    
    
    
    818Basic net income (loss) per share
    
    
    (0.02
    )
    
    
    0.05
    
    
    
    0.05
    
    
    
    0.05Diluted net income (loss) per share
    
    
    (0.02
    )
    
    
    0.05
    
    
    
    0.05
    
    
    
    0.05
  (16) Subsequent event (Unaudited)
    45




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##### Table of Contents



PART III
 
  Code of Ethics
    
   
   46




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##### Table of Contents



PART IV
 
  (a)
    
    The following documents are filed as part of this report:(1)
    
    Financial Statements
 
    
    Report of Independent Registered Public Accounting Firm
    
    Consolidated Balance Sheets as of December 31, 2006 and 2005
    
    Consolidated Statements of Operations for the years ended December 31, 2006, 2005 and 2004
    
    Consolidated Statements of Stockholders Equity for the years ended December 31,
2006, 2005 and 2004
    
    Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005 and 2004
    
    Notes to Consolidated Financial Statements
 (2)
    
    Financial Statement Schedules
 
    
    Report of Independent Registered Public Accounting Firm
    
    Schedule II (Valuation and Qualifying Accounts)
 (3)
    
    Exhibits
 47




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##### Table of Contents



EXHIBIT NO.
    
    DESCRIPTION2.1
    
    Agreement and Plan of Merger, dated February 22, 2007, among KEG Holdings,
Inc., Buckeye
Merger Co. and Applied Innovation Inc. (Reference is made to Exhibit 2.1 to the
Companys current report on Form 8-K, filed with the Securities and Exchange
Commission on February 23, 2007 and incorporated herein by reference).3.1
    
    Amended and Restated Certificate of Incorporation of the Company. (Reference is
made to Appendix C to the Companys Definitive Proxy Statement for the 2001 Annual
Meeting of Stockholders held on April 26, 2001, filed with the Securities and Exchange
Commission on March 23, 2001, and incorporated herein by reference).3.2
    
    By-laws of the Company, as amended. (Reference is made to Exhibit 3.2 to the
Companys Registration Statement on Form 10-SB, filed with the Securities and Exchange
Commission on March 10, 1993, and incorporated herein by reference).10.1+
    
    Form of Indemnification Agreement between the Company and officers and
directors. (Reference is made to Exhibit 10.8 to the Companys Annual Report on Form
10-K, filed with the Securities and Exchange Commission on March 31, 1994, and
incorporated herein by reference).10.2+
    
    Schedule of Indemnification Agreements. (Reference is made to Exhibit 10.2 to
the Companys Annual Report on Form 10-K filed with the Securities and Exchange
Commission on March 20, 2006, and incorporated herein by reference).10.3+
    
    Companys Amended and Restated 1996 Stock Option Plan. (Reference is made to
Exhibit 10.11 to the Companys Annual Report on Form 10-K, filed with the Securities
and Exchange Commission on March 30, 2000, and incorporated herein by reference).10.4+
    
    Companys 2001 Stock Incentive Plan. (Reference is made to Appendix B to the
Companys Definitive Proxy Statement for the 2001 Annual Meeting of Stockholders held
on April 26, 2001, filed with the Securities and Exchange Commission on March 23, 2001,
and incorporated herein by reference).10.5+
    
    Form of Option Agreement under the Companys 2001 Stock Incentive Plan
(Reference is made to Exhibit 10.1 to the Companys Current Report on Form 8-K filed
with the Securities and Exchange Commission on January 5, 2005, and incorporated herein
by reference).10.6+
    
    Form of Restricted Stock Award Agreement under the Companys 2001 Stock
Incentive Plan (Reference is made to Exhibit 10.1 to the Companys Current Report on
Form 8-K filed with the Securities and Exchange Commission on February 9, 2006, and
incorporated herein by reference).10.7
    
    Companys Employee Stock Purchase Plan. (Reference is made to Appendix A to the
Companys Definitive Proxy Statement for the 2002 Annual Meeting of Stockholders held
on April 25, 2002, filed with the Securities and Exchange Commission on March 22, 2002,
and incorporated herein by reference).10.8+
    
    Employment Agreement between the Company and Eric W. Langille. (Reference is
made to Exhibit 10.2 to the Companys Quarterly Report on Form 10-Q, filed with the
Securities and Exchange Commission on November 14, 2001, and incorporated herein by
reference).10.9+
    
    Employment Agreement between the Company and William H. Largent (Reference is
made to Exhibit 10.1 to the Companys Current Report on Form 8-K/A, filed with the
Securities and Exchange Commission on February 11, 2005, and incorporated herein by
reference).10.10+
    
    Employment Agreement between the Company and Julia Fratianne (Reference is made to
Exhibit 10.1 to the Companys Current Report on Form 8-K, filed with the Securities and
Exchange Commission on December 21, 2005, and incorporated herein by reference).10.11
    
    Description of Base Salaries the Material Terms of the Companys 2006
Management Bonus Program (Reference is made to Exhibit 10.1 to the Companys Current
Report on Form 8-K, filed with the Securities and Exchange Commission on February 15,
2006, and incorporated herein by reference).10.12
    
    Description of Chairman of the Board Fee, Base Salary, and the material terms
of the Amendment to the Companys 2006 Management Bonus Program (Reference is made to
Exhibit
 48




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##### Table of Contents



EXHIBIT NO.
    
    DESCRIPTION10.1 to the Companys Report on Form 8-K, filed with the Securities and Exchange
Commission on May 11, 2006, and incorporated herein by reference).10.13+
    
    Description of Director Compensation (Reference is made to the information under the
heading Compensation of Directors in the Companys Definitive Proxy Statement for the
2006 Annual Meeting of Stockholders held on May 11, 2006, filed with the Securities and
Exchange Commission on April 12, 2006, and incorporated herein by reference).10.16+
    
    Letter Agreement between the Company and John F. Petro (Reference is made to Exhibit
10.1 to the Companys Current Report on Form 8-K, filed with the Securities and
Exchange Commission on July 13, 2006, and incorporated herein by reference).10.17+
    
    Separation Agreement and Release of All Claims between the Company and John F. Petro
(Reference is made to Exhibit 10.2 to the Companys Current Report on Form 8-K, filed
with the Securities and Exchange Commission on July 13, 2006, and incorporated herein
by reference).10.18+
    
    Letter Agreement between the Company and Angela R. Pinette (Reference is made to
Exhibit 10.3 to the Companys Current Report on Form 8-K, filed with the Securities and
Exchange Commission on July 13, 2006, and incorporated herein by reference).10.19+
    
    Separation Agreement and Release of All Claims between the Company and Angela R.
Pinette (Reference is made to Exhibit 10.4 to the Companys Current Report on Form 8-K,
filed with the Securities and Exchange Commission on July 13, 2006, and incorporated
herein by reference).23*
    
    Consent of KPMG LLP.24*
    
    Power of Attorney.31.1*
    
    Rule 13a-14(a) Certification of Principal Executive Officer.31.2*
    
    Rule 13a-14(a) Certification of Principal Financial Officer.32.1**
    
    Section 1350 Certification of Principal Executive Officer.32.2**
    
    Section 1350 Certification of Principal Financial Officer.
 
 *
    
    Filed with this Annual Report on Form 10-K.**
    
    Furnished with this Annual Report on Form 10-K.+
    
    Management contract or compensatory plan or arrangement required to be filed
pursuant to Item 15(b) (b)
    
    Exhibits  The exhibits to this report follow the financial statement schedule and the
independent registered public accounting firms report thereon.(c)
    
    Financial Statement Schedule  The financial statement schedule and the independent
registered public accounting firms report thereon follow the signature page.
 49




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##### Table of Contents



SIGNATURES
  APPLIED INNOVATION INC.Date: March 23, 2007
    
    By:
    
    /s/ William H. LargentWilliam H. LargentChief Executive Officer and Director
  Signature
    
    Title/s/ William H. Largent
    
    William H. LargentChief
Executive Officer and Director
(Principal Executive Officer) 
 March 23, 2007/s/ Julia A. Fratianne
    
    Julia A. FratianneVice
President, Chief Financial Officer and Treasurer
(Principal  Financial and Principal Accounting Officer)
March 23, 2007* Gerard B. Moersdorf, Jr.
    
    Gerard B. Moersdorf, Jr. | Chairman
of the Board  | March 23,  2007* Thomas W. Huseby
    
    Thomas W. Huseby  | Director  |
March 23, 2007* Kenneth E. Jones
    
    Kenneth E. Jones | Director |
March 23, 2007* Curtis A. Loveland
    
    Curtis A. Loveland  | Director |
March 23, 2007* Alexander B. Trevor
    
    Alexander B. Trevor | Director |
March 23, 2007*By: /s/ William H. Largent
    
    William H. Largent (Attorney-in-Fact)
 50




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##### Table of Contents



Report of Independent Registered Public Accounting Firm
 
   Share-Based Payment
  
 APPLIED INNOVATION INC.
 
 Column A
    
    Column B
    
    
    
    Column D
    
    Column EColumn C/----------------Additions------------------/Balance at
    
    Charged to
    
    Charged to
    
    
    
    
    
    Balance atbeginning of
    
    costs and
    
    other
    
    
    
    
    
    end ofDescription
    
    period
    
    expense
    
    accounts
    
    Deductions
    
    periodYEAR ENDED DECEMBER 31, 2006:Allowance for doubtful accounts
    
    $
    150,000
    
    
    $
    
    
    
    $
    
    
    
    $
    78,000
    
    
    $
    72,000Allowance for obsolete inventory
    
    
    287,000
    
    
    
    49,000
    
    
    
    
    
    
    
    39,500
    
    
    
    296,500Warranty provision
    
    
    336,000
    
    
    
    190,473
    
    
    
    
    
    
    
    311,473
    
    
    
    215,000YEAR ENDED DECEMBER 31, 2005:Allowance for doubtful accounts
    
    $
    115,000
    
    
    $
    52,734
    
    
    $
    
    
    
    $
    17,734
    
    
    $
    150,000Allowance for obsolete inventory
    
    
    163,000
    
    
    
    233,000
    
    
    
    
    
    
    
    109,000
    
    
    
    287,000Warranty provision
    
    
    425,000
    
    
    
    248,740
    
    
    
    
    
    
    
    337,740
    
    
    
    336,000YEAR ENDED DECEMBER 31, 2004:Allowance for doubtful accounts
    
    $
    140,000
    
    
    $
    18,170
    
    
    $
    
    
    
    $
    43,170
    
    
    $
    115,000Allowance for obsolete inventory
    
    
    434,000
    
    
    
    146,000
    
    
    
    
    
    
    
    417,000
    
    
    
    163,000Warranty provision
    
    
    479,062
    
    
    
    543,738
    
    
    
    
    
    
    
    597,800
    
    
    
    425,000
 51